This commentary was published with permission in LIPPER HedgeWorld on December 5, 2007. Tavakoli Structured Finance retains the copyright.

Unless you already monetized your gains, you may want to check your documents to make sure they reflect the trade you think you closed. Traders are discovering that they are unsure of what they said some time ago when they put on trades, in which there are now huge gains (or losses). The problem is neither side knows for sure what was meant by the other side when the trade was executed.

Credit derivatives are confusing enough, but indexes add yet another layer of language complexity. You may think you have a gain of say, $100 million, but the other side of your trade may believe you owe them that payment. [Two large banks ended up in arbitration over a trade with more than $300 million at stake.]

How did that happen?

A credit default swap (CDS) is a transaction in which the credit protection buyer pays a fee, usually called a premium, to a credit protection provider (the seller) in exchange for a payment if a credit default event of a reference asset(s) occurs. The buyer of a credit default swap is the credit protection buyer, the premium payer, and is short credit risk. Put another way, the protection buyer is the seller of default risk similar to the seller of a bond. The seller of the credit default swap is the credit protection seller (also called the protection provider), the receiver of the premium and is a buyer of credit risk. The protection seller is long credit risk similar to the buyer of a bond. The protection seller is often called the investor and makes no payment unless a credit default event occurs.

The protection seller and the protection buyers are called credit default swap counterparties. It is no surprise that disputes frequently occur between counterparties. These disputes often arise long after the original transaction, particularly when the back office cannot keep up with the paperwork. Since the amounts involved are usually small, these disputes are often quickly—and invisibly—resolved.

Many hedge funds shorted the newly formed ABX (referencing rated bonds of various home equity loan trusts launched January 2006) and TABX (composed of standard tranches on the ABX.HE Index launched on Feb. 14, 2007). Hedge funds that bought protection early on by shorting one or more of these indexes made a leveraged bet skewed in their favor and rapidly multiplied the value of their hedges. In the language of the credit derivatives market, hedge funds bought protection on the index or shorted the index.

Or did they?

Remember that in the language of credit default swaps, if you buy a credit default swap you are the buyer of protection and short credit risk. Therefore, if you are executing a trade on an index, you must be even more careful to make sure the terms are crystal clear.

If someone on the other end of the phone says they are a seller, what do they mean? Do they mean they are a seller of credit protection and going long the index, or do they mean they are a buyer of credit default protection and are shorting the index? Unless you slow down and go through the exact terms of the transaction and run through the scenario of what each side will pay if you settle the trade after the index declines (or increases), neither side will catch a potentially costly mistake.

Disputes have arisen with these index-based transactions among investment banks facing each other as counterparties, but the amounts involved are much larger than for a typical credit derivatives transaction. Instead of a quick resolution, these disputes will end up in arbitration or in court.

Paulsen and Co. reported billions in gains from shorting the subprime market; Harbinger Capital Partners also reported eye-popping gains; Balestra Capital multiplied their money on transactions of more modest size; Lahde Capital has reported gains of 1,000% according to a Nov. 25 Financial Times article. Hedge funds may wish to review their documents now to see if there are similar disputes in their futures so that they get to monetize all of the gains they believe they have earned.

Read finance articles by Janet Tavakoli