Hedge Funds and Credit Default Swaps

Forbes magazine recently had an article on smart investors who suddenly won big during this summer's credit crunch.

One of those winners was a $12 billion New York City hedge fund called Harbinger Capital Partners.

According to a source, Harbinger started buying credit default swaps on sub-prime mortgages last November.

Each credit default swap meant that Harbinger agreed to pay an insurance premium over the life of a mortgage pool that it did not own. In return, Harbinger would receive a payout on principal losses from the underlying pool.

The Forbes article described it as "buying fire insurance on a building it doesn't own and then hoping for a fire."

But Harbinger didn't need a fire (i.e. the mortgage pool to have actual losses) before it could make a profit.

Like most derivatives, swaps can be resold. There was enough worry during the summer crunch that the swap prices tripled.

Harbinger sent a letter to investors saying that the fund was up 50% through the end of July.