One of the most successful investors to bet on a credit crunch was Jim Melcher, who has run Balestra Capital, a small New York hedge fund, for almost a decade. It has doubled so far this year. He did this by exploiting the complex new debt instruments that are now exploding in the faces of their inventors.
For example, he bought credit default swaps (CDSs) against a range of 30 collateralised debt obligations (CDOs) that were rated AA. Translated into English, he bought insurance against default by packages of loans that were not the highest quality, but were not junk either.
The cost to him, the effective premium, was 0.6 per cent per year. This was the most he could possibly lose from the strategy. The potential profit, if all the bonds issued by the CDOs were to default, was 100 per cent. He now expects to make this on about 20 of the CDOs for which he bought protection. "I've never seen a cheaper play to make where you could take less risk with more return than I was offered in this market," he says. That was a classic value investor's investment - tiny risks to the downside, with potentially huge profits. He is not waiting for the CDOs to go to zero and has taken profits on a third of these bets. In one case this involved taking $7m for an investment that had cost about $50,000 some months earlier.