How Hedge Funds Play GM

True, another short squeeze did not happen in January after Kerkorian rebuilt his position back to 9.9%. The stock barely moved then. But Kerkorian was merely replacing shares he sold a couple of months before. The trade could get interesting if Kerkorian tries to teach bears another lesson.

Finally, investors may be at risk due to the extremely high level of credit-derivative swaps written by managers to take long bond positions. Simply put, the writer of a credit-default swap offers credit protection to a buyer on the view that the bond is unlikely to default. If the bond does default, the writer will pay the value of the bond at par to the buyer. Such a bet is the equivalent of taking a long position on a bond without having to materially buy the bond. The writer of the derivative gets a premium for providing this guarantee to the buyer and that is the equivalent of being paid a coupon on the bond. On the other hand, buyers of credit-default swaps take the opposite view. They believe in the likelihood of a default. They have a bearish view. Their position is the equivalent of a short exposure on the bond.

Obviously, if too many people write credit-default swaps on GM and if the company does default, how will buyers of those derivative instruments get paid? That's the risk.

A manager estimates that the credit-default swaps on General Motors represent four times the value of the underlying debt. With a $121 billion debt for GM, such a derivative figure could be astonishingly high. "There will be a financial accident involving credit-default swaps in our future and it may well involve General Motors," says another hedge fund manager.