Funds Swap Into Subprime Short Plays

In essence, buying protection in the form of a credit default swap is the same as shorting the subprime asset-backed securities. The riskiest parts of the ABX index -- the triple-B tranches -- are the best bet for a fall, the hedge fund manager says. As assets become riskier, the swaps go up in value.

"This is a leveraged bet against subprime finance," the manager says.

This is a not a trade that your average retail investor can make. Credit default swaps are traded over the counter by major Wall Street brokers catering to institutional clients.

"A lot of hedge funds are using it," says Ben Logan, managing director of Markit Group, adding that longer-term investors are also buying the swaps. Logan estimates that there is currently $350 billion of default risk being insured against across the ABX index.

As of Tuesday, buying protection on the riskiest subprime indices, the BBB- tranches, cost about 13.4% on a spread basis to cover $10 million of default risk, equating to $1.34 million per year, according to Markit and CDS IndexCo. This is up sharply from 4% at the beginning of the year and 2.2% in September. The spread hit a high of 19.9% in late February, when New Century's stock started to tank.

Whether the ABX index will drop further -- resulting in more profits from those shorting the index -- remains to be seen.