Thursday, June 11, 2009

You live by the CDS, you die by it?

A Daring Trade Has Wall Street Seething

A canny trade by a small brokerage firm in two markets at the heart of the financial crisis has left some of the biggest players on Wall Street crying foul. The trade, by Amherst Holdings of Austin, Texas, was particularly galling to the big banks because it turned what they believed was a sure-fire profit into a loss. The burned banks include J.P. Morgan Chase & Co., Royal Bank of Scotland Group PLC and Bank of America Corp. Some banks have reached out to two industry trade groups about Amherst's actions, and the groups are reviewing the transaction, according to people familiar with their thinking. "It's all-out warfare" between the banks and Amherst, said a senior banker at one firm that lost money.

Posted by nathan @ 08:39 PM (1280 views)
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14 thoughts on “You live by the CDS, you die by it?

  • It seems you need to be a subscriber to see the whole article, but I managed to access by doing a news.google.com search for the article’s title and then clicking on the link.

    http://news.google.com/news?pz=1&ned=us&hl=en&q=%22A+Daring+Trade+Has+Wall+Street+Seething%22

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  • Essentially RBS, JP Morgan, and other banks purchased credit default swaps on bonds backed by subprime mortgages made on California homes around 2005. The banks bought the insurance since they assumed the bonds were becoming worthless and, as the insanity of credit default swaps is that they can be purchased on assets that you don’t own, people who didn’t own the bonds took the bet and purchased the insurance as well. The brokerage firm that sold the CDS’s then arranged (or at least doesn’t deny that it arranged) for the bonds to be paid in full because, as it turns out, “Normally an investor can’t pay off loans like that but if the amount of outstanding loans falls to less than 10% of the original pool, the servicer — or company that collects mortgage payments from homeowners and forwards them to investors who own the securities — can buy them and make bondholders whole.” So the swaps became worthless and those who bet on the bonds becoming worthless lost all their money.

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  • Genius

    You sell cover to everyone who wants to buy it for several times the value the of the insured assets (since you do not need an insurable interest you can bet (sorry hedge!) several times on the same bond . Then you use the part of the money raised from the CDS sales to purchase the bonds and pay them off in full and cap teh rest as profit. ROFL. Love it.

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  • mark wadsworth says:

    If it is as simple as the article explains, that is sheer and utter genius!

    To simplify it even more, Amherst invited Big Smart*rse Banks to place bets on whether various Unemployed-Men-In-String-Vests had $27 million or not.

    UMISV’s clearly only had $3 million, so Big Smart*rse Banks were prepared to bet $130 million that they didn’t have $27 million.

    Amherst then gave UMISV’s $27 million.

    Amherst then went back to BSB’s and collected their stake of $130 million.

    I haven’t laughed so hard since the Porsche/VW sting.

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  • Time_and_tide says:

    The best stings shaft those trying to shaft someone else. Poetic justice.

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  • Theemperorhasnoclothes says:

    Thanks mark for the “for dummies” explanation. What a perfect hussle!

    The big boys can’t complain, they are making money out of a casino economy, then they should expect to lose a hand or two. What they are doing is no different to professional poker, and is of no benefit to wider society.

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  • Nice. Those banks won’t knowingly deal with them ever again, but that’s probably worth $100m

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  • ..or A bets that B’s house burns down because he knows the arsonist is on his way there but the counterparty to A’s bet tells the cops, who nip the caper in the bud.

    If you play with fire……..Over-the-counter derivatives (CDOs, CDSs) are favourite tools of investment banks because of the leverage they facilitate. CDSs, which caught out the banks in this story, were very useful to banks because they have to insure their credit operations and this entails supplying collateral, but opaque, unregulated, over-the-counter CDSs do the job of providing this insurance without the commitment the amounts of banks’ capital that would normally have been required.

    Other bets are already in place that people’s houses will burn down (those placing the bets knowing that arsonists are on their way there) and it’s possible that counterparties to these bets will also shop the arsonists. Trouble is that if the big banks go crying to the regulator he may reign in the OTC stuff the banks have relied upon.

    Notice that the two banks that Washington / Wall Street allowed to fail (Bear and Lehman) are providing the expertise and services that in this instance caught out the banks that sunk them.

    The stuff of the Greek myths…..or Shakespeare’s ‘ hoist by his own petard’.

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  • I agree with Mark W, as always 🙂

    It does seem that the rules for such things are far too complex:

    “Normally an investor can’t pay off loans like that but if the amount of outstanding loans falls to less than 10% of the original pool, the servicer — or company that collects mortgage payments from homeowners and forwards them to investors who own the securities — can buy them and make bondholders whole.”

    The big boys should have known about that rule. However if even they didn’t know about it then clearly the entire system is far too complex. The next government of this country should burn as much red tape and legislation as possible.

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  • stillthinking says:

    Perhaps the reasons the major banks are angry about this is because it potentially damages the transfer of public funds. In this case the banks are publicly exposed as betting and profiting on debt default (the supposed bank nemesis..), and the debt is publicised as cheaper to honour than to cover the insurance claims. That is obviously sharp practice,
    but…
    I think they are worried because it shines a most unwelcome light on the transmission of funding from the US taxpayer to the banks, and introduces the idea that the US taxpayer could instead directly honour the mortgage, thereby the government owning at the very least the property for social use, rather than the US taxpayer directly honour the costs of default through the abstraction of insurance, and get nothing.
    Perhaps thats a bit too conspiracy looney.

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  • “rein” not “reign” @ 5.

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  • Hmm, These CDS thingies sound hard to control. Maybe someone ought to regulate them before they get out of hand!!

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  • mark [email protected], I don’t think it was the UMISVs who got $27 million. Wouldn’t the bonds have lost 90+% of their value only as a result of massive defaults? In that case, the money would have gone to whatever company had purchased the mortgages and then created and sold the bonds backed by them, if I understand correctly how this works. And it probably wouldn’t have to have even been $27 million, just the difference between the the mortgages and the values of the properties that were repossessed and sold in a firesale.

    I think the UMISVs are homeless now.

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  • So, it looks like Amherst managed to take a 10-15% loss instead of a 100% loss because they cleverly played the big boys.

    Have the large banks never heard of due diligence, or did they just think they were too smart? It’s not as if Amherst would have been able to cry foul if JP Morgan or RBS had shafted them in the same way.

    Not a jot of sympathy for the large banks in this instance. They thought they were going to rob someone for a few million and got stung instead themselves. I thought these guys were supposed to be clever enough not to fall for Nigerian 419 scams? 🙂

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