"How Little Amherst Holdings Beat Wall Street At Their Own Game"
"Amherst Holdings, a small Austin-based brokerage house, executed a CDS trade that ended up losing big banks, including JP Morgan Chase and Bank of America, tens of millions of dollars. Now, the big banks are trying to cry foul. The Wall Street Journal has the story:'Believing the securities would become worthless, traders at J.P. Morgan bought credit-default swaps over the past year from Amherst, according to people familiar with the matter. Credit-default swaps act like insurance, paying off the buyer if securities are hit by losses. Other banks including RBS Securities, which is the U.S. investment-banking arm of Royal Bank of Scotland, and BofA also bought swaps on the securities from different trading partners.
The banks had to pay up for the protection, similar to a person buying insurance on a beach house just before a hurricane. They paid as much as 80 to 90 cents for every dollar of insurance, the going rate last fall according to dealer quotes, expecting to receive a dollar back when the securities became worthless over the coming months.
In late April, traders at some banks were shocked to find out from monthly remittance reports that the bonds they had bet against had been paid off in full. 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.'
What happened? A small house, Amherst Holdings, has beaten the Wall Street titans at their own horrid game, according to the Wall Street Journal. It found a pool of $29 million of particularly repulsive California subprime mortgages,half of which were already delinquent or in default. Betting that the loans weren't worth $29 million sounds like easy money. Since this waste was so toxic the big houses were prepared to pay up to 80% for each dollar of CDS insurance to insure against it. Amherst then sold $130 million notional of CDS on them to J.P. Morgan Chase, Royal Bank of Scotland, and Bank of America. It sold insurance for 4 1/2 times the maximum possible loss, but hey, that's finance. Then it quietly went round and paid all the debts of the lucky homeowners owing the $29 million. At that point, since there were no defaults, it was able to keep the $100 million in premiums (net of the loan repayments, a $70 million profit).The big guys, on the other hand, paid perhaps a hundred million and got back zip. Clear so far?
Simple, really! Wall Streeters are furious and, inevitably, suing, but in fact Amherst's coup was a perfectly legitimate use of this corrupt and foolish structure, far more so than many of the shenanigans undertaken by the likes of Goldman Sachs. After all, Amherst's operation PREVENTED a number of defaults and foreclosures.
The article says that the affected firms have alerted the SEC and the American Securitization Forum about the trade. Amherst said it simply “took advantage of an opportunity when it emerged,” according to the WSJ. I would be very proud of the government if, for once, it doesn’t do anything to protect the big banks. From what I read in the article’s comments section, it sounds like the big banks will blackball Amherst anyway, as a kind of repayment for embarrassing them. I’m crossing my fingers for more underdog stories like this one."
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