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.
At issue is a move by Amherst to boost the price of bonds to avoid paying out on credit-default swaps it had sold. Banks are questioning whether Amherst set them up by selling credit-default swaps and then rendering them worthless.
Amherst says it didn't do anything improper, but took advantage of an opportunity when it emerged. A lawyer reviewed and blessed the strategy for the firm, according to people familiar with the matter.
Privately held Amherst says it acted in good faith trying to limit losses for clients, who had sold credit-default swaps on the securities. "We wouldn't jeopardize our business and reputation by entering into an opportunistic trade knowing what the outcome would be," said Amherst's chief executive, Sean Dobson.
The dispute echoes battles over the largely unregulated credit-default-swap market during last year's financial turmoil. Companies including Morgan Stanley accused investors of using the insurance-like contracts to hurt the value of their shares, creating a panic among other investors and the firms' clients.
In 2007, a group of hedge funds led by Paulson & Co. suspected Bear Stearns of plotting to boost the value of subprime-mortgage securities. At the time, Bear (which was later bought by J.P. Morgan) denied planning to engage in such transactions.
So far the latest dust-up has been all words, in part, bankers say, because they are wary of attracting more regulatory scrutiny at a time when lawmakers are planning major reforms in the largely unregulated derivatives markets, long lucrative for banks. While the banks' combined losses from the trade were in the tens of millions of dollars -- modest by recent standards -- they are the buzz of Wall Street as firms try to prevent a repeat of the episode.
The trade involved credit-default swaps and securities backed by subprime mortgages. The original securities had been sold by Lehman Brothers and were backed by $335 million of subprime mortgages mostly on homes in California made at the housing bubble's peak in 2005, according to the prospectus.
Following a wave of refinancing and defaults, only $29 million of the loans were left outstanding by March 2009, half of which were delinquent or in default, according to a performance report by Moody's Investors Service.
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.
Traders can buy credit-default swaps on securities they don't own. At one point, at least $130 million of bets had been made on the performance of around $27 million in securities, according to a person familiar with the matter.
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.
That's what happened in this case. In April, a servicer called Aurora Loan Services at the behest of Amherst purchased the remaining loans and paid off the bonds.
Although Amherst won't provide specifics and won't comment on its arrangement with Aurora, it doesn't deny that it took this approach. (Aurora says it is a subsidiary of Lehman Brothers Bank, but not part of the Lehman Brothers Holdings bankruptcy filing.)
A spokeswoman for Aurora says these servicer provisions are customary and when rights are exercised it ensures that appropriate requirements are met.
When the bonds got paid off, the swaps became worthless, meaning the banks effectively forfeited what they had paid for the insurance. J.P. Morgan lost millions, while RBS and BofA suffered minimal losses, said people familiar with the matter.
On April 28 representatives of banks including J.P. Morgan, Goldman Sachs Group Inc. and UBS AG's UBS Securities held a conference call to discuss the trade but didn't come to any conclusion, according to people familiar with the matter.
Amherst is the antithesis of the big Wall Street banks. With its Austin headquarters and around 100 employees, the 15-year-old firm has long been a player in the mortgage market, but is now one of the upstarts trying to take business from banks weakened by the credit crisis. The firms has hired bankers, mortgage traders and research analysts who had left banks such as Bear Stearns and UBS, while raising new capital to expand its trading activities.
Since the mortgage securities were valued at just $3 million or so in the market, well below the $27 million they were redeemed for, traders believe Amherst entered into an uneconomic transaction to profit from its swap positions.
Firms that suffered losses as well as some that didn't have brought the trade to the attention of two financial industry groups, the Securities Industry and Financial Markets Association, and the American Securitization Forum, which are considering their concerns, say people familiar with the trade groups' thinking.
Critics of these markets say such conflicts aren't a surprise. In secretive, over-the-counter markets "there are hidden risks and fault lines that don't show up until times of stress or when people are losing money," says Martin Weiss of Weiss Research, an investment consultancy in Jupiter, Fla., not involved in the trade.
Many credit-default swap contracts that were written on subprime mortgage securities over the past three years remain outstanding, and holders could lose out if more bonds are made whole. Deutsche Bank has sent a list, reviewed by The Wall Street Journal, to its clients of more than two dozen other mortgage pools that could see similar moves.Printed in The Wall Street Journal, page A17
Posted in the Econobrowser by James Hamilton:
The fun and games begin when multiple contracts get written on a single credit event and the notional value of outstanding contracts on that event-- the total amount of money that is promised to be paid to the buyers of those CDS in the event of a default on the underlying asset-- becomes larger than the par value of the underlying asset itself. Then it would clearly pay the party who sold those contracts to buy the underlying asset itself at par, relieve the original debtors of their burdensome obligations, and be out only $X (the underlying event) rather than some multiple of $X (all the contracts written on the event).
And so the WSJ recounts the tale of a security based on $29 million (par) worth of subprime loans in California, half of which were already delinquent or in default. Betting that the loans weren't worth $29 million sounds like easy money, and the smart guys were willing to pay 80 to 90 cents for each dollar of CDS insurance.
It appears from the WSJ account as if little Amherst Holdings of Austin, Texas was happy to sell the big guys like J.P. Morgan Chase, Royal Bank of Scotland, and Bank of America something like $130 million notional CDS on a $27 million credit event, used the proceeds to buy off and make good the underlying subprime loans, and pocketed $70 million or so for their troubles. The big guys, on the other hand, paid perhaps a hundred million and got back zip.
Said big guys, naturally, are screaming bloody murder, trying to bring in the lawyers to show that Amherst wasn't playing by the rules of the game.
For my money, the first rule we need would be a law, not a rule, that notional not exceed actual.
Barring that, here's another rule I trust: a fool and his money are soon parted.