Skip to comments.Tiny Texas Brokerage Crushes Wall Street With Daring Mortgage Trade
Posted on 06/11/2009 7:09:27 PM PDT by FromLori
Todays Wall Street Journal carries the amazing story of a small Texas brokerage that pulled a fast one on some of the biggest banks in the world. The short version goes like this. Amherst, the Texas brokerage, and others sold hundreds of millions of dollars of credit default swaps on bonds back by $29 million of subprime mortgages to JP Morgan, Goldman, UBS RBS and other banking giants.
The banks paid steeply for the swapsup to 90 cents for every dollar of insurancebut thought it was easy money. After all, these were Lehman packaged California subprime loans made in 2005, a class of loans that pretty much define toxic. The upside seemed limited but almost certain. What happened next is that a loan servicer, probably at the behest of Amherst, turned around and bought up all the mortgages, paying them off in whole.
Apparently because the original amount of loans backing the bonds was $335 millionmeaning the amount of outstanding loans had fallen to just 10% of original amount due to defaults and refinancingsthe mortgage servicer was free to buy them up and make bond holders whole. Of course, this meant that the entire $130 million of credit default swaps was suddenly worthless. The banks are sure that the mortgage servicer was acting on behalf of Amherst, which would mean the 100 person Texas brokerage had made a tidy sum by buying toxic mortgages while selling insurance on the bonds.
The banks are crying foul, although its not clear if anything illegal happened. It may just be that the banks were simply outsmarted by a wily brokerage who had found a way to exploit the unhealthy appetite for these credit default swaps. We can squint out eyes and see this as Wall Street getting punished for its greedy desire to
(Excerpt) Read more at businessinsider.com ...
I don’t often need to read things twice to understand them. Though I just read that once, I couldn’t understand it.
It’s not just you. I read it 4 times and I still don’t get what they did. There must be missing information.
this is a good one!
Bought insurance on known ‘bad’ debt
Bought up / piad off the bad debt for $0.10 on the dollar
Made the bonds whole
Kept all the insurance dough
Better not mess with Texas....
there’s a better explanation with a diagram in today’s wsj.
Texas - Suckering idiot Yankees who think they’re smarter than the “dumb rednecks” since 1836.
They bought insurance, that’s an expense.
So what “insurance dough” do they get to keep?
So what insurance dough do they get to keep?
The banks are alleging the brokerage and the insurance company were in cahoots.
Basically, the banks bought insurance against those bonds tanking, which would have resulted in a huge premium when they did tank.
Instead, the insuring firm (Amherst) *paid off* those bonds, early, thus insuring they didn’t have to pay out any of the “insurance” money and that not only were the banks out the money for the bonds in the first place, they were out the insurance premiums *and* whatever else they’d leveraged off it.
Much like credit cards, actually. If you pay off your cards early, the credit card company can actually lose money. Same kind of thing here.
er “huge premium” should have read “huge payout”.
See the posts following yours.
Credit swap = insurace against default
Bonds paid off means no default
The little guy keeps the insurance (credit swap) dough.
Cahoots are not, the little guys got one over on the city slickers....
So who’s more to blame here if anyone? I mean, which companies’ greed was worse? The bank thought it was a good deal for them, all the companies are motivated to their own best interests. They sure the hell weren’t doing charity work when they bought subprime loans expecting they were going to do well because of it.
I think it is the case of a big city bank crying sour grapes, personally. They got beaten in a clever fashion and they’re crying about it like small-time little pussies.
I enjoy your posts. If you have a ping list, put me on it.
The crowd at Dealbreaker is having fun with this.
(warning to those unfamiliar with Dealbreaker: there is NO moderation over there w/respect to use of obscenities, etc, and these are mainly young male traders spouting off — not a good site to visit from your work computer if you have prudish internet-use spies)
The only thing making Wall Street angry about it is that they didn’t think of it first.
Amherst is just doing what AIG should have been doing all along.
AIG sold insurance on bonds. If the bonds defaulted, AIG pays up. Except, this is special insurance...called a derivative...also known as a credit default swap.
And because it’s special, people in addition to the original lender can buy it.
With normal insurance, only say...a homeowner can purchase fire insurance on her house.
...but with credit default swap insurance, your neighbors and friends can each purchase fire insurance on *your* house.
So multiple credit default swap insurance policies can be sold for the same house. If your one house burns down, then AIG has to pay each of your friends full face value for your house; multiple payoffs.
Amherst did the math and saw that was silly. There were 5 brokerages on Wall Street betting that these circa 2005 Lehman sub-prime mortgages would default, so Amherst sold 5 insurance policies.
Wall Street was so certain that these loans would default that they were paying 90% of the home mortgage value as their insurance premium to buy the credit default swaps.
5 * 90% = 450% of face value.
Amherst then bought the mortgages and paid them off with their own money. Thus, the deadbeat homeowners couldn’t default...they got their houses for free.
And Amherst got 450% of the face value of those toxic sub-prime loans by selling so many credit default swap insurance derivative contracts to the brainiacs on Wall Street.
Easy money. Amherst *knew* that those loans couldn’t default because Amherst was buying them.
Well, that’s how AIG’s derivatives should have been handled.
Instead, the Fed paid off all of AIG’s contracts. That’s like paying out Amherst’s 450% above due to being too stupid to know to just buy the discounted loans.
There is no one to blame here.
The reasons why the big Wall Street outfits are whining are:
1. They thought that only they should be able to game the CDS market. After all, they’ve been able to use the unregulated CDS market to their almost exclusive advantage. AIG has shaken a huge pot of money out of the taxpayers as a result of selling a lot of CDS contracts that they had no hope in hell of paying off. In an ordinary universe, AIG should have been allowed to fail when the contracts came due - but no, they’ve got both front feet in the feed trough.
2. The outfit that “ripped them off” is out of Texas. I’m sure all those terribly smart Ivy League graduates on Wall Street think this is a case of the gap-toothed, banjo-strumming rednecks from Texas just ripped them off big-time. And what New Yorker wouldn’t resent this? Instead of the money being spent on $5000/hour call girls, expensive European sedans and vacation homes on Long Island, the money will probably be spent on a pickup, a jug of shine and a date with their cousin! (so the New Yorkers think).
3. Let’s face facts: the bit about paying off the mortgages to make the bonds whole was so obvious and straightforward a way to dead-end a CDS that ABSOLUTELY NO ONE ON WALL STREET THOUGHT OF IT. This is what REALLY pisses off the Wall Street Elite and Oh-So-Terribly-Smart Ivy League MBA’s: There’s no “financial engineering” going on here at all. This is very straightforward cash-on-the-barrelhead horse trading. Not a partial differential equation anywhere to be seen.
Cue up Vizzini from “The Princess Bride:”
4. Last, but not least, the Oh-So-Terribly-Smart Wall Street boys thought that they had things pretty well stabilized for now on that sub-prime paper. That’s why they were buying CDS contracts at $0.90/dollar on the RMBS paper backed by sub-prime. They probably are the guys who sold the RMBS sub-prime paper, so they thought they knew all the nasty little details therein - they thought they had the inside track on the assets they were “insuring.”
They figured the bonds would soon meet the qualifications of “default” - because they’ve woken up to the fact we’re in a debt deflation and they’re just waiting for the debt deflation and high unemployment rate to do what is inevitable: cause people to default on mortgages they couldn’t afford in the first place. It looked like a sure bet to make 10% (the 90% CDS cost subtracted from the $1.00 face value of the sub-prime backed bonds). The Ivy League MBA boys thought they had this one NAILED. They are probably the ones who created the secondary market for the crap sub-prime mortgages. They’re probably the ones who created the template for the CDS. They’re probably the guys who sold the sub-prime RMBS paper into the secondary market. They thought they were masters of the universe on this one.
And along comes some little outfit from Texas, whom most people have never heard of, who takes a huge chunk of money off of them by doing something so obvious that no one on Wall Street has stopped their idiotic “financial engineering” exercises long enough to think of it.
You can positive *feel* the burn coming off these stooges on Wall Street.
And it is delicious.
They didn’t buy insurance as an expense; they bought it as a tradeable investment asset. They didn’t own the bonds that the insurance contracts were written on (or at least nowhere near as many as they bought insurance for). And there was no “insurance company”. Amherst itself sold the “insurance” — contracts called credit default swaps.
Credit default swaps overwhelmingly exist as market gambling tools, not as actual insurance. If they were being used as insurance, there wouldn’t be swaps “insuring” several times as many bonds from a specific issue, as were ever issued. It’s like if 50 different people held insurance policies on your house. You may have one insurance policy on the house that was actually bought as insurance, but the other 50 people obviously had something else in mind when they bought their policies, since they don’t have a financial interest in the house to begin with (and no, you can’t actually do that with houses as far as I know, but you can do it with bonds).
It’s not a matter of “better greed” or “worse greed”. It’s a matter of “smart greed” vs. “dumb greed”. In this case, the little Texas firm had smart greed, and the big-swinging-dick Wall Street firms had dumb greed. Smart greed wins.
Thanks I was thinking of starting one as soon as I figure out a good way to do it lol if I do I certainly will.
Bump for later reading, rereading and further rereading.
At first read is seems like goobly gook to me, but it sounds interesting and ironic.
Ron Perelman played a criminally brilliant variation of this game some years back with Revlon bonds, only he actually *did* own the underlying asset. Made himself a tidy half billion or so. Bought a controlling (actually consolidating) interest in Revlon’s stock, artificially ran up the price of the stock with a lot of fraudulent sales figures (er, I mean “innovative accounting methods”), sold about $1 billion in bonds backed by the Revlon stock he owned while the stock was flying high, then let the truth about the sales figures come out. Stock tanked, bonds tanked, and he bought back all the bonds at about 50 cents on the dollar — but of course he still had the original billion from the bond issue to buy them back with, so the difference was his profit.
I classify Perelman as a criminal (notwithstanding the fact that he’s never actually been convicted of anything), but the people who bought these bonds were so stupid they shouldn’t be allowed to have money, and Perelman made it so.
Thanks for that explanation, it makes sense now.
This reminds me of the Insurable Interest clause in life insurance. Simply: “If you want to buy a life insurance policy on someone else’s life, you must have an interest in that person remaining alive, or expect emotional or financial loss from that person’s death. This is called an insurable interest. Without this requirement, it would be very easy to make a living by purchasing life insurance policies on elderly strangers, and then collecting the proceeds when they died. The insurable interest requirement also prevents people from buying a life insurance policy on someone and then causing or hastening that person’s death.”
There’s a reason the insurance industry is heavily regulated — it’s to keep crap like this from happening. When selling what amounts to insurance, the financial industry should be regulated as well.
I’m assuming that the CDS “premiums” paid to Amherst were more than sufficient for them to pay ten cents on the dollar, and yet still retain a handsome profit?
Think they are just mad cause they didn’t think of some scam first???? lol
Amherst sold “insurance”. Really a gambling contract on mortgage defaults.
Then they bought the mortgages and the cropier swiped all the bets into the house bin. No bets paid.
How much US Taxpayer money did the Texas casino gain? Better it be in Texas than in DC or NYC, that’s for sure.
Sheep are made to be sheared.
I much prefer the tiny brokerage houses anyway.
Women: So, you’re in ‘the market’?
George: Yeah I’m, eh, in ‘the market’.
Women: Which market?
George: Which market, the, eh, big one, the big market, the big board. Bull market, bear market, you name the market, I’m there.
Women: So, do you work for one of those big brokerage houses?
George: They wish. I hate the big brokerage houses. Hate them with a passion. Big brokerage houses killed my father.
George: Well, they hurt him bad. Really hurt his feelings. It’s a long story. I- I don’t like to talk about it, but I swore then that I would never work for big brokerage houses. See, all they care about is money. I’m about more than money, I’m about people, always gone my own way and I’ve never looked back.
*Train horn blows and George looks back*
Yup. New Yorkers think they’re so slick.... it makes them easy to legally fleece. Texas history is full of suave con-men from the North and East, flush with success in other parts of the South and Midwest, coming to Texas and getting totally wiped out by “dumb” Texas natives.
Word to the wise: It’s called Texas Hold ‘Em for a *reason*.
I think the whole deal with the financial meltdown, at the top, was that the insurance contract (swap) was for "market value of a derivative of mortgage bonds" not face value.
When the crunch came, the insurers stood to say "the value is 10% because no one is buying". The entire meltdown transpired because Uncle Sam or whoever changed to mark to market and there was no market.
Nothing could be settled short of court which never transpired, no one could value their assets, credit and lending collapsed, financial markets came to a standstill, .
Try reading this version of the story
Do I need DiffEQ to figure this one?
(Plain old calc ain’t worth squat!!)
ok, the whole cds debacle is because you can buy insurance on stuff where you have zero relationship with the insured and you can sell insurance without putting aside money to cover losses.
this leads to rampant speculation and gambling.
that is you can buy life insurance on a person and then have him killed (figuratively speaking) or you can buy insurance on bear sterns then short the crap out of the investments bear holds “killing the insured”
In this case, the big banks bought life insurance on a patient who was dying making what they thought was a good bet. Then they leveraged themselves and bought more life insurance thinking they would make money. They did this even though they had no relationship to the dying man (defaulting mortgages).
The little Texas bank sold the life insurance even though they had no relationship to the dying man/mortgages. Then the little bank made sure the man/mortgages outlived the insurance.
Normal with a real dying man this does not work but because they could sell insurance on the same man/mortgage many times over, it worked.
Yep, and the question now is whether it was illegal. It was certainly unethical IMO.
They made a bet. They bet that the bonds would default. This Texas company realized that the volume of bets outstanding exceeded the market value of the bonds, so it made sense to buy the bonds so they would not have to pay off the bets.
No, it’s not unethical to pay off someone else’s bonds so that there is no loan default. That’s often mere charity; in this case it made business sense, too.
...that large Wall Street players assumed that no one would be so clever is another story altogether.
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