Tiny Texas Brokerage Crushes Wall Street With Daring Mortgage Trade

The Business Insider ^ | 6/11/09

[FromLori]

Today’s 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 swaps—up to 90 cents for every dollar of insurance—but 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 million—meaning the amount of outstanding loans had fallen to just 10% of original amount due to defaults and refinancings—the 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 it’s 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

[staytrue]

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.

[Moonman62]

The banks are alleging the brokerage and the insurance company were in cahoots.

Yep, and the question now is whether it was illegal. It was certainly unethical IMO.

[PapaBear3625]

A better way of looking at it, is to not call it "bond insurance", since they didn't insure bonds they actually owned.

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.

[Southack]

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.