A Fool and His Money….

I love this story (Via James Hamilton),

Its behind the WSJ subscription but here are the basics of the story,

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.

Brilliant. Of course it was not without its risks. If the security went bad before they collected at the money to make the loans good they’d be holding the bag for tens of millions. Still this was a smart an obvious move. Once the dollar value being wagered on a credit event exceeds the value of the credit event itself those issueing credit default swaps have an incentive to buy the object, relieve the debtor of his debt and be out only the dollar value of the credit object itself.

Of course, if you want to stop this kind of thing then, as Prof. Hamilton notes, you’d have to prevent the notional value not exceed the actual value. That is you cannot sell CDS past the actual value of the credit object at issue. In the case above, at most you could sell only $29 million in CDS. Either that or some sort of law requiring disclosure on how much in CDS a particular credit object has. Once the notional value equals the par value stop buying the CDS.

FILED UNDER: Economics and Business, ,
Steve Verdon
About Steve Verdon
Steve has a B.A. in Economics from the University of California, Los Angeles and attended graduate school at The George Washington University, leaving school shortly before staring work on his dissertation when his first child was born. He works in the energy industry and prior to that worked at the Bureau of Labor Statistics in the Division of Price Index and Number Research. He joined the staff at OTB in November 2004.

Comments

  1. Drew says:

    Tee-he-he-he

    This ain’t for the faint of heart.

  2. bigfire says:

    This illustrates the importance of reading the whole thing.

    The banks were lure by the 30%-40% default rate that they can afford to pay 70 cents on a dollar to get a dollar. Amherst is counting on them not reading the provision of the CDS vendor back filling the mortage thus nullifying CDS. And to think, these bankers were paid big bucks and they missed it.

    Well, this is a one time only event, I sincerly doubt if Amherst can pull off this scam again, and they’re most certaintly going to be black balled by the banks that got burned.

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