This WSJ article is pure genius. Anyone who doesn't think Wall Street banks wouldn't do the same exact thing given the chance are fooling themselves. If the JPM guys had been smart, they would have utilized the exact same strategy (buying the underlying mortgages at the end) and make sure they were not paid off but instead defaulted.
Some highlights below:
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.
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.)
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.
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.
We here at TILB love this stuff. WSJ continues its streak of excellent reporting.