Tongues were wagging in financial circles around the world last week regarding this Wall Street Journal article about Austin-based Amherst Holdings’ amazing play in which they sold credit default swaps on mortgage bonds to a number of Wall Street and London’s biggest banks. Amherst then turned around and bought the mortgages underlying the bonds upon which the CDS were written to prevent a default that would have triggered Amherst’s obligation to pay on the CDS.
Thus, in short, Amherst sold CDS on bonds and then bought the security for the bonds, thereby rendering the CDS worthless. Although the amount of profit is somewhat unclear, Amherst reportedly pocketed tens of millions of dollars on the deal.
The Financial Times’ economist Willem Buiter does an entertaining job of explaining Amherst’s transactional plan in the context of gambling and the difficulties involved in regulating such transactions. In so doing, he makes the following observation:
"The scheme is beautiful in its simplicity, absolutely outrageous, quite unethical, deeply deceptive and duplicitous, indeed quite immoral, but apparently legal."
Geez, maybe these Amherst sharpies could have saved AIG?
And some people wonder why the system is collapsing! Thanks for this post, keep up the good work.
The deal was absolutely not outrageous, not unethical, not deceptive, not duplicitous and not in the least immoral.
In devising credit default swaps, certain strategies simply were not considered. This is one of them. In an unregulated, over the counter marketplace, creative and previously not conceived structures are called “innovation.”
What we are seeing is that Wall Street is losing its ability to corner the market in financial expertise. This trend started with the explosions in hedge funds and will be accelerated by the pay restrictions and stagnant cultures of New York money center banks and the reclassification of investment banks to commercial banks.
If Goldman or Citadel had effected this transactions, no one would have said a word. However, when it is a bunch of hicks from *GASP!* Texas, ivory tower elites are up in arms decrying the deal in every way possible.
This trade is a good example of how markets right themselves. The banks having been bitten by this, CDS traders will be more careful in the future. This is exactly the kind of thing that gives rise to self-correcting behavior in free markets.
Will anyone be surprised if the SEC or Justice Department commences an Enron-type criminal witch hunt related to this transaction?
However, if the principals at Amherst Holdings were Obama contributors (which would not surprise me, given that their base of operations is Austin), they should be in the clear.