Thursday, June 11, 2009

The Amherst Trade

The WSJ article about Texas brokerage Amherst Holdings duping the big Wall Street banks is a hot topic today. Based solely on the WSJ article, it appears that Amherst sold CDS on $335 million of subprime MBS to various Wall Street banks over the past year, including J.P. Morgan, RBS, and BofA. The mortgage-backed securities were about as toxic as they come (California, vintage 2005—so you know it's good):

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. ... 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.
In April, the servicer, Aurora Loan Services, surprised the banks by exercising its "cleanup call" provisions "at the behest of Amherst." Cleanup calls give a specified party (in this case, the servicer) the right to purchase all the remaining mortgages when the remaining pool balance falls below 10% of the original balance. When Aurora exercised its cleanup calls, it apparently made the noteholders whole, which made the banks' CDS worthless. The banks are crying foul, and most people aren't inclined to feel sorry for them. However, it's possible that the banks have a valid complaint. It's impossible to say who's right without seeing any of the documents, so take this post with a grain of salt. I should note that it's possible that the banks' objections are based on the specific terms of the cleanup calls. For example, some cleanup call provisions prohibit the servicer from exercising the call unless the aggregate fair market value of the mortgage loans exceeds the stated principal balance of the mortgage loans. If that restriction were in place, then the banks would have every right to complain (more on this later). I suspect the main issue is the arrangement between Aurora and Amherst. The Journal says that Aurora exercised the cleanup calls "at the behest of Amherst," and the key is what that means. Amherst refused to comment on its arrangement with Aurora, but "it doesn't deny that it took this approach" (whatever that means). I'm guessing the banks were so shocked because it made no sense for Aurora to exercise the cleanup calls. It received a deeply discounted pool of subprime mortgages, half of which were deliquent or in default. And yet it made noteholders whole? Something doesn't add up. The banks' traders are apparently puzzled too:
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.
The simplest explanation is that Amherst made up the difference, essentially paying Aurora to exercise its cleanup calls. If true, then Amherst was just artificially propping up the value of securities on which it sold CDS protection in order to prevent the protection buyers from collecting payouts. That could raise potential market manipulation issues. Moreover, if Amherst had already arranged for Aurora to exercise its cleanup calls before selling CDS on the mortgage-backed securities, then the banks might also have valid legal complaints (duty of good faith?). Of course, this is pure speculation on my part. It's very possible that the banks have no legal argument, and are just whining about getting their asses handed to them by a Texas brokerage. Amherst may not be the biggest brokerage around, but they have some serious financial talent, including former UBS managing director (and well-known securitization analyst) Laurie Goodman. All I'm saying is that based on the limited information in the WSJ article, Amherst's trade seems a little sketchy, and the banks may have a valid complaint.

19 comments:

Tom Lindmark said...

Somehow this isn't adding up. There has to be a piece or two missing. James Hamilton at Econbrowser is suggesting that the banks were just speculating and not hedging existing exposure. Can't imagine they would be raising this stink if that were the case but I suspect we are going to see one or two surprises before this one can be fully parsed. Here's the link to Hamilton's thoughts. http://www.econbrowser.com/archives/2009/06/how_to_lose_on.html

mattw said...

If you buy $130M of coverage on $30M of exposure, it would seem there is something beyond pure hedging going on. Of course, they could have been trying to hedge related exposure, but given the pricing, it seems an odd way to do it.

Don said...

I actually waited to see what you were going to say about this, if anything. Thanks.

Don the libertarian Democrat

csissoko said...

You seem to be taking a very narrow view of this: Under current law it is possible that the banks have a legitimate complaint.

But that has nothing to do with what makes this so funny. The banks have spent years arguing that the world is a better place when it is possible to essentially sell insurance in amounts worth several times the insurable interest in question. Now that the natural economic consequences of this position have revealed themselves they are upset.

Step back and think about this for a second: Do you really think that the resources of our legal system are best spent adjudicating whether this is "manipulation"? Why should our system be set up to make such "manipulation" easy and even likely? Doesn't it make more sense to prevent these cases from wasting the time of the judiciary by limiting the amount of "insurance" that can be sold?

Anonymous said...

From a Bloomberg story: "Two years ago, a group of hedge funds said banks were planning to derail bets against subprime-mortgage bonds with similar tactics. New York-based Paulson & Co. sent a letter to the U.S. Securities and Exchange Commission asking the regulator to be on the lookout for manipulation. Banks dismissed the complaints, and the ISDA declined to recommend changes to contracts that would address the funds’ concerns. “Existing legal prohibitions were specifically designed to deter a broad range of misconduct that constitutes fraud or manipulation,” the industry group said in a statement after a
June 2007 meeting between 100 dealers and investors. Adding
restrictions “would artificially inhibit legitimate market
activity, favoring the position of one side of the market at the
expense of the other,” ISDA said."

Temporarily said...

From Temporarily-Impaired ( wait maybe they were other-than-temporarily impaired )
to Performing Assets in one week or less.....


Shouldn't Distressed Assets Managers duplicate this transaction

Tao Jones said...

The article says that Aurora sold about $130 million in CDS on that same $27 million in RMBS.

Amherst's spending $24 million to net $103 million does not seem like an "uneconomic transaction" to me. It seems like a great deal for Aurora/Amherst.

I don't know what the choice of law provisions say, but I doubt any arguments about the implied covenant of good faith and fair dealing will go anywhere, primarily because the CDS holders were "made whole" under the terms of the contract. I don't know enough about the laws against market manipulation to say whether any of them apply, but considering unfair competition laws, I doubt there's anything on the books that prevents bad outcomes that are within the terms of the contract.

Unless the banks can show fraud, I think they're out of luck.

inferno said...

Is there a better example of why ISDA should be eliminated in favor of government regulations? The only parties served by this situation are the guys that sold it and got credit in their bonuses.

All these contracts should be put under the SEC and traded on exchanges. There’s nothing “unique” about them. It’s insurance that can be standardized AND meet min. funding requirements.

Would the “hedge” cost more with regulation? Absolutely. And obviously in this case, that hedge should have been more expense… or better yet almost unavailable and very expensive.

You have no idea what the "cleanup calls" language actually says. There’s no way to know. How can the public judge the liability?

When you extend that risk across 10’s of thousands of contracts, there’s no way of knowing how much risk is in the system… a system that’s ultimately backed by taxpayers.

- BTW: Excellent blog. I’ve got a little experience in structured derivatives and I’m always bitterly disappointed in lack of coherent coverage.

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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.

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