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.