The Wall Street Journal Glosses Over the Pitfalls of Credit Default Swaps

"A Daring Trade Has Wall Street Seething," is a simplified case study into the pitfalls of credit default swaps. Nobody, including The Wall Street Journal's reporters, could figure out exactly what was going on. The transaction, illustrated by Journal below, involved sophisticated players who ostensibly knew what they were doing.

In this particular deal, a group of large banks held mortgage securities that they thought were worthless, so they decided to cut their losses, in order to recover 10 - 20 cents on the dollar. They bought credit insurance, aka credit default swaps, with a huge upfront premium, equal to 80 - 90 percent of the bonds' face amount. The banks expected that the bonds would default, at which point Amherst would pay out 100 percent of the bonds' face value. The banks did, in fact, receive a 100 percent payout on the bonds, but not from Amherst.

Instead, "Amherst arranged for the bonds to be paid off in full. That move assured Amherst wouldn't have to make payouts." But where did the $27 million, used to pay down the bonds, come from? Nobody who knows is talking, though the Journal found some people who have a pretty good guess:

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.

Why would Aurora pay face value for bonds that were trading at a deep discount? It makes no sense unless it had a side deal with Amherst. The Journal writes:

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.

That's the way it usually works, with derivatives and with insurance. Amherst purportedly made a profit on one side of the deal (credit default swap fees), a loss on the other side of the deal (redeeming the bonds at par), and presumably netted out some small difference. If the markets were transparent and efficient, the net result would have been the same as if Amherst simply purchased the bonds outright at 10 - 20 cents on the dollar.

But the deal caused an uproar.

'It's all-out warfare' between the banks and Amherst, said a senior banker at one firm that lost money...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.

The mischaracterization of those "losses" is the key element of the story that the Journal glossed over. Everyone "forfeits" his insurance premium if he has no need to file a claim. (If you aren't dead yet, you forfeited the premiums on your term life insurance.) The large banks are fully aware of how these instruments work. Yet they saw the Amherst deal as a dangerous precedent.

Firms that suffered losses as well as some that didn't have brought the trade to the attention of two financial industry groups, the Securities Industry and Financial Markets Association, and the American Securitization Forum, which are considering their concerns, say people familiar with the trade groups' thinking.

...
Many credit-default swap contracts that were written on subprime mortgage securities over the past three years remain outstanding, and holders could lose out if more bonds are made whole. Deutsche Bank has sent a list, reviewed by The Wall Street Journal, to its clients of more than two dozen other mortgage pools that could see similar moves.

The story illustrates the systemic pitfalls of credit default swaps, which are unlike all other types of swaps. If you enter into an interest rate swap (e.g. fixed rates for floating), or a currency swap (e.g. Euros for dollars) or an energy swap (e.g. oil for natural gas), you are effectively exchanging the price of one freely traded commodity for another. Over the life of the swap, both counterparties pay out at an agreed-upon price, and the referenced commodities should continue trading on the open markets.

A credit default swap is entirely different. One side is willing to make a bet that a company -- or in Amherst's case, a group of subprime homeowners -- will not go bankrupt, and the other side will make an upfront payment to insulate itself from that bankruptcy risk. After closing, the only time that one party pays out is when there is a payment default. If you look to the substance of the transaction, rather its form, you see that credit default swaps are really insurance policies.

Credit default swaps are insurance without the normal restraints imposed traditional insurance. Normally, you are not supposed to insure an asset that you do not own. Also, you are not supposed to insure an asset for many times more than its market value.

That's not how it works with credit default swaps. "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," writes the Journal.

The implication is that Amherst collected insurance premiums for many times the value of the bonds, and used the proceeds to redeem the bonds at a small fraction of the cost incurred for paying out on the insured claims.

In other words, if you sell a credit default swap, you may have an incentive to prop up the creditworthiness of the company, or other entity, with which you have no direct business relationship. And if you buy a credit default swap, you have an incentive to promote that company's failure. George Soros raised this issue in today's Financial Times:

Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS [i.e. credit default swaps] and stood to gain more by bankruptcy than by reorganization. It is like buying life insurance on someone else's life and owning a license to kill him. CDS are instruments of destruction that ought to be outlawed.

Why would someone take out insurance on an asset he doesn't own? There are a number of reasons. The market for credit default swaps is more active than the market for subprime securities, and some investors may have purchased these swaps as an imperfect hedge against similar mortgage bonds. (The primary benchmark for pricing subprime securities, the ABX index, is in fact a credit default swap on a reference list of securities.) Also, beginning in 2006, investment banks started issuing "synthetic CDOs," which are exotic securities that were no longer backed by bonds of mortgages, but by credit default swaps.

Clearly, people did not understand what they were getting themselves into. And the unintended consequences have not fully played out.

Comments

[blindhog]

One must remember who owns the WALL STREET JOURNAL now.

[Sundialsvc4]

What part of "compulsive gambler" is so hard to comprehend?

[Raphi]

If there is no moral honor among these thieves, why then do bonuses and similar contracts have to be honored? Why do they feel so entitled?

Insurance and CDS. Akin to the practice of buying life insurance on workers (unknown to them) whereby the company profits by death. Nice, huh. Human resources.­.. strip-mined and clear-cut; then the worn out carcasses tossed back into devastated physical and economic landscapes. We'd feel sympathy if it were animals.

Yet the system cannot function without the political and legal stability it undermines. And cannot function without a thriving consumer base. Who are... (see above.)

Let's call these cabals what they are: ECONOMIC TERRORISTS.

[grateful4thedead]

ya gotta admit that the small firm out of texas pulled a quick one on the the big boys! I saw this trade mentioned approx 2 weeks ago and must admit that i laughed like hell.

[RoloTomassi]

"Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS [i.e. credit default swaps] and stood to gain more by bankruptcy than by reorganization. It is like buying life insurance on someone else's life and owning a license to kill him."

Assuming that the above analysis is accurate, why are there no plans to restrict CDS generation in the future?

Give the nature of the CDS beast and the boundless greed of Wall St. players, isn't it likely--if these instruments are allowed to persist--that it's only a matter of time and opportunity before someone figures out a new method of destructive madness for the sake of personal gain? If that assertion has any merit, then will not the financial system remain in state of systemic jeopardy?

[StevieRae]

As David points out, CDS's were one of the largest frauds perpetrated on the investment market which eventual led to our financial system collapse. Biggest reason, investors were allowed to buy "insurance" regarding the future viability of a company, without the investor having any insurable interest in the company.

This was the purest form of gambling not dissimilar to gambling at a craps table. The notion of paying off an investor who gambled on the failure of a company is tantamount to robbing a bank and we, as taxpayers were screwed in financing these payoffs.

For the WSJ to not review the accurate history of CDS's can only be attributed to its new owner of what once was the primier business journal.

[nellyb stl]

The rating systems were in bed with Wall Street and the Banks; but we found the money somehow to bail them out. We've found the billions to further the 'war on terror.' Now why can't we find the billions to Reform health care. Americans will not forget it is our money who bailed them out.; and it is our money thats fighting the war on terror; and it's our money that pays for health care.