Banks Burnt on "Sure Fire" Credit Default Swaps

The Wall Street Journal has the story of how a bunch of the large investment banks got burned investing in "sure fire" credit default swaps. (paid subscription required)

You get a copy of the article here.



This kind of crap is why naked credit default swaps should be banned.

This ain't nothing but a bunco game, straight out of the Mel Brooks movie, and Broadway musical, The Producers.

Some quotes from the article, and my comments:

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.

(all emphasis in quotes mine)

If the profit is "sure fire" it means that someone is engaging in deceptive activity.

Privately held Amherst says it acted in good faith trying to limit losses for clients, who had sold credit-default swaps on the securities. "We wouldn't jeopardize our business and reputation by entering into an opportunistic trade knowing what the outcome would be," said Amherst's chief executive, Sean Dobson.

This is a shot across the bow of the banks on the other side, since this is exactly what the big investment banks intended.

So far the latest dust-up has been all words, in part, bankers say, because they are wary of attracting more regulatory scrutiny at a time when lawmakers are planning major reforms in the largely unregulated derivatives markets, long lucrative for banks. While the banks' combined losses from the trade were in the tens of millions of dollars -- modest by recent standards -- they are the buzz of Wall Street as firms try to prevent a repeat of the episode.

Ban naked CDS contracts, and it will not repeat.

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.

This is the part where credit default swaps, called a "naked" CDS in industry parlance, become a 3 card Monte game, and not insurance.

This kind of shit happens, and when things fall apart, you end up with AIG owing 40 or 50 times the value of the asset in insurance payouts.

This is why, 263 years ago, parliament passed the Marine Insurance Act of 1746, which required that anyone wanting an insurance payout demonstrate an interest in the continued existence of the property.

We have known for over 2½ centuries, since the South Sea Bubble, that this sort of insurance is dangerous and does nothing but create opportunities to game the system.

The frightening part here is that this scam is completely legal

Here is how it works:

1. Amherst Holdings sells credit default swaps on a bunch of bonds to J.P. Morgan Chase & Co.
   
2. Amherst Holdings sells credit default swaps on a bunch of bonds to Royal Amherst Holdings sells credit default swaps on a bunch of bonds to Bank of Scotland Group PLC
   
3. Amherst Holdings sells credit default swaps on a bunch of bonds to Goldman Sachs
   
4. Amherst Holdings sells credit default swaps on a bunch of bonds to UBS
   
5. Amherst Holdings sells credit default swaps on a bunch of Bank of America Corp.
   
6. Amherst Holdings sells credit default swaps on a bunch of bonds to a bunch of other banks
   
7. Premiums exceed the face value of the bonds by many times.
   
8. Amherst Holdings takes some of the premiums, and gives this to Aurora Loan Services with instructions to buy and retire the bonds.
   
9. The CDS contracts are now worthless, and Amherst Holdings has taken way more in premiums than it spent on the bonds.
   
10. Collect underpants.
    
11. Profit!

OK, it doesn't actually involve underpants, but still.