Viewpoint: At Amherst, a Simple Game

Perhaps the best story this week (outside of the coverage you’ll see here at HW, of course) involves a mortgage-related trading strategy pulled off successfully by Austin-based Amherst Securities Group LP, a fixed-income specialist focusing on mortgage-related investments. Imagine taking the big boys at JP Morgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS) for a ride, using the most simple of economic observations: when too many people go left, it can become very profitable to turn to the right. According to the Wall Street Journal, which broke the story Thursday, that’s exactly what Austin, Tex.-based Amherst Securities recently did. In this case, clients of the Austin-based firm had sold credit default swaps — essentially, an insurance contract — on bonds backed by pools of subprime mortgages in California. The original loan pool in question here was $335m of mostly 2005-vintage loans, and that pool had fallen to just $29m in par by March 2009, thanks to (what else?) a surge of borrower defaults. Trading desks at JPM and elsewhere, looking to hedge what they saw as certain losses, bought CDS contracts from Amherst’s clients for 80 to 90 cents on the dollar. The idea among Wall Street traders at the time was simple: with half of the $29m remaining already in default, they were sure to gain an even-dollar payout from the CDS seller when the bonds fell even further. Great hedge, right? Not exactly. The value of the payouts, called the notional value — the CDS contracts outstanding — ended up far exceeding the actual value of the assets the CDS contracts were written against. The WSJ reports that on that little $29m subprime mortgage pool, more than $130m in CDS were outstanding at one point in time, as everyone looked to hedge their positions. So little Amherst went ahead and asked the servicer on the loans — in this case, Aurora Loan Services — to purchase the remaining $29m in loans and pay off existing bondholders at par. (Servicers can purchase out a pool of loans when UPB falls to 10% of the original pool). The stunning, yet elegantly simple, result is thus: every single one of the CDS contracts outstanding became instantly worthless. Amherst executives told the WSJ that they merely saw an opportunity to protect client interests, and jumped on it after getting a thumbs up from legal. But, according to the Journal, JPM and Goldman aren’t exactly content to sit on their laurels about the issue, and have brought their concerns to both SIFMA and the American Securitization Forum. And if you think their concerns are limited merely to a couple of hundred of millions of dollars worth of exposure, it’s time you started to think again. Wall Street’s lead dogs likely now see just how badly they might have been had, because nearly every major player in the mortgage bond market has run headlong into CDS in the past 18 months in an effort to hedge their quickly-souring subprime mortgage bond exposures (and Alt-A, too, among other asset classes). There are CDS contracts out there that involve pools of mortgages far greater than $29m in par — and you’d better believe JPM, Goldman and others know it, and are now suddenly all-too-aware of their potentially precarious position. The Journal reports that Deutsche Bank (DB), for example, has sent a list to clients of other mortgage pools that are potentially exposed to the same sort of trade. You can bet there are other lists circulating elsewhere, and now being feverishly compiled. Write to Paul Jackson. Disclosure: The author held no relevant investment positions when this story was published. Indirect holdings may exist via mutual fund investments.