Thursday, June 11, 2009

The Amherst CDS trade (trading)

This WSJ article was making the rounds today:

"A Daring Trade Has Wall Street Seething"

(EDIT: It appears the link leads to the usual WSJ thing where it says you have to be a subscriber. To bypass this, type the name of the article in google, and the google link to the WSJ article will allow you to read it in full)

It was an interesting situation, and the journal article did a good job of explaining everything such that someone not in finance could still figure out what happened. In short, a small firm sold a lot of CDS on a bunch of bonds backed by subprime mortgages that were about to fail. After selling an amount that was multiples of the underlying bonds, the company "somehow managed" to get the servicer to buy up all the bonds and pay off the principal (something which was allowed only in this circumstance because what was left was 10% of the original batch) and caused the CDS to be worthless. Some of the big banks (JPM, RBS, and BofA were named) who had bought up the CDS, at 85+cents on the dollar, were now whining.

Another example of the problem when the derivative is bigger than the underlying instrument. Of course if the market was regulated and open interest was available for all to see, this coup might not have happened. Regardless, this was a great trade for whoever Amherst was representing and just an apalling oversight on the part of the named banks because this certainly had to have been foreseeable.

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