Banks get greedy...take it in the shorts

In a recent article in WSJ and detailed in this blog post, you can read about how a small securities firm out of Texas pulled a fast one on the likes of JP Morgan Chase, BofA, and RBS.

Here's how it went down.

Lehman Brothers purchased a bunch of loans and put them into a mortgage backed security in 2005. These were mainly Alt-A loans secured by properties in CA at the height of the market. Predictably, the $337 million pool is worth just a tiny bit less than that now. Between borrowers refinancing, selling, but mostly being foreclosed on, the principal balance of the pool was down to just $27m.

Lehman Brothers serviced the loans through their subsidiary, Aurora Loan Services. The actual owners of the pool were made up mainly of other institutions, namely Chase, BofA, and RBS.

Since these investors knew that the $27m was the outstanding balance of the principal, but that most of the loans were either already defaulting, in foreclosure, or were very likely to go to foreclosure, they valued the pool at something like $3m.

Thinking they were smart and wanting to hedge against the inevitable loss that they were going to take on the pool, they purchased a type of insurance called a Credit Default Swap.

The Credit Default Swap (CDS) insures them against the chance that the borrowers defaulted on the remaining loans.

They purchased these swaps from a small brokerage in Austin, TX called Amherst Holdings.

Amherst wasn't dumb and they knew that there was a very high chance that the borrowers would default and that the banks would cash in on their policy, so they charged through the nose for it.

They would charge the banks as much as 90 cents for every $1 of insurance. The banks obviously thought that more than 90% of the loans would default and they would collect their $1 and make a tidy little 10% profit on the remainder of this pool.

Follow so far....

Here's where it gets interesting.

Sicne the CDS market is unregulated, anyone can purchase a CDS on this particular security...WHETHER YOU ACTUALLY OWN IT OR NOT. It's similar to purchasing insurance on your neighbor's house.

The Banks thought, well this is about as gauranteed as it gets, so they loaded up on these contracts.

Amherst ended up selling over $130 million worth of insurance on $27 million worth of loans. Sicne they were charging up to 90 cents on the dollar, they collected over $100 million in premiums for this insurance.

They then simply took $27 million of it paid off the loans.

So the banks now have their $27m back, but they paid for $100 million in premiums.

Whoopsie.