Wall Street Wizards? Not so Much.
Here’s a nice post on how little old Amherst Holdings of Austin, TX got the best of J.P. Morgan Chase, Royal Bank of Scotland, and Bank of America. Amherst sold them all Credit Default Swaps (CDSs) against mortgages that were already under water. CDSs pay out if the underlying mortgages default. Everyone knew these mortgages were in bad trouble. Sure thing for the big guys, right? Wrong.
It turns out you can sell as many CDSs on the same mortgages as you want. So Amherst sold more CDSs than the face value of the mortgages. Way more as it turns out. Then they simply bought up the loans and paid them off. No default, so the CDSs don’t pay out. They pocket the difference between the value of the CDSs they sold and the face value of the mortgages they had to buy up. About $70M according to this report.
Of course, the Wall Street wizards are calling foul. This is silly because if each of them had only bought enough CDSs to cover his own exposure, they all would have been fine. But they got greedy and thought they’d try to take advantage of Amherst by buying several times as much coverage as they needed. My wrestling coach had a piece of advice for what to do when your opponent makes a monumental mistake. “NEVER give a sucker an even break.”