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Hamilton on CDS Trade: "A fool and his money ..."

By Anonymous

I was going to post something on this CDS trade, but Professor Hamilton did a much better job than I could: How to lose on a sure-fire bet

Read Hamilton's take ...

Here are the details of the trade from the WSJ: A Daring Trade Has Wall Street Seething

The trade involved credit-default swaps and securities backed by subprime mortgages. The original securities ... were backed by $335 million of subprime mortgages mostly on homes in California made at the housing bubble's peak in 2005 ...

Following a wave of refinancing and defaults, only $29 million of the loans were left outstanding by March 2009, half of which were delinquent or in default...

Believing the securities would become worthless, traders at J.P. Morgan bought credit-default swaps over the past year from Amherst ... Other banks including RBS Securities ... and BofA also bought swaps on the securities from different trading partners.

The banks ... paid as much as 80 to 90 cents for every dollar of insurance, the going rate last fall according to dealer quotes, expecting to receive a dollar back when the securities became worthless ...

At one point, at least $130 million of bets had been made on the performance of around $27 million in securities ...

In late April, traders at some banks were shocked to find out from monthly remittance reports that the bonds they had bet against had been paid off in full. Normally an investor can't pay off loans like that but if the amount of outstanding loans falls to less than 10% of the original pool, the servicer ... can buy them and make bondholders whole.

That's what happened in this case. In April, a servicer called Aurora Loan Services at the behest of Amherst purchased the remaining loans and paid off the bonds.

Full post as published by Calculated Risk on June 11, 2009 (boomark / email).