Spotted: a free lunch

June 11, 2009 in Finance

The internets are buzzing about the CDS trade that netted small brokerage firm Amherst a nice profit at the expense of Wall Street giant JPM.

I may be missing something, but it seems to me that the risk hasn't disappeared (as is being implied), it has merely been transferred from the mortgage originators (or whomever they sold the bonds to) to Aurora, the mortgage servicer. It's a key distinction.

Basically, as I see it, Amherst raised a lot of money based on the fear of default and used those proceeds to eliminate the possibility of default as it pertains to the original risk-takers. It so happens that they were able to "raise" so much money that they ended up being paid to perform this service (such as it may be). They did not, however, eliminate the risk of mortgage default. Aurora now holds those bonds and is on the line if homeowners should fail to pay; I'm sure Amherst has passed on enough of the profit so that Aurora can not lose money on the deal.

So the "risk" still exists nominally, but so much profit was extracted from the trade that there is no downside risk to the arbitrageurs.

Ah, there's the key word that I haven't seen in any article - arbitrage. Not often you can point to such an obvious example in plain daylight, but nonetheless I'm surprised no one is calling this what it is. Amherst was able to sell (potentially unlimited) amounts of CDS at a price which was obviously too high. At a lower price, simple cash constraints may have prevented them from exploiting the trade, since no counterparty would sufficiently pay them enough to call the entire bond issue.

The system isn't broken; on the contrary, this is it in action! To all you Markowitz mean-variance CAPM scholars out there: you need events like this to ensure equilibrium! Unless, of course, you assume them away (or worse, into the mysterious realm of "endogenaity").

Leave a Comment

Previous post:

Next post: