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”).
I really enjoyed a new post from Rortybomb that includes a great distillation of the mark to market debate:
So in the early 1990s, when I was in Junior High, there was a craze about collecting and trading baseball cards. Our classroom would have a corner during lunch where we’d all compare, with our binders and those 3×3 plastic containers for cards, who had what, and we’d trade back and forth accordingly. And of course we had our model, The Model, in fact, the Black-Scholes of our trading.
So while other kids were mowing lawns or delivering newspapers, I decided I was going to make my profit by arbitraging the volatile Frank Thomas rookie card market. I took a highly leveraged position in the Upper Deck Frank Thomas rookie card – I borrowed against future allowances, and bought several cards for $7 each from a kid who wanted to get out of collecting baseball cards in order to try hanging out with girls (loser!). Upper Deck is like the AAA of baseball cards. The guide said that these cards were worth $9. Buy at $7, sell at $9, instant money. My dad took me to the convention center, and I was all ready to make some cash money, when I found out that all the tables were only buying them for $5. Sensing my frustration (and also perhaps worried, since, like the FDIC or those with a savings account, he was providing all the leverage for me), he asked me, “wait, what are those cards worth again?”
I answered that they are worth $9. That’s what the guide, my model, says they are worth. No doubt those guide values are created by the most brilliant minds available. My dad, not in business or finance, was very clear in trying to explain to me “no son, they are only worth what someone is willing to pay you for them.” I responded that this card convention center was completely wrong in how they were valuing my baseball cards. I was but a little financial engineer back then; now I would have know to say “Dad, clearly the Soxs are having a bad season, and/or this isn’t the time in the year-long sporting cycle when demand is reasonable for baseball cards. I don’t feel I should get punished for the normal ups-and-downs of the baseball cycle.” I may have also noted that the flood of crap Fleer-brand baseball cards, the Mortgage Backed Security of its day, was destroying liquidity in the market, but that I had the trust of then Treasury Secretary Brady to start buying up those crappy baseball cards and get them transferred onto the government’s balance sheet.
So who was right? Me, with the model of the Baseball Collectors Guide and the excuse of the business cycle, at $9? Or my dad, who says they are worth whatever somone is willing to pay you in an open market, at $5? How you answer that question should color how you are disposed to to marking assets to the model, versus marking them to the market. Mind you, this was not just an academic exercise – at $5, my dad realizes I’ve made some terrible calls, and is probably going to make me start mowing lawns until I can pay him back. If I could convince him they were worth $9, I would not have to mow lawns (which I sincerely did not want to do) but instead could probably borrow some more…