We were intrigued by a headline in yesterday's Wall Street Journal: "Daring Trade Has Wall Street Seething!" it said. "Texas Brokerage Firm Outwits the Big Banks in a Mortgage-Related Deal, and Now It's War." War! How exciting! But when we tried to read the story, we suddenly understood how Tom Cruise must have felt back when he was dyslexic, before Scientology healed him. It was as if the letters were numbers. Like, for instance, in this paragraph:
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 -- or company that collects mortgage payments from homeowners and forwards them to investors who own the securities -- can buy them and make bondholders whole.
We're just going to admit it: The only words we really comprehended were "shocked," "paid off in full," and "normally." What was going on? Did we have to turn to the Church of L. Ron to figure it out? No, we figured, that would take too much time. So we called a hedge-fund friend— a real one, not an imaginary one—and asked him to explain in the language of humans.
Here is what he said:
HFF: Okay, so you know what a CDS is, right?
Daily Intel: Yes! It is insurance on something not getting paid back!
HFF: Okay, good. So. JPMorgan had $335 million worth of securities that they bought from Lehman Brothers. When they bought them, they thought they were investing in something with a high rate of return. But then everyone defaulted on their mortgages, and there was only $29 million worth of loans in the securities, or 10 percent of the value.
Daily Intel: Wow.
HFF: Those are the actual mortgages that are paying the interest. All that is left is $29 million. And of that $29 million, half of them are not paying their mortgages, they are in default. So JPMorgan has this on their balance sheet, and they're aware that there is very little they are going to get out of it. So they say, let's get rid of it. Let's buy a CDS, the insurance on it, so at least we can be assured of a percentage.
Daily Intel: So who sells them the CDS?
HFF: Amherst, the Texas brokerage. JPMorgan had to pay 90 cents on the dollar. Amherst says, Okay, JPMorgan, we'll insure that, but you have to pay us 90 percent of the value of what's left. And JPMorgan is like, okay, it's a risk-free trade. We're protected, we'll at least get 10 percent. And Amherst said, okay, the worst thing that will happen to us is that the default will go from 90 percent to 100 percent, and we lose 10 percent. So JPMorgan ends up paying like $130 million to insure this $29 million of securities, with the expectation that the loans will default and they will get 10 percent back. But then, Amherst gets a really good idea. They said to themselves: What if we can get someone to pay off the underlying loans? So they get this company, Aurora, to pay off the amount that is remaining. And in the end JPMorgan's swaps were made worthless, and Amherst kept the fee they paid.
Daily Intel: I think I get it. But what was in it for the other company, Aurora?
HFF: It doesn't say in the Journal: "Amherst won't provide specifics and won't comment on its arrangement with Aurora." There was probably some kind of backroom deal, like a "We'll split the profits on it" type of thing.
Daily Intel: Sounds like a sneaky thing to do. But not actually illegal, right?
HFF: It was a totally legal and even reasonable trade. One of the risks, one of the reasons so much money was made, is that there are all these little holes that can be exploited. There's a lot of loopholes in the process. Falling into them is risk you take when you play around with these securities.
Daily Intel: Still, it doesn't seem very nice of Amherst to do.
HFF: It's true, it's not a very good-guy thing to do. You'd be pissed if your friend did it.
Daily Intel: I really would.