Amherst Holdings: A case study in legal fraud?

tomterm8

An excerpt from the FT http://blogs.ft.com/maverecon/2009/06/the-magical-world-of-credit-default-swaps-once-again/ :

FT wrote:

...
Instead of buying up the entire outstanding stock of the bond directly and holding the bonds to maturity without calling a default, or forgiving the debt, I could instead, if the bond were some asset-backed security, purchase enough of the assets underlying the bond at prices in excess of their fair value to ensure that the issuer of the bond would have sufficient funds to pay off all the bond holders, should the bond be ‘called’, that is, retired prematurely. If in addition, I could make sure that the bond would indeed be called, I would again, through this financial manipulation, have reduced the probability of default on the bond to zero.

The scheme is beautiful in its simplicity, absolutely outrageous, quite unethical, deeply deceptive and duplicitous, indeed quite immoral, but apparently legal.

This in essence, is what has been reported to have happened recently, when a small Austin Texas-based brokerage , Amherst Holdings, which had sold CDS (default protection insurance) on mortgage bonds, then purchased the property loans underlying these bonds at above-market prices to prevent a default that would trigger payments to buyers of the contracts.

Some mortgage bonds can be “called,” or retired early, when the amount of loans backing the debt is reduced to certain levels by refinancing, loan repayments or defaults. The mortgage bonds targeted by Amherst fell into that category. So the mechanism through which Amherst made sure enough money would be available to the issuer of the mortgage bonds to pay the obligations due on these bonds, also caused the bonds to be called. The bonds were paid off in full, and the CDS Amherst had sold on these mortgage bonds became worthless.

Many household names in Wall Street and the City of London were at the wrong end of this transaction. Amherst has been reported as selling more than $100 million worth of CDS on $29 million of mortgage bonds outstanding - a tidy profit of at least $70 million. It certainly beats working for a living.

Generali

Caveat emptor.

These markets stink - at least with the stock exchange all the transactions are meant to be above board (I'd make CFDs subject to the same rules as share trades personally).

If you get involved with CDSs and so on you get what you deserve.

Count_Dante

It's a wise guy profit making scheme, like matched betting just on a far bigger scale. Sometimes you can only shake your head and laugh.

Count_Dante

Interesting comment (#18).

I don't see that much wrong with what Amherst did, because they essentially fleeced the gamblers without hurting those that were genuinely looking for insurance. Those who were using CDS to hedge against risk to a real insurable interest got exactly what they wanted and paid for: no default. They maybe even got it cheaper because Amherst was desperate to sell as much protection as possible. Other holders of those bonds who didn't buy protection basically got free protection when they were able to unload their bonds onto Amherst. The people who lost were the gamblers that thought they could make free money. Even their loss is useful if it serves as a warning to other would-be excessive risk-takers.

Mr_Mumble

I don't see the problem here. CDSs are supposed to be insurance devices, if chumps decide to buy $100m of insurance on only $29m of assets then they deserve to lose.

edit: beaten by Count Dante.

tomterm8

The point is, the people who argue that CDSs are an insurance product are proved wrong by the fact that Amherst Holdings sold more CDSs than the notional value of the bonds "insured". In an insurance context, knowingly overinsuring would breach the very basic insurance principal of utmost good faith, and allow the contract to be voided.

It is important to note that "Caveat emptor" does not apply to insurance contracts, the legal doctrine of "Uberrima fides" does.

In addition, there is no requirement in the contract for there to be an insurable interest. Unlike in insurance contracts, there was no requirement that the buyer of the CDS holds bonds or any actual risk.

And so...

The CDS's in this case were clearly gambling. Both the buyers and sellers of the CDS almost certainly contemplated that it was a gambling contract. Amherst Holdings was acting a bookie. If you were to put a £5 on Blue Dude to win the 3.10 at doncaster, and the Bookie bought the horse and didn't run it, you would feel rather aggrieved.

michaels

It is a bit like the whole third world debt forgiveness scam. Suppose a poor country is only likely to repay about 50% of its debts, its debt is likely to trade at about 50% of face value. If 50% of the debt is then written off suddenly there is a good chance that all the outstanding debt can be paid off and it jumps in value to par. Net effect is that the poor country still ends up paying off just as much debt as without the cancellation...

My theory is that some philanthropist should secretly buy up all the debt of an over indebted poor country at distressed value of say 20p in the £ and write off all the debt. The newly debt free country could then borrow enough to pay back the philanthropist at market rates as its new borrowings would only be 20% of its previous ones and thus would be accessible at a reasonable rate of interest.

Generali

michaels wrote: »

It is a bit like the whole third world debt forgiveness scam. Suppose a poor country is only likely to repay about 50% of its debts, its debt is likely to trade at about 50% of face value. If 50% of the debt is then written off suddenly there is a good chance that all the outstanding debt can be paid off and it jumps in value to par. Net effect is that the poor country still ends up paying off just as much debt as without the cancellation...

That only works if the country concerned has the money to buy debt up in the market and retire it which usually isn't the case with 'HIPCs' (Highly Indebted Poor Country - horrid phrase). They have to pay back the face value of the debt.

The way I understand the debt forgiveness works is that investors are persuaded to give up the right to some of the debt in return for being more likely to get all of what remains as structural reforms and increased aid improve the HIPC's economy.