It’s Not Gambling, It’s Sophisticated Investing. Right.

A recent sting operation perpetuated on several Big City Banks by a smallish Hedge Fund puts my Schadenfreude Meter off the scales. This one feels even better than a vicious lawyer joke.

Let’s see if I can explain what they did. [Note: the following narrative is based on an article in the Wall Street Journal but I have not confirmed its accuracy.]

One of the Financial Products created by the rocket scientists who almost brought down the world’s financial system is called a Credit Default Swap. As originally implemented it was/is a very worthwhile instrument. Let’s say I decide to buy a bond issued by General Electric, but I’m worried that when the bond matures they don’t have the money to pay back my investment as they agreed.

We Are Your Sophisticated Money Managers

I can buy a CDS from a third party, say one of the big investment banks, who will agree to pay me in case General Electric defaults. It’s like an insurance policy. Nothing wrong with that, and as Allen Greenspan famously said, these instruments spread the risk around the market and are good for the overall system.

Only one teensy, weensy, minor detail. The way the regulations work, I don’t actually have to own the original GE bond to buy the CDS. In this case I am really just placing a bet against GE with the bank that sold me the CDS. Isn’t that neat? Of course we don’t call this gambling, because we are sophisticated money managers.

So in the case we are discussing, it wasn’t a GE bond but a collection of subprime loans that a number of large banks were convinced would default. Those banks reportedly include J.P. Morgan Chase, Royal Bank of Scotland, Bank of America plus other investors. These people bought CDSs from Amherst Holdings of Austin, Texas betting that the loans would default.

Because you don’t need to actually own the securities being insured, at one point there were $130 million of bets that had been made on the performance of around $27 million in securities! Oh sorry, I slipped and called these sophisticated investment, bets.

Now guess what is reported to have happend next. Oh, I love this. Amherst Holdings took the money they got from the sales of the CDSs to the banks who thought they were betting on a sure thing, and paid off the underlying mortgages, thus making the CDSs absolutely worthless! And they did it with the bank’s own money!

It was the ‘loophole’ that allowed the banks to buy the CDS without owning the underlying assets that essentially led them to shoot themselves in the foot. That’s because if only the real owners of the securities could buy insurance then Amherst Holdings could never have collected enough in premiums to pay off all the underlying loans.

There should be a way to expand this idea and save all those foreclosed homes and kick-start the housing market, don’t you think?

Here is your link to the original Wall Street Journal article. And below is a simplified illustration of the sting operation. Click on the graphic to expand.

More disclosures. Although I’d like to take credit for turning up this great story, it was pointed out to me by my son, Matthew. If you’d like to thank him, you can do that by clicking on the link to the right of this post and go to TreasuredFinds.com which is his website.

One final TIP. If you clicked on the Wall Street Journal link above and didn’t get the full article because you are not a paid subscriber, here’s a workaround that usually succeeds. Type the following into a google search box

Wall Street Journal A Daring Trade Has Wall Street Seething

When the links come up in google, click on the one from the WSJ’s site. You can pick it by looking at the url. I guess the WSJ lets you read articles that are searched through google. It’s a neat trick, but you need to know part of the article title.

Enjoy, no charge for that tip.