Credit Default Swaps: How to Lose On a Sure-Fire Bet

There was a wonderful story in today’s WSJ about how some big banks managed to lose some of their hard-earned TARP money.

Let me begin with a little background. A credit default swap is sometimes described as an insurance contract written against the possibility of default of a particular underlying asset. If I buy a CDS and the specified asset defaults, I get to collect money from whoever sold me the contract. If I also have a long position in the asset in question, I might consider buying a CDS written against that asset as an insurance or hedge against the possibility that the asset loses its value.

But I don’t actually have to own the asset in question in order to buy a CDS from somebody else. I might want to buy a CDS as a partial hedge against some other asset I hold with which the specified security could be correlated. Or maybe I just feel like making a bet with somebody I think is dumber than I am.

The fun and games begin when multiple contracts get written on a single credit event and the notional value of outstanding contracts on that event– the total amount of money that is promised to be paid to the buyers of those CDS in the event of a default on the underlying asset– becomes larger than the par value of the underlying asset itself. Then it would clearly pay the party who sold those contracts to buy the underlying asset itself at par, relieve the original debtors of their burdensome obligations, and be out only $X (the underlying event) rather than some multiple of $X (all the contracts written on the event).

And so the WSJ recounts the tale of a security based on $29 million (par) worth of subprime loans in California, half of which were already delinquent or in default. Betting that the loans weren’t worth $29 million sounds like easy money, and the smart guys were willing to pay 80 to 90 cents for each dollar of CDS insurance.

It appears from the WSJ account as if little Amherst Holdings of Austin, Texas was happy to sell the big guys like J.P. Morgan Chase, Royal Bank of Scotland, and Bank of America something like $130 million notional CDS on a $27 million credit event, used the proceeds to buy off and make good the underlying subprime loans, and pocketed $70 million or so for their troubles. The big guys, on the other hand, paid perhaps a hundred million and got back zip.

Said big guys, naturally, are screaming bloody murder, trying to bring in the lawyers to show that Amherst wasn’t playing by the rules of the game.

For my money, the first rule we need would be a law, not a rule, that notional not exceed actual.

Barring that, here’s another rule I trust: a fool and his money are soon parted.

How to lose on a sure-fire bet

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