Amherst Credit-Default Swap Trades Spark JPMorgan, RBS Protests

By Jody Shenn and Shannon D. Harrington

June 12 (Bloomberg) — JPMorgan Chase & Co., Royal Bank of Scotland Plc and at least five other banks are considering rules to require sellers of credit-default swaps on mortgage bonds to disclose when they may have the power to render the contracts worthless, according to people familiar with the situation.

The American Securitization Forum, a New York-based trade group, arranged a conference call yesterday with officials of the companies after the Wall Street Journal reported that JPMorgan and other banks lost “millions” of dollars in credit- default swaps tied to bonds backed by home loans. The value of the contracts, which were sold by Austin, Texas-based Amherst Holdings LLC or its clients, evaporated when the bonds were called at the behest of Amherst, the people said.

“This was like a freshman mistake in college,” Andrey Krakovsky, the chief investment officer in New York at Tacticus Capital, said of the banks. Krakovsky is raising money for a hedge fund that plans to use loans from the Federal Reserve to buy asset-backed securities.

The $38.6 trillion privately negotiated market for credit- default swaps, designed to protect investors from borrowers who don’t pay their debts, is largely unregulated. The Fed wants more transparency after American International Group Inc. was brought to the brink of bankruptcy because of bad bets using the derivatives and Lehman Brothers Holdings Inc., one of the biggest dealers, collapsed.

‘Their Market’

“This is what the dealers wanted, this is their market,” said Christopher Whalen, managing director of Torrance, California-based Institutional Risk Analytics, which analyzes banks for investors. “They can’t come to me now and say this is so unfair.”

Dealers agreed this month for the first time to report all trades to a central repository by July 17, giving regulators a more complete view of the risks. Traders have also started moving some of the most common types of credit swaps, those backing corporate debt, through a clearinghouse run by Intercontinental Exchange Inc. in an effort to contain losses if a firm failed.

At issue in the Amherst trades is whether sellers of protection on mortgage bonds can purchase loans underlying the debt at above-market prices to prevent a default that would trigger payments to buyers of the contracts. Credit-default swaps pay the buyer if the securities aren’t repaid as expected.

‘Foul Play’

The call of the securities at their face value of $29 million, the amount remaining in the bond issue, caused the banks to lose money. Bankers on the American Securitization Forum call probably couldn’t ban the strategy for existing trades, said the people.

Proposals included creating agreements for new swaps that would force sellers to disclose whether they have the right to call the securities, and “best practices” guidelines to say such trades shouldn’t be executed, they said.

In a note to clients two months ago, strategists at Frankfurt-based Deutsche Bank AG said the practice was potentially illegal, or at least “foul play.”

Tom Johnson, a spokesman for Amherst at Abernathy MacGregor Group in New York, said the firm doesn’t “comment on specific trades.” Amherst, led by Chief Executive Officer Sean Dobson, “acts in good faith,” Johnson said. “They wouldn’t enter into opportunistic trades knowing what the outcome would be.”

Other banks on the call included Charlotte, North Carolina- based Bank of America Corp., Deutsche Bank, Barclays Plc of London, New York-based Morgan Stanley and Goldman Sachs Group Inc, also in New York, the people said. Spokesmen for the firms either declined to comment or didn’t respond to requests.

Katrina Cavalli, a spokeswoman for the securitization forum in New York, didn’t return messages seeking comment. Louise Marshall, a spokeswoman for the International Swaps & Derivatives Association in New York, didn’t immediately comment.

Paulson’s Complaint

Two years ago, a group of hedge funds said banks were planning to derail bets against subprime-mortgage bonds with similar tactics. New York-based Paulson & Co. sent a letter to the U.S. Securities and Exchange Commission asking the regulator to be on the lookout for manipulation.

Banks dismissed the complaints, and the ISDA declined to recommend changes to contracts that would address the funds’ concerns.

“Existing legal prohibitions were specifically designed to deter a broad range of misconduct that constitutes fraud or manipulation,” the industry group said in a statement after a June 2007 meeting between 100 dealers and investors. Adding restrictions “would artificially inhibit legitimate market activity, favoring the position of one side of the market at the expense of the other,” ISDA said.

Unwinding Deals

Some mortgage bonds can be “called,” or retired early with the remaining securities paid off at face value, when the amount of loans backing the debt is reduced to certain levels by refinancing, loan repayments or defaults. That’s because the administrative expense for the securities becomes too large compared with the interest and principal the loans generate. The right to unwind deals usually is held by servicers or owners of their lowest-ranking classes of the bonds.

Deutsche Bank strategists discussed the bonds at the center of the Amherst trade in an April 29 note to clients. Contracts on the securities at one point totaled as much as $130 million, the Journal reported.

The bank concluded that if investors bought the mortgages and seized homes backing the securities at par, they would pay $13 million more than the loans were likely worth. The purchase would be needed to repay the bonds at face value as required in a call. Offering above-market prices would still allow investors to profit had they sold at least $14.44 million of credit- default swaps tied to the bonds, according to the Deutsche Bank note.

‘Quintessential ‘Insider”

Such activity may not be “legal,” especially if the seller of credit-default swaps knew before entering into the contracts that it had the right to call the bonds and planned to do so, Deutsche Bank said in the note. The seller would be a “quintessential ‘insider,’” the note said.

Aurora Loan Services, a Littleton, Colorado unit of Lehman Brothers Bank, serviced the loans on behalf of owners of the securities. The bank’s former parent, Lehman Brothers Holdings Inc., underwrote the about $330 million of bonds. Deborah Munies, a spokeswoman for Aurora, declined to comment.

The Amherst situation differs from what funds accused banks of planning in 2007 because the firm didn’t own the servicer, so the strategy shouldn’t be considered “manipulative,” Tacticus’s Krakovsky said.


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