The Wall Street Journal has a neat little story (subscription required) that illustrates the state of play in the investment banking business. There is an element of David vs. Goliath, but the more significant message seems to be that things have not changed in the world of credit default swaps.

The Journal's lede, "A canny trade by a small brokerage firm in two markets at the heart of the financial crisis has left some of the biggest players on Wall Street crying foul," is true enough, but ought to be beside the point. We then must slog through several hundred words about how J.P. Morgan and the Royal Bank of Scotland are mad as hell at Amherst Holdings of Austin, Texas, before learning how the deal actually worked.

Turns out, it's a story of how toxic loans were made good by a little bank, and how big banks are mad about it.

The story begins with $135 billion worth of subprime mortgages bundled up by Lehman Bros. According to the Journal, most of the loans, which had been crammed into a collateralized debt obligation (CDO), were either paid off or delinquent by last year. Only about $29 billion worth of loans were left, most of which were delinquent. The big banks wanted to make money on this.

So they bought credit default swaps on the bond. CDS act like an insurance policy. You pay a premium, and if the bond goes bad, the company that sold the CDS is supposed to pay you off.

As we've discussed, there are two problems with this system. First, although CDSs act like insurance policies, the banks (and others) who sell them are not regulated like insurance companies, and they don't need to have any collateral to back up the potential claims. Like a drunken compulsive gambler, they can just make bets and hope nobody kneecaps them when they can't collect. The second problem is that anyone can bet against any bond. You don't have to have any interest in the underlying bond in order to buy default insurance. In this way, the CDS market multiplied the apparent amount of money in the financial system by an order of magnitude.

The trouble came to a head last spring, when Bear Stearns collapsed and the U.S. taxpayers started shoveling money at all the other big banks and investment firms. There wasn't enough money in the world to make good on all the bad bets, so Uncle Sam has effectively printed money and made the bets good.

Some of them, anyway.

So a year after all this, after the near-collapse of the world financial system, after the U.S. Treasury has pledged trillions of dollars to prop up the wreckage, the game is still on. J.P. Morgan, RBS, Bank of America and others see this little bundle of bad debt and decide to buy insurance against its default. The big banks figure there's no way the bond won't fail, and they're far from alone in thinking this: At the time, the cost of this insurance was about 90 cents on the dollar. Amherst sold them some of this coverage, in the form of CDS, and took the premium payment with a smile. The herd mentality was at work here, the WSJ reports:

At one point, at least $130 million of bets had been made on the performance of around $27 million in securities, according to a person familiar with the matter.
Then Amherst went to work. It had way more money in hand than the bonds were worth. But Amherst faced a payout of even more still when the bonds defaulted. So they did the logical thing: they paid off the bond holders directly, and pocketed the difference between their premium payments and the bond payments:

When the bonds got paid off, the swaps became worthless, meaning the banks effectively forfeited what they had paid for the insurance. J.P. Morgan lost millions, while RBS and BofA suffered minimal losses, said people familiar with the matter.
So now the big banks are crying. But only that, WSJ notes:

So far the latest dust-up has been all words, in part, bankers say, because they are wary of attracting more regulatory scrutiny at a time when lawmakers are planning major reforms in the largely unregulated derivatives markets, long lucrative for banks.

To these guys, the only thing worse than trying to make a living in a completely inefficient, rigged scamatorium would be if someone came in to shut it down.