By Andrew Dittmer, a mathematician with hedge fund experience, and Richard Smith, a UK based capital markets IT consultant
Readers of this blog are by now familiar with the incredible story of how a single hedge fund (Magnetar) managed to play a shockingly extensive role in inflating the housing bubble in 2006-2007. The story was first broken seven weeks ago in Yves’ book ECONNED (completed in early October 2009). Despite the obvious importance of the Magnetar strategy, the media at large was still generally ignorant of what happened.
Earlier this month, though, this silence has been broken with an extensive report on the Magnetar trade prepared by the public interest research group ProPublica. The ProPublica piece contains a wealth of narrative detail and some useful links to documents including prospectuses of particular Magnetar CDOs. The official Magnetar responses (and refusals to comment) to particular questions from ProPublica are especially illuminating.
Of course, the ProPublica team had no way of knowing that Yves’ book would contain a chapter on the same material, and it might have been frustrating for them to see a story to which they had devoted so much effort first appear elsewhere. Still, they have every reason to feel proud – their article contains important information about the Magnetar trade that is not found in ECONNED, and remains valuable in its own right.
Given the intrinsic worth of the ProPublica piece, it is hard to understand why its authors felt it necessary to try to minimize the treatment of the Magnetar story in ECONNED. They write:
Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, “Econned,” that “Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.”
In other words, the ProPublica authors credit Yves for some “reporting” on the Magnetar trade and for a sound bite, while claiming to have been the only ones to have “assembled a full narrative.” A reader of the ProPublica piece would have no clue from this description that Yves’ book contains 22 pages of detailed description of the Magnetar trade, together with footnotes and an appendix that discuss even more technical details.
By far the most important consideration is to help make sure that the Magnetar and similar trading strategies become as well understood and widely known as possible. Since we believe that the ProPublica authors similarly put the public interest ahead of any worries about who gets the spotlight for the story, we are troubled by what looks like an attempt to diminish Yves’ role. Perhaps the authors were in a hurry to finish their piece and did not actually read ECONNED carefully enough to understand Yves’ contribution.
The most constructive response therefore seems to be to reiterate how important it is for people who genuinely care about financial reform to support one other, and then to discuss some of the differences between the two pieces, and how they complement one another.
The ProPublica piece is especially notable for containing
• information about how Magnetar sought CDO structures that were particularly congenial to its strategy (so-called “triggerless” structures).
• a list of 26 of the (purportedly) 30 CDOs in the Magnetar Constellation program, together with some information about those CDOs.
• a convenient timeline showing when these CDOs were created
• a study of how rapidly the Magnetar CDOs blew up compared to similar CDOs that were not sponsored by Magnetar.
• some information about who ended up with tranches of the Magnetar CDOs, although a great deal of work still remains to be done here by people who are interested in this issue.
• a case where another party (Ischus Capital Management), refused to do a deal with Magnetar.
One particularly interesting detail in the ProPublica piece is the account of how Magnetar offloaded some of the equity slices they had retained by stuffing 18 of them into a special CDO (Tigris) that through the usual miracles was rated by S&P and Fitch and then sold to the Japanese bank Mizuho.
Our own research is largely consistent with the list that ProPublica provides of 26 Magnetar CDOs. Specifically, the transaction detail we have worked out to date identifies 29 of perhaps as many as 50 Magnetar CDOs and supplies some information not given in the ProPublica piece. There are some cases where the ProPublica numbers for par value diverge from ours on the upside; knowledgeable readers are encouraged to weigh in, both to confirm numbers that disagree and to identify the mysterious “last” Magnetar CDO. See our spreadsheet on the transactions, developed with the input of market participants and prepared by Tom Adams and Andrew Dittmer, here.
What is regrettable is that the ProPublica piece does not emphasize the huge systemic role that the Magnetar strategy played in amplifying the impact of the subprime bubble. The authors begin their piece by pointing out that
In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.
Despite this promising beginning, the ProPublica authors never actually explain to the reader the connection between the Magnetar story and [emphasize] why, contrary to what should have been expected, the housing bubble swelled to massive proportions in 2006-2007. Even with the rating agencies’ colossal and deservedly criticized misratings, the subprime bubble would have died a much earlier, less costly death absent the way Magnetar’s strategy drove demand and multiplied the size of the total exposures in the toxic phase of the subprime bubble.
The fact that a single hedge fund, with a comparatively small amount of capital, could wreak such damage, indicates that the true leverage and costs of recent financial “innovations” are not well understood. Omitting the systemic importance of Magnetar risks turning the Magnetar story into a scandal about an individual firm, rather than what it truly is: an indictment of the financial system as a whole.
Some other important details about the Magnetar trades that are discussed in ECONNED include:
• How a seemingly small amount of BBB tranches from subprime bonds used in Magnetar’s CDOs, had a devastating impact on the subprime market. Consistently conservative analyses indicate that in the peak years of 2006 and early 2007, Magnetar’s program drove the demand for roughly 35% of subprime bonds. Industry sources have estimated that the number may be as high as 50% to 75%.
• Magnetar’s trade was imitated by other hedge funds and dealers, further increasing the systemic impact.
• The deals were mostly hybrids, typically with 20% cash bonds and 80% credit default swaps; why this structure was advantageous for Magnetar.
• The links between the demand for CDOs and the “negative basis trade” that was arguably a widespread form of bonus fraud. (When a AAA instrument was insured by an AAA guarantor, internal reports typically treated it as if all the expected income in future years was discounted to the present. As we know now, in the overwhelming majority of cases, bonuses were paid on income that was never earned. This mechanism was THE reason many banks would up holding so much AAA CDO inventory – it was more lucrative for the traders to retain and “hedge” it than sell it.)
• The masquerade of almost entirely BBB subprime risk as AAA suppressed CDS spreads on BBB subprime bonds, the most actively traded tranche of the original bonds. Via arbitrage, this also influenced subprime bond pricing, which in turn lowered the yield on the loans themselves. In this manner, the mezzanine CDO market directly influenced spreads in the subprime housing market.
There’s perverse irony at work here. The blogosphere often complains of having its scoops ignored or worse, stolen by the mainstream media. Here we have a case where an critical story presented via the absurd long lead time off books (the finalization deadline of early October 2009 versus a publication date of early March 2010) still beats MSM and blogosphere to the punch by six weeks, yet has been given less recognition that it would seem to deserve by both. And the side effect is serious, that the systemic impact of the Magnetar trade still remains largely under the radar.
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Andrew Dittmer writes:
>> Given the intrinsic worth of the ProPublica piece, it is hard to understand why its authors felt it necessary to try to minimize the treatment of the Magnetar story in ECONNED.
Not only them. Paul Krugman says:
“And Goldman isn’t the only financial firm accused of doing this. According to the Pulitzer-winning investigative journalism Web site ProPublica, several banks helped market designed-to-fail investments on behalf of the hedge fund Magnetar, which was betting on that failure.”
http://www.nytimes.com/2010/04/19/opinion/19krugman.html
I guess some people may perceive Yves as somewhat rough lady. Don’t want to judge here personally.
one source of discrepancies is that on most of the Citigroup CDOs you identified as Magnetar deals, you omitted to include the super senior tranche (which may have been issued in unfunded form).
The first two Cetus deals were $1 billion each, as was Octans. Each had, in addition to the $300 million of tranches you identified, a $700 million super senior, bringing each to $1 billion.
The fourth Cetus was $1.5 billion: your $450 million of tranches plus a $1.05 billion super senior.
Lacerta was $2 billion: your $600 million of tranches plus a $1.4 billion super senior.
Thanks for the update Oriduck – we were relying on Moody’s data for those.
The biggest point of all?
We’ve been robbed and nothing is ever going to be done about it. Guys sitting on billions of dollars in Evanston, IL are laughing at us… protected by the Powers That Be who want nothing else but to maintain the status quo. At this pace in the world of capital markets/structured products, the next batch of CDOs are only six months away. The GSEs are subsidizing the majority of the loss… AIG/QE took care of most of the rest. The American people don’t care and the Government will continue to ignore righteousness until the last few people who get the joke stop caring.
We have been had. Our country has been stolen and our money has been transfered to the Oligopoly. As long as American Idol comes on as scheduled, nothing will ever happen to correct this — the single greatest injustice in the history of man.
I apologize for being so dire… I hope I helped where I could. But we have a choice. Revolution or Acceptance. Well written, studiously researched, and eloquent prose just isn’t going to make a difference.
The dream that was America was fun while it lasted…
“I apologize for being so dire.”
Nothing to apologize for….many of us out here believe the very same. Obama’s staff have been receiving an overwhelming number of comments addressed similarly (from my inner White House source).
I’ve had much difficulty explaining things to all the Ameritards I’ve run into over the years, especially lately (I refer to anyone over the age of 35 who is completely oblivious to the extraordinary economic damage to the USA of offshoring jobs, money and technology over the preceding 50 years).
The simplest of explanations: Imagine if the American response to World War II had been to immediately being offshoring our money, jobs and technology?
Well, that is what’s been happening over the past 50 years, increasing with every decade, until we’ve reached critical mass this past decade.
Which is why ANY recovery is mathematically impossible….
Sgt_doom,
I beg your pardon… but there’s enough blame to go around. Personally, I will never forgive the “Reagan Democrats” and still find it hard to sit in the same room with them. I am 58, mortgage-free, debt-free, and have been that way for most of my adult life. Wish many in my generation could say the same. Looking backwards, the credit spigot was only turned on to obfuscate declining living standards brought about by the decline of manufacturing and outsourcing of which you speak. Here in Ohio it began much sooner than elsewhere in this country as plants relocated to the right-to-work Southern states. But this was no accident…
There are many of us over 35 who saw the writing on the wall and did everything we possibly could to communicate where this would end, trashing careers, marriages, and the like along the way. Many of us have been in the poltical wilderness for most of our adult lives – political refugees – marginalized by the MSM as pot-smoking hippies… But that could not be further from the truth. It’s a stereotype to dissuade many of you from critically analyzing what actually transpired. Were mistakes made? Yes… Often missing from such accounts is the COUNTERREVOLUTION waged by the reactionary forces in this country that came in its wake. A reaction to the 60s that sought to undo every vestige of the New Deal and take us back to the days of the robber barons – starving the beast if you will. Well we’re there… This was no accident either.
How many between 18-45 still adhere to Ayn Rand’s free market utopian bullshit – even after this mess? Have you read ECONNED? This libertarian-back-to-the-idyllic-world-of-free-markets anti-government, anti-regulatory, anti-union vitriol of rabid individualism spewed by many in this age cohort is every bit as damnable, if not laughable. Let’s dismantle the state and replace it with the benevolent despotism of the MNC – market totalitarianism – in which the technopeasantry is happy to have a job. Makes “cents” to me! Utter nonsense but is anyone under 45 listening? Of course, some are but is the MSM media paying attention? Why not? We’ve been here before…
More importantly, with such a sweeping generalization indicting the over 35 crowd for this debacle is precisely the divide-and-conquer strategy that pits one generation against another in a beggar-thy-generation downward spiral that will not end well for either. And there’s only one winner in such a game and it won’t be the average American irrespective of his/her age.
Back in the 60s it was our parent’s fault… They just didn’t get it! WE DON’T GET FOOLED AGAIN was a popular refrain. But it looks like some of you already have…
There was no reforming it then and there’s no reforming it now. But finding an alternative that is equitable, sustainable, and profitable for all stakeholders is where some of us over 35 are at… working hard at it. Care to come along or just blame everyone over 35 for everything that went wrong? Just write us off as legacy costs… like most corporations do, something to be discarded like widgets, but only after we paid for your college education. Talk about a waste of f—–g money!
ARBEIT MACHT FREI!
“the credit spigot was only turned on to obfuscate declining living standards brought about by the decline of manufacturing and outsourcing of which you speak.”
This is such a critical element to how the whole fleecing worked!
I’m speaking as one who’s been trying to wake people up to this for decades and found that people generally and sadly prefer to cling to their fantasies as long as possible… even when they’ll admit their own mystification at how it all holds together!
They’re comforted by the assurance of our main-stream ‘experts’ (they used to be called Shaman, wizards and oracles and now use complexity to create magic instead of lizard guts)…
But I think people are wising-up. At least they may pay more attention as things get more challenging.
But good leadership is essential. And right now our systems don’t do a good job of finding or encouraging that. Especially a recognition of a need for ideas and approaches outside of a very narrow range of viewpoints, which is the input that’s needed.
Economics is a failed discipline because it sees itself as more than it is. Money and credit are technologies, very essential technologies but very, VERY flawed… and NOT able to reach all fundamentals of what makes a society sustainable even if they were perfectible.
And add the problem of an eco-system reaching its limits… well, its ugly.
What happens when the colony of bacteria in the petri dish reach their greatest success? They run out of agar!
Poor dumb bacteria. We’re much smarter right?
Well, I only first heard of Magnetar 10 days ago on a masaccio post at FDL, and my hair promptly ignited. I promptly read the ProPublica site, and didn’t get my copy of Yves’ book until late last week.
However, a lot of people are still finding out about ProPublica.
And people are still learning about NC.
It wasn’t until last weekend that I heard people talking about Goldman Sachs, the SEC, and ‘derivatives’ with the kind of impassioned conversation they generally reserve for politics, the Seattle Mariners, golf, or their tennis sets.
So I think that no matter where people first encounter the story of Magnetar, the story is so breathtaking that it arouses curiosity: the villany, the duplicity, the scale, the velocity — news about Magnetar, Goldman Sachs/SEC, and WaMu has all really converged in the past week.
I think this is a doozy of a story and we’re only in the prelude.
Cue up the sound track, because I think that the audience will continue to build, and the fact that Yves isn’t the only one trying to explain this story clearly actually only increases her credibility.
Wait a few weeks: I think this is almost certain to build, because its so mind-boggling, and it involves sums of money so much larger than state and national governments that it really does grab people’s curiosity and attention.
I think the view of this is Magnetar as the cowcatcher on the train wreck that is occurring.
I agree with another commenter’s suggestion that Appendix II of your book be provided as a special posting….it will sell more copies of the book, IMO.
Quite the book, Yves. I think it will become a text book in some coming classes.
I want my copy of your book signed someday, darn it! Get stuck in Portland OR instead bloody old England. We have a volcano near us too if you get lonely.
Good points.
I can understand from a perspective of selling books why one would want credit and lots of it for breaking and explaining a story.
But the ProPublica piece helps get the story out and build interest in it. The more people out there learn about how this stuff works, the more a certain percentage will want to dig deeper.
It likes a big beer company making a speciality beer. The craft beer maker may complain about the big brewer taking customers, but the big brewer customer would never be so adventuresome to try a speciality beer without the big brewer brand. Out of those who do try it, a few will like it and want the real thing. The craft brewer will get more customers than otherwise.
Long story short: every one who gets in on this story the better – people can look inside the cover of the book and figure out who knew what when.
Most people still consume weak watered down beer – and that is fine if they like that. NC will never get as many hits as the NYT. But for those who want deep insight THAT IS CORRECT, NC is the place to be. I have been reading NC for a few years now, and I remember when this came up I was skeptical – because I didn’t truly understand it. I’m still not the brightest bulb on the Christmas tree, but now at least I can see who Santa is, and distinguish him from the dog pissing on me.
I think we’re in uncharted waters, journalism wise. While I agree Yves is not getting the acknowledgement she, and the significance of Magnetar on the cash market, deserves, I think that’s temporary.
The first shoes have dropped and the immediate focus is on the revulsion at the deal structure. As more shoes drop the focus is going to shift to the underlying cash market implications.
Ecconned has the most substantive coverage. It’s a cogent primer for the generic structure underlying the Magnetar, Pualson copycats, so I suspect journalists are going to continue to return to it as the list of players expands.
Rolfe Winkler wrote a great piece on the Econned appedix
http://blogs.reuters.com/rolfe-winkler/2010/04/19/in-the-wake-of-secgoldman-the-must-read-appendix/,Ft ALphaville included it in the links today.
I think it’s time to publish the Appendix as a special Sunday supplement at NC. It’ll be a classic must keep bookmark document.
On a separate note, here’s an interesting story about a key player in the Goldman Abacus deals who also had a role in Magnetar deals, Laura Schwartz at ACA . Its interesting that GS outed her role in Magnetar deals. Its also interesting that her earnings were pretty small fry (by WS standards) considering her role in this. It looks to me like further evidence that the quality of the staff, and the quality of the firm (ACA) was a key consideration in GS choice of managers. Even the rating agencies weren’t impressed.
http://ftalphaville.ft.com/blog/2010/04/20/206801/the-experience-of-laura-schwartz/
Again, please allow me to repeat (although the Magnetar info was important), please pay especially close attention, in Ms. Smith’s book, ECONned, to pp.
201, 209, 244-245 and 252.
How can corporate america make money if average Joe’s wallet is hurting. Apple reporting higher earnings. Are they real dollars or number on paper dollars?
http://financialtraders.blogspot.com/2010/04/apple-earnings-call-transcript.html
I’m disappointed that Rahm Emanuel wasn’t investigated to see if he was involved in hiding Freddie Mac’s losses. So I’m hoping he’ll be investigated to see if he was involved in any of Magnetar’s dirty dealing. I find Rahm Emanual to be the the sleaziest of the sleaze, so I wouldn’t put it past him to have helped emit Magnetar’s toxic radiation across the US!
“Hope and Change” took a swift kick to the nuts when Rahm came on board. Investigate Rahm? As far as I can tell, DOJ has investigated exactly NO ONE to date. No clue what they do all day. Worst case scenario – an administration overseeing the worst outbreak of fraud and criminality in history, yet absolutely NO ONE nor anything is investigated.
put the entire chapter in pdf form on nakedcap. show this was written in october 2009, as it was. will also help promote the book.
and if the information goes viral….other news sites will pick up on the previously unknown details, further promoting the book.
magnetar is really econned’s story. it definitely has the most detailed analysis. in order to claim it, i think the chapter should be released on the internet for all to see. (send it to huffpost, harpers, and more).
I can’t do that under my contract. And given that one chapter plus the appendix is about 1/10 of the book, there is no way my publisher will waive their rights. They’ll see this as giving away one of the big reasons to buy the book.
We marketed that chapter to Harper’s prepublication. They had no interest (and Roger Hodge, who was editing it then, like my work, I had an article under contract when he was fired). It’s even less attractive post pub. It’s worth more in the book (from my publisher’s perspective) than sold separately.
I see, ok, my apologies I didn’t know the details. I have low to high level contacts at some other places(mainly HuffPo) if you or Andrew or Richard wanted to write a piece on the significance of Magnetar. I think the fact Propublica was a link from HuffPo is what amplified their coverage. Would be happy to find out more for everyone.
Not to worry, appreciate any ideas to get the word out.
And would very much appreciate any help re HuffPo. I can put up post there, both in my name and in Tom Adams and my name, which I have been doing since the end of December, mainly on CDOs. But truth be told, except for the Rahm post, NONE have gotten decent placement. The problem with HuffPo is they have so many article that it is very easy to get lost in the shuffle. And as a result, I’ve posted there much less than I might because I don’t rate there. No joke, I had posts here which have gotten good comment volume that have gotten 3 comments at HuffPo. Why bother?
the pictures of the girls at Huffington post distracts some of us (er, some people, not me of course) from our important work of reading economic analysis ;)
Thanks for a great post. I often wondered how the bubble continued to inflate long after it was obvious, even to econ-challenged plebes like us (it was so obvious here, we sold our Phx house in 05). That Goldman, Magnetar, Paulson (and maybe even Greenspan now in Paulson’s stable?), continued to loft the bubble deliberately in order to make a killing is egregious—a self-evident crime regardless of the legislative paper it hides behind. It is indeed a dysfunctional, unsustainable system that sanctions such predatory slaughter.
As for ProPublica’s slighting of Yves’ groundbreaking scoop, it was likely unintended as you suggest (so much to read, so little time). Still, it’s good press, and at least they spell her name correctly. It’s also fair to say they’ve broken new ground just by virtue of the time advantage, but that shouldn’t diminish Yves’ contribution.
what new ground??
Gleaning only from this post, “[ProPublica’s] article contains important information about the Magnetar trade that is not found in ECONNED, and remains valuable in its own right.” , including “…a convenient timeline… [and]…some information about who ended up with tranches of the Magnetar CDOs.”
I assume that is simply a time factor. Beyond that, not having read either Yves’ account in Econned yet or Propublica’s, I plead ignorance.
Any one else feel like its Sunday, last day, of some convention in Vegas and all the houses are raking in the last remaining pocket change….before every one has to go home.
Skippy…honey how was your trip…good love…I made back the loss equity in our house….phew…but, got an STD in the transaction…still love me[?]
So far, it looks like the Japanese stock markets haven’t responded to Mizuho’s involvement in Magnetar deal. Japanese financial stocks including Mizuho were sold just after the news on SEC’s lawsuit against Goldman Sachs, but they have recovered since then. Mizuho is one of the three largest banks (called “Mega-bank”) in Japan, and has the lowest stock price among the three. I’m not sure how it affects Mizuho’s performance when Magnetar case comes to the surface.
KD,
Mizuho was a late entrant, so their exposure is probably not large, and they did not have an integrated real estate business (remember the CDOs were the way to dispose of bits of subprime RMBS that were hard to sell). Plus the Japanese banks have a proud tradition of entering overseas lending businesses lat in the cycle and sustaining losses. So this looks a lot like business as usual in Japan.
I saw that, your work is not being reocgnized as it should.
I tried to do a “corrective” overview link piece implying as such,
http://www.economicpopulist.org/content/all-things-magnetar
Ya all, I don’t know why so many are in love with scribd and embedded documents. I never can read them myself on a laptop 14″.
I also noticed Ratigan is acknowledging some, but not the real diggers, which NC is a leader. I found that strange too.
An under-noted point: having broken the unions and sucked the life out of the productive economy with its rentier mentality, Finance has no where to go but to devour itself and its cohort.
How long before these parasites find “market opportunities” in destabilizing the dollar?
Far be it for me to defend Magnetar, what they did was evil. However you must at least acknowledge one of Goldman’s key arguments… There must be exactly as many shorts as longs. It so happens the longs didn’t want the 5% equity, so Magnetar bought that so they could get the 100% short. They may have been playing the longs for suckers, but without those longs there would be no bubble. Usually shorts are defended as being early piercers of bubbles. I totally get the holes in my logic, however any piece that claims that shorts blew a bubble must be at least partially missing the point.
Sorry that Propublica is taking some of Yves credit. I respect them both for their efforts on this point.
Everyone’s chasing tails Yves and competition is hearty. But, we must put that all aside, and organize, ourselves, the victims, and the initiatives. It’s time to take your book, and others similar to you and get exponential in our force.
For three decades the same dog is wagging several tails, some long, some short. 2002-2006 zero rates, you could sit and wait for the tails to emerge in crime, tort, and mis-allocation of production. But, this time, the empire as we know it is at stake. They crossed the rubicon in 08. Ever mindful of the need for banks yet mindful of the destruction that could be wrought in just years, it will be a sticky wicket needing a great collection of people acting with a collective purpose.
I must admit, it was the propublica article rather than Yves’ writing that made me take notice of magnetar because it was (a) freely accessible and (b) readable and, probably for the same reasons, widely referred to elsewhere. At least the propublica article refers to Yves’ book, so people who are interested can follow up the story there, and if, given the ability of a book to go into more detail, Yves’ version becomes the definitive account, people will be referring to the book for years to come.
I am not convinced that the magnetar trade really did expand the sub-prime CDO market. Yes, magnetar created demand for sub-prime mortgages to go into CDOs, but they also must have had something of the opposite effect by buying protection on them. Their position seems more like a basis (cash hedged with futures) trade, perhaps even a net short (given how much money they apparently made).
Rebel,
Although correlation is not causation, so many market distortions support the charge that it’s hard to dispel them. And (putting on my management consultant hat), informed people on the ground usually are accurate observers. The people I have come across who saw and understood Magnetar’s strategy at the time it was being executed (admittedly very few, given the lengths to which they went to stay under the radar), all see Magnetar as a direct driver of the subprime RMBS bubble in its toxic phase.
You need to focus on three issues:
1. Recall what constrained subprime or any risky loan demand in the world of securitization: willingness to buy the risky tranches. AAA paper was regarded as safe, although most savvy people understood that asset-backed CDOs weren’t the most pristine AAA (they were priced more like AA and those in the know saw it as a bit of a ratings arb, getting to buy AA paper that was treated as AAA for risk weighting purposes. But the repo market until late treated it more like AAA, suggesting the leverage/capital charge treatment was trumping credit-related views. Since repos were short term, presumably dealers figured they had ample time to start avoiding AAA rated CDOs if they started to decay. The problem is that there was so much of it it was hard to find bagholders when the dealer community wanted to shed its exposure). So you have a lot of demand for something that will be called AAA (in this case, the AAA tranches of subprime bonds).
2. The implication of 1. is that it you can create unnatural demand for lower rated tranches of a particular type of structured credit product, you will see it sold to a disproportionate degree (relative to other products where the normal checks are in place). You saw that, dramatically, with subprime RMBS. As noted, it continued to show robust demand even as Fed rate increases were choking off demand for prime mortgages. You saw parallel behavior in the takeover loan business (due to CLOs, which were a better designed product with vastly less embedded leverage, since they are not resecuritizations, but we still have major overhang and rollover risk in 2012).
3. ABS CDOs that use CDS as a significant component have massive explicit and embedded leverage. ECONNED goes through the math on this point. That meant very small amounts of capital could have enormous influence.
Thanks, Yves. I see what you mean, although I think that it would be better not to use loaded words like “unnatural” and “disproportionate”. Basically, demand existed for components of sub-prime mortgages – credit risk on the part of bond insurers and AAA debt on the part of fund managers – but less so for the whole thing. To the extent that CDOs allowed these components to be unbundled and sold, and that this allowed poorer people to have a chance at owner-occupation, I do not think that magnetar did anything wrong. I would point the finger more at careless house buyers, unscrupulous mortgage brokers, fund managers who chose to buy AAA rated bonds either without understanding what the bonds were, or knowing but caring more about their performance bonus than other peoples’ money, and the managers of the CDOs, some of whom allowed themselves to be influenced about what assets were included in the pool.
I dare say that some people who have seen my occasional comments here will consider me an apologist for “bankers”. I am not; I am concerned that, attracted by a simple story of blame (“greedy bankers”), we will miss what I consider to be the real underlying causes of the crisis – complacency and lack of rigour about financial matters generally – and discard some useful financial innovations – such as CDOs and CDSs.
There are a few more threads of the giant blanket of deceit coming unraveled thanks to people like Yves. Listen to the testimony yesterday (C-Span3) on the collapse/postmortem of Lehman’s to get an idea of how vast this sham gets. Goldman didn’t suffer the same fate, after all their former CEO was Treasury Secy (not to excuse Lehman for their role of fraud and malfeasance). If you don’t have time for the entire testimony, pay attention to the inquiry of the last panel.
The Magnestar trade the tip of massive iceberg of fraud. Ask yourself who purchased these securities. One German bank ‘trusted’ these securities and its ratings/wrapping to give them legitimacy, suffered collapse. A UK bank also suffered tremendous losses upon purchasing what was nothing but a bag of poo wrapped in gold foil with a bow on top.
Do you have a pension plan anywhere as they too were purchasers of these types of securities chasing ever dwindling yields elsewhere. Securities like these were actively hawked as super-safe investments (much like ARS and muni-bonds) to those ‘sophisticated investors’. Due Diligence required reading through 100,000 pages of documents. Like many scams its what isn’t said, rather than what is, that is the catch and propels this and similar securities into the realm of fraud. This is/was a systemic practice among those large broker/dealers/international bankers. No matter, we trust that what is good for Goldman is good for the economy. We trust our banking system works for us rather than gaming against us. eh? including advice and counsel on how we secure our futures with the earnings from our productive endeavors over our lifetimes. Its the best and brightest working in our interest allocating capital to benefit our economy/society, right?
Yves deserves high praise and recognition of her courage to reveal openly how rigged our economy became, most profoundly over the last 11 years. We need new sheriffs, the ones we have now have too many conflicts of interest and dinner dates with those they purportedly police.
My apologies Yves…I was writing apparently while you were. :-) Feel free to delete my post as yours is far, far better. No hard feelings from me.
A view from Europe: while I am still waiting for my copy of
“ECONNED”, I can only stress one thing: the Pro-publica article reportedly required a seven month investigation, and, imho, by the time it came out, “ECONNED” was just out.
So hat tip to both, and I would also like to give credit
to Janet Takavoli and David Fiderer for their own research and
articles on the “Doomsday finance machine”( Martin Wolf this morning ) instruments and their dangerousness.
Just a question. If Goldman had not done the Abacus deal would there have more or less total losses relating to the mortgages that were in the portfolio?
Answer: The total losses would have been the same. The losses would have been experienced by other parties however.
GS did NOT create bad mortgages, CountryWide (and a bunch of others did). So the swill that brought the house down was out there. Goldman just moved the deck chairs on the Titanic.
Given that Abacus played an important role in bankrupting IKB and that the bankruptcy of IKB was one of the important events that set off the whole credit crisis (remember IKB’s SIV was one of the first to default), it’s far beyond reasonable to claim that the losses to the economy as a whole would have been the same without Abacus.
The statement that derivatives only redistribute losses is only true in a model without bankruptcy.
I did a piece for Huffington Post in 2007 on the time bomb represented by the embedded leverage in CDO constructed out of mezz tranches: http://www.huffingtonpost.com/eugene-linden/the-ecology-of-toxic-mort_b_55105.html
When it was published, arguing that 1% increase in subprime default rates could wipe out $1 billion securitizations, there were resounding scoffs in the blogosphere. In the light of Magnetar, Abacus et al., judge for yourself. Relevant paragraphs below:
“Take a billion dollars in subprime mortgages and package them into a new security. Typically, a model security would rate about 95% of the slices in this new bond as investment grade. Under these high-rated slices are what are called mezzanine tranches, the lowest piece of the investment grade slices, and the lowest of these would be rated BBB-, or just above junk status. Typically, these mezzanine tranches will amount to about 4% of the$1 billion total value. Below the mezz pieces would be the lowest rated tranches, including the equity which absorbs the first losses if borrowers default. In this idealized securitization, the BBB- tranches might represent 1% of the total value of the bond and be buffered from losses by about 5% of equity and junk (which represents a computer model’s estimate of the outer limit of realized losses).
So in this case, those buying the BBB- tranche are betting that losses for the entire billion dollars in loans never rise above $50 million over the life of the bond. Fair enough, but if they do rise higher, those holding this tranche lose money in a hurry. Let’s say, losses rise to 8% (some predictions are even higher). In that case, the value of the BBB- tranche would be worthless, and losses would take out all of the BBB tranche and half the BBB+ tranche as well. That’s the price of leverage.
But it gets worse.
Given the risks of subprime loans, many lenders could not afford to make large volumes of loans if they were forced to keep the loans on their own books since they would tie up too much capital. So they finance the loans with short term borrowing and then sell the mortgages into securitizations. The buyer — the securitizer — then puts together his MBS. To do this, the buyer has to sell the mezzanine tranches (many securitizers keep the equity themselves). These tranches buffer the whole structure from losses, and once they have been sold, it’s easy to sell the higher rated stuff.
In recent years, the money funding these mezzanine tranches has come from a subset of another securitization called collateralized debt obligation or CDO. To form a CDO that invests in subprime mortgages, a securitizer will buy up mezzanine tranches from perhaps 100 different mortgage-backed securities, and then package them in different tranches similar to the way a mortgage backed security was packaged in the first place. Thus, some CDO’s can consist entirely of BBB- tranches of subprime mortgage MBS, but still have 95% of their value rated investment grade.
Here is where leverage is the true killer. While an increase in realized losses from 5% to 8% will wreck havoc on a $1 billion MBS, even a smaller increase from say 5% to 6% losses could utterly destroy a CDO based on BBB- tranches where the leverage is over 100 to one. That additional one percent in losses will not only wipe out the bottom tranches of the CDO, but it will eat through most of the investment-grade slices as well. Bearing in mind that many hedge funds also used leverage (meaning that they borrowed most of the funds to buy a CDO tranche), it becomes obvious that even minor variations from the expected performance of subprime loans can have a huge impact on results.”
Whether ProPublica or ECONNED, this is a distraction, one that focuses on a tree in the larger forest. ECONNED is so much broader in scope as not to warrant such trivial pursuits. I don’t know Yves Smith, but would like to, and suspect she could care less. Her book is more than able to stand on its own without acknowledgment from ProPublica for her investigation of Magnetar.
If I recall correctly, ECONNED argues that it was the expansion of CREDIT in general of which securitization, repo, and CDOs were only the means with which to propagate/multiply such credit that was the underlying source of the current fiasco. It’s the CREDIT… stupid. Magnetar is only one star in this universal swindle of other peoples’ money to the tune of somewhere between 8 to 23 TRILLION dollars. That’s what is likely to affect us more directly in the long run than knowing who did it, how it was done, and what can be done to prevent it from happening again. For as Yves’ suggests, the chance of reform – meaningful change – to prevent this from occurring again is NOT likely. Isn’t that the real message? That this is likely to occur again and is already underway? It’s just a matter of time before the next shoe drops… There’s nothing left to loot except the family silver and the taxpayer! WE are the host on which the parasitic beast now feeds.
I have more to say directly on ECONNED itself, typos found and the like of which I would be happy to forward on, but this is not the venue to do it. Let us know as I’m sure others are in the same boat.
Send it to yves@nakedcapitalism.com (contact name is meant to be up at NC but isn’t…long story)