As longstanding readers of this blog presumably know, we broke the story of Magnetar, a Chicago-based hedge fund. Magnetar was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).
Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.
As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:
At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .
Magnetar’s idea was that CDOs were destined for long term failure—that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.
The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions—i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.
Magnetar made A TON of money . . . I’d expect every bit as much as Paulson
The important part of this arrangement was that the equity funder put up 4-5% of the deal in a cash or hybrid CDO. Because this was the scarce part of the equation, and the riskiest exposure, this investor was the sponsor of the deal and gained control over its parameters. At a minimum, the equity investor had veto rights over the bond exposures chosen, and reports from various Magnetar deals indicate that in some cases it presented lists of bonds to go into the deal and/or set criteria (as in the bonds be particularly “spready” which also meant drecky). Since Magnetar was using its equity stake to make sure it would be able to establish a short position that was a multiple of its equity position, making it net short, its interest lay in using its influence to make sure the CDO had particularly bad exposures.
Even JP Morgan, which was less active in the CDO game than other major dealers, wound up working with Magnetar. The Financial Times discusses that the SEC is negotiating a settlement with JPM on a Magnetar CDO called Squared that lost 80% of its value. Note that Magnetar piously insists it did not select the bonds in this deal. Technically, that role fell to the CDO manager, but they were very responsive to the desires of equity sponsors, thus providing useful legal cover. But
From the Financial Times:
The SEC probe into JPMorgan is focused on whether the bank told investors that Magnetar, a hedge fund that bet against certain parts of the deal, helped select the portfolio.
JPMorgan ultimately lost $880m on the CDO, known as Squared, after the housing market collapsed.
Magnetar has not been accused of any wrongdoing.
Previously, a spokesman for Magnetar said the firm “did not select the assets for the Squared transaction or require that any specific assets be put into that transaction. Further, it did not originate the Squared transaction”. The firm also said it had been “transparent in its dealings with market participants”.
Note that CDOs were sold as exempt transactions without any SEC registration or involvement, which meant it provided even less protection to investors than mortgage-backed securities investors had. Before 1995 these offerings, which were private placements had to comply with Section 12 of the 1933 Securities Act:
Any person who…offers or sells a security …by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,…shall be liable … to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.
This section would appear to impose liability for false and misleading statements and omissions in private placements just as in the case for public offerings. That was the view of securities lawyers up to the landmark 1995 Supreme Court decision, Gustaffson v. Alloyd. In Gustaffson, however, the Court ruled that offering documents in private placements were not prospectuses as defined under the 1933 Act which mean there was no liability attached under Section 12.
As a result, investors in a private placement could rely only on Rule 10b-5 to protect them from false and misleading statements or omissions. But the problem is that Rule 10b-5 is that investors not only have to prove that the disclosure was deficient, but also that the seller had the intent to defraud.
Proving intent is a much higher bar for prospective plaintiffs. The Gustaffson made it much more difficult for fleeced CDO investors to prevail.
And now you see why Magnetar continues to insist it was clean. Intent is hard to prove, and the hedge fund appears to have been particularly careful about its communications. But our contacts on dealer desks understood full well that the objective was to create deals that would crater.
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We fully deserve the injustices we tolerate…
How do I tolerate them? How do you tolerate them? What should we do?
demand TRUTH.
Obviously the only way to empower the American people is to
end all campaign contributions-money = property-not “speech”
I’m not a lawyer (thank god :-), but couldn’t there be prosecution under liability for defective products. Unless an investor is aware that a product is designed to fail — and thus invests because he desires that outcome — a product that is designed to fail is, by definition, an intentionally defective product with respect to the normal expectation that a consumer has that a product will ‘work’.
Intent is easy to prove. Look at any u.s. supreme court decision that goes against the poor defendant. Besides, behavior is truth.
What rock have you been under for the last 8 years??
My original reply was meant for Sleeper, not you. My apology.
Please the real culprit in all of this is the deadbeat borrowers. Magnetar and JP Morgan are just solid American companies that happen to be in the financial business. Magnetar, in particular was a real innovator in the finansial business. After all these folks aren’t criminals – they haven’t been indicted or prosecuted.
That’s an absolutely brilliant point, sleeper. And I’d like to see a reverse class action lawsuit brought by the financial industry against taxpayers for making them feel guilty about bailouts.
You need to read my book. You could not be more wrong about this. The CDOs were sold to investors as being the same as cash CDOs, which would have been the result of lending made supposedly by people who didn’t want the loans to go bad. The CDO managers were falsely represented as being independent when they depended on the investment bank packagers for the warehouse lines. The CDOs had the effect of distorting price signals and undermining normal market mechanisms.
Or else you think “innovation” means “deceiving the public and doing tremendous damage to fatten your wallet”. But that’s not how most people define it. Magnetar was incredibly clever but also incredibly destructive. Look up what a magnetar is, their name is very deliberately chosen.
Yves! Pretty sure they are joking. They should read your book of course. But it would be funny to bring a class-action suit against deadbeat borrowers/Wisconsin teachers/etc. for making bankers feel guilty about their bailouts.
I believe that was sarcasm, although it could have been clearer and there is a risk that newer blog readers would not recognize it as such.
The description of the Magnetar trade in your book struck me as the clearest possible argument for regulation of CDS protection and long/short positions in tranched products. I would challenge any policy maker of the “all regulation is bad” school to fully understand the structure of the Magnetar trade and then explain exactly how it could be prevented without regulation. It’s effectively a mechanism for engineering a financial crisis and profiting from it, and, absent significant regulatory change, it’s legal and 100% repeatable.
The 1933 Act has always exempted transactions not involving a public offering. Why would anyone have thought it applied to CDOs placed with institutions?
That is not the point. The point is that the basis for suing people now is far more limited than under registered deals, so the SEC and private investors have less recourse.
And the documents did mimic the form of SEC offerings, while other private placements I’ve worked on (like offering memos for the sale of private companies) don’t.
The issue is that the folks involved in these private placements were assumed to know what they were doing. (Knowing what one is doing is defined by the total resources of the investor in question). In the case of those who are supposed to know what they are doing due diligence is assumed, but as we have seen from many cases the investors were to (stupid,busy,ignorant) to do the checking. Clearly the first mod is to say that all government entities doing investing are no longer eligible for private placements. (As most politicians don’t know what they are doing in this area, deferring to the venal salesman for expertise).
I suspect that most of the CDO’s were more sold than bought, more proof that even if you have a lot of money, hanging up on salesmen is a good thing. Of course if you are managing others funds it might mean that in the short term you give up yield and may loose these funds.
You are operating under incorrect assumptions here. The number of investors in these deals was incredibly small. Ex some stuffees that got junior tranches (some went to dopey hedge funds in Australia like Basis), the longs on the AAA tranches were AIG, the monolines, IKB, the Bear Stearns hedge funds, and the investment banks/Eurobanks. You can trace almost all the AAA purchases to that crowd. The lower tranches went to correlation traders, mainly foreign stuffees, and got rolled into other CDOs.
Well, personally I like choosing what things I have to be a busybody, smart and non-ignorant about. It’s that time management course I had to take way back when I discovered I had too many things to do, and not enough hours in the day.
But I’m sure that’s why everyone says that “disclosure” is a necessary prerequisite to “due diligence”. Otherwise we all would spend way too much time researching fairy tales.
But that gets us back to the role of ratings agencies in the entire securitization universe. My understanding of how that worked is the only ones that get complete loan file info are the ratings agencies. Then for complex structured CDOs they are the ones that buy off on the heady math model that purports to transform a pool of mortgages into tranches, each with the nebulous characteristics of loan quality neatly transformed into a small subset of the alphabet. Then guarantees are made to the investor about the accuracy of the process and that the assumptions are sound.
Then if the “sophisticated” institutional investors smell something fishy, the creators of the product go back to the drawing board with the unsold parts and recycle them into CDO Squared for a second chance at the market. Toxic waste recycled, before anyone really tagged it as toxic waste.
If nothing else, putting up with this is a huge waste of time.
Of course the sophisticated investors could have just said no unless they got the detailed data. If enough did it then the info would have been disclosed. However because their real concern was the performance of their funds in the short term, because thats all their clients care about (being willing to move the money at the drop of a hat) they did not care to just say no. It was because they had to keep the investment pool big so that they (the sophisticated investors) could get their big bonuses that they refused to demand the data.
The fundamental issue is that people pay investment professionals to beat the market when it is intuitively obvious with such a large percent of the market in the hands of the sophisticated investors, that at least 1/2 (before fees) and likely including fees 2/3 can’t possibly beat the market.
This has been demonstrated with actively managed equity funds, and now in the fixed income space. Of course the index of mortgages (ABX) came along a bit late but did fairly quickly reveal how rotten the entire mess was. But if you invested in the ABX you would not beat the mortgage market just break even, and after fees loose. Wall Street does not like index investing because it means less money for those on the street, and sooner or later fewer investment types in the future.
Forty years experience with Wall Street (not on Wall Street) tells me you are right on the money. Anyone who has worked at “managing” his own money understands it can be done only on inside information or in retrospect or by following the herd and jumping off just in time. Wall Street “disclosure” is a ludicrous blend of misinformation, accounting fraud, conventional stupidity and cant. You might as well look for truth in advertising or political discourse. Financial instruments no longer have value but every one has a price. Take your pick and good luck when you need to sell. The oldest truism is that more money has been lost chasing yield than at the point of a gun. Of course, the money lost belongs to other people, not the guys whose gullible and greedy myopia are responsible for losing it. As for financial litigation, there are no beneficiaries except the lawyers milking the suits. The whole thing would be simply funny if so many people’s financial lives did not depend on it, but perhaps that is funny too?
And we also have Magnetar and Norma..
http://frederickcountytimes.com/new-documents-show-hedge-fund-magnetar-influenced-deal-despite-denials/1050/
New Documents Show Hedge Fund Magnetar Influenced Deal, Despite Denials
by Jesse Eisinger and Jake Bernstein
ProPublica
A Financial Crisis Inquiry Commission document shows the hedge fund Magnetar selected hundreds of millions of dollars’ worth of assets that went into a billion dollar Merrill Lynch mortgage securities deal, despite having long asserted otherwise.
According to the commission report, Magnetar made the selections without the knowledge of the manager legally charged with picking the assets for the CDO or the risk department of the bank that helped create the deal.
“When one Merrill employee learned that Magnetar had executed approximately $600 million in trades for Norma without NIR’s apparent involvement or knowledge, she e-mailed colleagues, ‘Dumb question. Is Magnetar allowed to trade for NIR?’ ” according to the report.
The Merrill employee was one of the risk managers in charge of policing the firm’s CDO business.
“NIR abdicated its asset selection duties to Magnetar with Merrill’s knowledge,” the FCIC report states.
The FCIC ran into a roadblock in its investigation of the Norma transaction. Bank of America, which now owns Merrill Lynch, “failed to produce documents related to this issue requested by the FCIC,” the report says.
Yves,
Your exposure of the Magnetar deals is very helpful.
I do wonder, have you considered what the fuel for the asset price bubbles has been and how that fuel is the energy that drives the speculative deals that are designed to fail in a way that creates success in the failure?
I also wonder if the social value of the very destructive CDO/CDS trade is fully appreciated as to how it operates to destroy what is simply a price bubble.
What does the thoughtful observer do when he sees grossly over priced assets? Some of us look for the short trade. Now my question is: Isn’t the short trade socially productive in that operates to return rational pricing to the market. Which is to observe that if prices are continuosly irrational, there will be continuous mal-allocation and investment which will lead to social disorder.
There is a force that nutures mal-investment and that force is also the seed bed of criminality. Could we create a meme; ‘Follow the Money’?
“Isn’t the short trade socially productive in that operates to return rational pricing to the market?”
It might be socially productive in a world where speculators used their own money and absorbed their own losses. In a world of bank counterfeiting enabled by a FRS you can measure social productivity by the economic loss suffered by the productive sector. Leverage supplied by synthetic CDOs guaranteed a financial tsunami. Not so socially productive as market enthusiast clowns like Dr. Greekspeak and Larry Summerbreeze and WhatAboutBob RubItIn would have us believe.
I’m not at all opposed to shorting in stocks or bonds. I’m VERY opposed to shorting via CDS because you are not constrained by the actual amount of cash bonds. When you can create short exposures that are a multiple of the actual real economy activity, you create huge perverse incentives.
Yves,
As always, couldn’t agree more. Derivatives with no cash or equity offset need to be outlawed as they distort incentives and increase system fragility. The presumption needs to change where derivative products need to be economically justified before they are allowed to exist and then only in such proportion as is consistent with sound economics. Or as a consolation may be just allow capitalism to work and those who made bad bets suffer consequences and allow those responsible to catch some form of consequence. While I’m at it lets invent calorie free chocolate and put the Cubs in the world series.
The arbitrage characteristic of many derivatives also points to a lack of meaningful enforcement. They are regularly used to circumvent tax laws and other regulations with the loser often being the honest player or taxpayer. If a derivative product was set up to get around taxes or other regulations a competent regulator would just say no.
Ah the Cubs in the World Serious, but then will the Grecian Goat from Lower Wacker Drive deign to bless such an occurance? That’s the question of the hour.
The CDO/CDS trade isn’t a neutron bomb. The CDS/CDO trade doesn’t just kill the target, it leaves a lot of collateral damage. And the damage is particularly onerous when we have the canard TBTF rampant in a field fiat money and fractional reserve banking.
I say legalize the CDS by calling it what it is, insurance, and then demand standing to buy and adequate reserves to fund. That would make the trade grossly uneconomic.
Little off-topic but maybe …
I just had a chance to rub elbows with bankers at a hipster party in Frankfurt. For example after being introduced to K. I was told that he was a banker. What’s a question that would have more potential to be satisfyingly than asking about where K. works?
Are you in private placements or public offerings?
Goldman creates a trash portfolio by request, sells it short confidentially and is considered the pillar of finance, then goes to advise the government. Is it any wonder what’s going on?
I don’t think for the Invisible Hand to use a “neutron bomb” to prove that pricing is irrational is quite what Adam Smith had in mind !
Magnetar is a prime example of what David Apgar described in pointing out in a recent post:
I’ve wondered whether the Magnetar creators are so full of themselves that they think they’ve invented the ‘infrared’ part of the financial spectrum, invisible only to those — like themselves — with the special telescopes and background to spot what’s happening.
The Magnetar CDO beneficiaries are economically radioactive.
Thanks for your many comments here, Yves. People do need to read your book!
Was Magnetar asked: “Did you select the assets for the transaction, have any form of approval of the assets for the transaction, submit a list of what you would consider as acceptable assets for the transaction (from which a final list would be constructed), or in any other way influence which assets became part of this transaction?” Jesus, I don’t even play a lawyer on TV and recognize that Magnetar’s answer is pretty narrow. I hope the SEC probe asked some hard questions.
That’s as likely as R. Kelly insisting on seeing a girl’s drivers license prior to taking her out. I met the head of a regional SEC office after a seminar to an audience of largely securities attnys of defense bar. That person couldn’t have appeared more friendly and toothless if they had brought cookies, rolled onto their back and started panting. This person went on to express how the gov had frozen all new hiring and talked of how far behind the industry they were in terms of technology and understanding the structure of these deals. I then approached said figurehead after to inquire after an enforcement position and I brought up Magnetar and the conflict of interest in the selection of bonds issue. He looked like a deer in the head lights with nothing to say and grew cold. Could not have been more discouraging. After all, this person probably doesn’t want to hazard that lucrative Goldman retirement job.
Its regulatory capture and starve the beast down there. Not that its surprising, but they have little interest in prosecuting these cases, don’t have the resources and like to telegraph to the defense bar how impotent, clueless and friendly they are. SEC probe was likely a cool neck-breeze on a hot day.
Yves: “I’m VERY opposed to shorting via CDS because you are not constrained by the actual amount of cash bonds. When you can create short exposures that are a multiple of the actual real economy activity, you create huge perverse incentives.”
So, shouldn’t you favor CDS be centrally-cleared thru an exchange, like thru the CME or EUREX, instead of being traded OTC?
Just can’t believe that every agency, political actors and individuals (including myself) couldn’t have attenuated all this mess when this level of corruption of the finance industry was so well-established rather early on (e.g. see:http://www.businessweek.com/magazine/content/02_19/b3782001.htm
)