Magnetar Hedge Fund. A Case Study On How To Fleece The Innocent.
As we’ve explained before, a lot of money that flowed into building a housing bubble came from derivative securities.
These derivatives included several layers, or ‘tranches.’ The topmost tranche was rated very safe, AAA. As you went down the tranches the ratings fell until you got to the smallest and riskiest tranche, the ‘equity’ tranche which normally amounted to about 5% of the derivative’s value. The problem for investment banks who constructed and then sold these derivatives–normally valued at $100 million in total–was that pesky equity tranche. It was hard to sell because of its risk. But if it wasn’t sold to someone, the entire derivative fell through.
So along comes Magnetar, a hedge fund. They basically bought the equity slices and thus made the derivative securities possible for sale. Why would they do this? Because they shorted the derivatives they made possible. In fact they were often allowed to pick the underlying securities that went into the derivative, thus making it more likely the whole caboodle would collapse if housing prices fell. And the Magnetar guys were smart. They could see that this was a bubble and it was headed for a crash. In fact, a lot of Wall Street saw it coming and did the same thing. Magnetar wasn’t alone, it was just among the largest.
What about the investment bank? It was making hefty commissions all along the way and Magnetar’s equity purchases increased those commissions. But didn’t the investment bank have a whiff that this stuff was toxic, or ‘nuclear’ as was a common descriptor? Of course they did. Like Magnetar they were shorting their own product even as they were selling it to supposedly sophisticated clients. The investment bank’s problem wasn’t that they didn’t realize the crash was coming, what they didn’t realize was they would get caught with hundreds of millions, even billions of dollars, worth of unsold nuclear derivatives. When the turn came, the investment banks found out the market for this security toxic waste was very thin. That’s known as an ‘illiquid’ market.
So Magnetar made billions of dollars shorting that which they made possible. And the investment banks, en masse, became insolvent almost overnight, in the end to be bailed out by taxpayers. Socialism for the rich.
And that dear reader is how you loot an economy.
Beezer here. In any sane world this is considered fraud and subject to criminal prosecution. So now we’re supposed to believe further de-regulation is going to help?
Tags: Derivatives, equity tranche, Investment Banks, Looting, Magnetar
April 12th, 2012 at 7:42 am
so a cdo or clo is now a derivative? you’re missing the main problem here which is the reliance on “models”. These models allowed the creation of these securities and them to be classified as AAA in most cases because of the historical prices of houses (they rarely went down). Use of these models and the supposed “worst case” for housing prices is what in the end caused the most harm.
Also, you confuse me. Investment banks are supposed to facilitate the transfer of risk from one party to another. In this case, the risk of the mortgage defaulting and housing prices going down. Why in the world they were even allowed to warehouse loans without taking appropriate offsetting derivative transactions to hedge that risk is the fault of regulators and the bank themselves.
April 13th, 2012 at 9:18 am
The investment banks drank their own Kool Aid. These are OTC markets, don’t forget. So the bankers had to own enough of their own product to make a market. What they underestimated was the how fast liquidity would dry up. It made all their ‘models’ wrong. Of course, the mathematician Nassim Taleb explains that the math economist and quants use in their models is inappropriate for financial markets.
Greed advisor, plain and simple. It blinds everyone to risk. And if no one’s being a cop on the beat, greed allows people to commit fraud. All over the freaking place. Lying to clients for starters. Giving anyone who walked through the door a mortgage just because there was so much money flooding into housing. In fact it was flooding into pretty much every damn thing, from credit cards to student loans to merger and acquisition.
At the very bottom however, lies a poor understanding of how the real world operates economically. Free markets and capitalism work well, overall, but they’re far from perfect. And in some cases they’re simply lousy tools to get goals accomplished in any effective way. Health care being a prime example.
Capt. has a Potemkin Village version of economics hard wired into the core of his brain. He is simply incapable of learning anything new or different. Works for his particular world and any change, no matter how minor, puts him emotionally into ‘fight or flee’ mode. Other than that defect, he’s a pretty good guy.
April 13th, 2012 at 1:54 pm
The ‘model’ problem you reference involves more than just security models. It infuses the economics profession too. That’s one reason why so few economists foresaw the tsunami heading our way. Like the security models, most economic models, no matter how elegant their mathematics, rely on Gaussian math which understates risk probabilities, rather than Mandelbrotian math which is far more accurate.
The other problem is the concept of equilibrium that’s in all economic thought. Economist’s are wedded to the idea that economies will return to some optimum ‘equilibrium’ all by themselves. At best this is assumption is a gross over-simplification of how economies operate under normal circumstances, not to mention how they operate when they get some external ‘shock.’
Somewhere in the models, the math and the equilibrium concept plain old common sense gets discarded. A lot.
April 17th, 2012 at 7:02 am
given all the recent fuss over banking regulations, which, if you remember, i told you would slow loan growth and slow the economy (it has), i’m surprised there hasn’t been a bigger uproar over the regulation of hedge funds. This bastion of gunslingers has grown immensely over the last 10 yrs and imo now represents the same sort of financial risk that the bigger banks have. A 30 billion dollar hedge fund levered to the hilt can represent 500 billion in exposure. Strangely this group, through its generous giving to both parties has somehow remained unscathed through this whole crisis, and there are more than a few risk junkies given their pay incentives. Have we forgotten 1998 and ltcm? If you haven’t read when genius fails, do so. And remember, those guys were all the ivory tower types.
The bigger problem with these and any models is that people WANT them to work, so they tend to underestimate the inherent risks. And to answer your question about risk, i think people vastly underestimate how relatively new and small the sampling size is for these markets. 100 years of data isn’t much, and we don’t really go back more that 30 years for options/derivatives.
April 17th, 2012 at 10:47 am
I’m not sure hedge funds have come in for much in the way of regulation. At least not yet. Dodd-Frank is primarily aimed at unwinding TBTF banks, if necessary; imposing a modified Glass Steagall rule, called the Volcker rule; and raising equity requirements and capital levels in an attempt to dampen leverage.
What Dodd Frank doesn’t do is bring the OTC derivative markets out into the open, or much else for that matter which would help monitor shadow banking activities, a main component of which is hedge funds.
The tax break of carried interest is under scrutiny, however. But like almost any attempts at real reform, the Tea Party force in Congress can effectively stop most efforts. Take the Buffet rule, it failed to gain the required 60 votes in the Senate yesterday. So Mitt’s safe for now.
April 17th, 2012 at 11:01 am
As for Long Term Capital Management, they used various mathematical models that assumed there existed some ‘equilibrium’ where different asset classes would eventually return to whenever they deviated.. So they speculated accordingly and it worked–until it didn’t.
Nassim Taleb, in his book Black Swan, clearly explains the problems with the math. It was Gaussian math when, insofar as finance is concerned, Benoit Mandelbrot’s fractal math is what’s needed. Mandelbrot’s math posits that, in finance among other areas, the further from the mean the more probable divergence will be, not less.
So LTCM went merrily along, leveraging to the stratosphere because their math was Guassian and it predicted large divergences would be highly improbable. So they underappreciated the likelihood of larger divergences. They though they couldn’t happen. Until poof, they did!
LTCM was bailed out by taxpayers, by the way, to the tune of more than a trillion dollars: The largest bailout on record until the one of four years ago–another leverage blowout enabled, in part, because the math is wrong.
April 18th, 2012 at 6:38 am
carried interest is a joke….unless you’re a hedge fund manager. Not that it looks like its going to be changed anytime soon. Unfortunately, so is dodd-frank where still most of it has yet to be decided by the porn watchers at the sec and the fed. Funny how the tbtf banks are now bigger….
April 18th, 2012 at 7:23 am
Treasury has put out a bunch of graphs re: actions by government to fight recession. One of them shows that our big banks aren’t as big as many other countries banks are, as a percentage of total banking. Small comfort, that.
Also news today regulators are lifting some restrictions on derivatives. Lord!