Financial Arsonist Found ?
Robert Waldmann
Jesse Eisinger and Jake Bernstein come very close to accusing Alec Litowitz of the Magnetar hedge fund of being a financial arsonist. I have been speculating about financial arson for a year and a half now.
The hypothesis is that Magnetar deliberately set up especially low quality CDOs and bought CDS insurance on them. Magnetar bought the equity tranches of the CDOs and so had a voice in the selection of underlying assets. Many anonymous sources claim that Magnetar pressed for risky assets to be included in the CDOs.
Magnetar clearly used the revenue from their equity tranches to invest massively in CDSs. They claim they were net losers when all but one of the CDOs which they sponsored defaulted. So ? Arson analogy after the jump.
First I admit that in my old posts, I didn’t discuss setting up an especially bad CDO. I think it would be legal for Magnetar to have over-insured their holding in a CDO which they sponsored. However, it seems that they didn’t insuring just enough that a default would cover the loss of all value of the equity tranche and using the rest of the cash flow to invest in CDSs of similar CDOs which they didn’t sponsor.
I think they still made money when the CDOs which they sponsored defaulted — the value of CDSs on similar CDOs surely shot up. If Eisinger and Bernstein’s suspicions are correct, this would be a trick as the apparently similar CDOs were not really all that similar, they hadn’t been deliberately engineered to fail.
The arson analogy is as follows — I buy fire insurance on my house equal to its value. I also buy fire insurance on my neighbors house. I light a fire in my house (oooops). Then I sell my neighbor the policy on his house before the fire department puts out the fire.
My house is not over-insured. His house didn’t burn down. There is no problem. Except I made money via arson.
The difference is that it appears that everything Magnetar did was legal.
Oh and also it prolonged the housing bubble and caused much more damage than any fire started in Chicago since a cow kicked over a latern.
Think that might work with Greece, Portugal, Spain, Italy, Latvia, Iceland, Ireland, Britain, CDSi as well?
i don’t know the details of what they did, but i imagine it was something like this:
1) litowitz wants to make a massive short bet against the housing market and notices that CDS on senior tranches are very cheap and so wants to buy a ton of them
2) there are two problems with this. first, he can’t get enough of them because there aren’t enough equity holders and second he can’t convince his investors to pay the CDS premiums
3) a lightbulb goes off and he thinks, OK, i will buy the equity tranche and short the senior tranche.
4) further he tries to set these deals up so that they will fail ie losses will reach the senior tranche.
there are a lot of ways this trade goes wrong. if the equity tranche stops paying before the senior tranche completes its default, he could end up in a situation where he isn’t receiving any coupons but can’t monetize the CDS.
(note that the CDS is bespoke and probably marked to model at the same dealer who owes him money — whereas he is telling his investors something else probably — so he would not really want to cash these out.)
any scenario where losses are quick but reasonable would kill him in the long run. he loses money on equity; losses end up eating half the mezzanine tranche somewhere and the CDS pays out zero. so the strategy depends on him unwinding the CDSs at a very specific point in time, which may not have happened.
I listened to the Magnetar feature in This American Life today:
Did Magnetar put undue pressure on the CDO manager to include crap mortgages? If they didn’t and didn’t lie when they legally were required to speak the truth, they will be able to enjoy their booty. On the other hand, did the CDO managers fulfill their fiduciary duty to investors to dislose all material informations. If they didn’t, can the investors at least claw back the CDO manager’s fees on those trades?
I’m halfway through Gasparino’s book and it appears there was plenty of blame to go around on Wall Street, as well as two warnings (1994 and 1998).
After both warnings the leverage was ramped up again and the instrments became more bizarre.
Gaparino was aware of cases where the IBs who were creating structured CDOi would actively canvass sub-prime loan brokers for more “material” to make “product”, and would imply they were not that concerned about loan quality.
Take that as a foundation, mix it with 30x short term repo leverage, then insure it with CDSi.
I goes KABOOM? No shit.
You can figure out when to throw it too?
We’ll all be rich!
The mess doesn’t take arson. All the home owner has to do is negect the roof, foundation, electrical wiring and plumbing. Then insure the house and the neighbors and then let the “accidental” fire spread to the neighbors.
What is that old saying? “Don’t blame it on a conspiracy when incompetence is more likely.”
Incompetence is more likely than a conspiracy? Maybe so, but from all indications, fraud was rampant. Bubbles attract it. According to William Black, by the end even cursory investigation revealed illegalities. Perhaps most of it was in the original loans, but it seems highly unlikely that it was contained there.
robert, you should read this article:
http://www.macroresilience.com/2010/04/11/the-magnetar-trade/