Magnetar:
Rahm Emanuel:
White House Chief of Staff
Politician selected by Magnetar's CEO to be sole recipient of his political donations, 2006-2008
Strange as it may seem, nearly three years after the onset of the global financial crisis, its greatest, most destructive, and most profitable "it ought to have been a crime" has gone almost entirely unnoticed.
Most people believe that they understand the broad outlines of the financial crisis, and that a central element was an explosion in mortgages made to people who could not afford them.
But how did such destructive behavior occur on such a large scale? The conventional view is that the subprime mortgage blowup resulted from bank executives being shortsighted, greedy, or both.
But that simple story deters inquiry into how and why this disaster came to pass. Some recognize that the appetite for subprime mortgages seemed to come from investors. In fact, it resulted in a large degree from the way traders at certain large banks used subprime mortgages in a strategy to make their profits seem much larger than they actually were. The effect of this "negative basis trade" strategy was to overpay employees of those banks and consequently eviscerate the banks' abilities to withstand future economic uncertainty.
The appetite for subprime mortgages was also inflated by people who were betting that the housing market would fail.
Moreover, the devastation wrought by this strategy remains virtually a secret. The fact that it has been almost invisible and appears to have been entirely legal, demonstrates a set of vexing problems. First, that investigations of the crisis have not delved deeply enough, and second, that the deregulation so keenly sought by the financial services industry has made activities legal that by any common-sense standard should be criminal.
But the sponsors of this toxic trade did bother to make sure they had a powerful friend. The head of the firm in question gave substantial amounts of money by political contribution standards to Rahm Emanuel's PACs, and only his PACs, over the period when these transactions were in play.
The moving force behind a brilliant and devastating subprime short strategy was a heretofore unknown Chicago hedge fund, Magnetar, headed by Alec Litowitz, formerly of the hedge fund behemoth Citadel. Our studies indicate that Magnetar alone accounted for between 35% and 60% of demand for subprime mortgages in the year 2006.
This is how their strategy worked in detail.
The ruse at the heart of their transactions was creating subprime (so called "mezz" or mezzanine) collateralized debt obligations by investing in the riskiest layer, the so-called equity tranche. This kind of CDO consisted almost entirely of not just any subprime risk, but that of the dodgiest layer that could be sold short, the BBB tranches, via a combination of actual bonds and credit default swaps.
But Magnetar's true objective was not to invest in this toxic waste, which its role as funder of the CDO would lead most to believe. While Magnetar paid roughly 5% of the total deal value for its equity stake, it took a much bigger short position by acting as a protection buyer on some of the credit default swaps created by these same CDOs. This insurance in turn was artificially cheap because over 80% of the deal was rated AAA. Most investors did not understand what Magnetar recognized: this concentrated exposure to the very riskiest type of bond associated with risky mortgage borrowers, each of these CDOs was a binary bet. It would either work out (in which case Magnetar would still show a thin profit) or it would fail completely, giving Magnetar an enormous profit and wiping out even the AAA investors who mistakenly believed they were protected by having other investors sit below them and take losses first. Thus the AAA investors were only earning AAA returns for BBB risk.
As the equity investor, Magnetar could further stack the deck in its favor through the influence it gained over the deals' parameters. It was able to ensure that the CDOs held particularly dubious BBB exposures, and pushed for, and often got, "triggerless" structures, which stripped away another protection most deals had. When CDOs start to show significant losses, the payments to the lower-tier investors, including the equity tranche, are cut or halted to defend the AAA layer, much the way the human body, when exposed to severe cold, will restrict blood flow from the extremities to save the brain and organs. But triggerless deals, even as they started to fail, kept paying the lower tranche holders, including, in this case, Magnetar itself.
While these transactions may sound similar to the widely decried Goldman synthetic CDO program, Abacus, by which the firm went short various real estate exposures, effectively dumping the risk on customers, the Magnetar program was not only much larger, but also produced far more devastating systemic consequences, thanks to the distinctive structure of its CDOs.
As I explain at greater length in my book ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, the use of cash bonds turned mezz CDOs from a dumping ground for otherwise unsellable mortgage bond risk to a breeding ground for demand. Ex Magnetar-inspired appetite, it is hard to find an explanation for the widely-discussed phenomenon of 2006 and 2007, of the mortgage securitization pipeline screaming for more subprime product, precisely when Federal Reserve interest rate increases should have stanched demand for risky loans above all others.
Market participants have estimated that Magnetar's CDOs drove over 50% of demand for subprime bonds during the market's toxic phase, 2006 and 2007. With the input of a team including professionals who have worked on some of these trades, ECONNED, we've performed repeated, conservative analyses that indicate the true figure is probably at least 35% of demand, and perhaps as high as 60%. And that's before allowing for the fact that Magnetar's strategy was imitated by the proprietary trading desks of major dealers. And for good reason. Magnetar made billions, some observers contend as much as subprime kingpin John Paulson, whose fund earned over $20 billion on its short strategy.
And the hedge fund's cagey bet on Rahm? Litowitz and his wife had never before made significant political donations. In 2005, they started giving to Rahm and his PACs, and only PACs connected to Rahm, just before the Magnetar CDO program began, and continued through the first quarter of 2008, when the trade would have started to pay out handsomely. The Litowitzs gave a total of $8,000 to Emanuel and $10,000 to his Our Common Values PAC in May 2005. In 2006 and 2007, they contributed $51,700 to the Democratic Congressional Campaign Committee, while Emanuel was chairman. We have been advised by individuals involved in political fundraising that the amounts given would be considered significant, and the way the payments were distributed across the PACs is sophisticated. Put it another way: this money was not given impersonally.
But this troubling connection should be no surprise. Rahm has long been a favorite of the hedge funds, having raised more money from them than any Senator not running for President. Not surprisingly, he has been a staunch supporter of the financial services industry, and is widely credited with playing a key role in securing passage of the TARP after its initial defeat.
As the Magnetar-Rahm connection highlights, Obama raised more money from financial services players than any previous presidential candidate, so it can hardly be a surprise that he and his minions are happy to give the industry a free pass. Key policy figures maintain that no one was at fault, that there was a pervasive lack of regulation, and there are therefore no bad actors. That party line also means that destructive behavior is and will remain unquestioned, unexamined, uncorrected, and unpunished. We are still paying for the costs of the financial train wreck of 2007 and 2008. We can no longer afford the costs of willful blindness.
Addendum: Hat tip to Corrente who posted on this relationship on April 11, and finally prodded us to post our writeup of this story. We worked closely with Moe Tkacik on the story she put up on DailyFinance and took down, and had held off publishing our version pending her releasing her final version.
Follow Yves Smith on Twitter: www.twitter.com/yvessmith
Whats up, folks?
Years earlier I said the CDO machines should be shut down for deceptive structrures. I wrote the SEC in Feb 2007 saying it should immediately revoke the rating agencies' status (NRSRO designation) for structured products.
Merrill Lynch crafted the CDO, N.I.R. "managed" the deal, and Magnetar invested in the equity. http://online.wsj.com/article/SB119871820846351717.html
The Wall Street Journal's fine work in this area got the word out before Bear Stearns imploded in March 2008 and before the September 2008 crisis. Albeit most of main stream media (and most of the blogosphere) was late to pay attention, the WSJ wrote important stories in time for Washintgon and regulators to have mitigated some damage, if they had been paying attention.
My compliments on your dedication and knowledge so well organized. I used to manage employee benefit plans and have almost committed to memory pages 199 and 200 of 13 Bankers wherein an account (citing you) is given of a deal sold to a public pension plan. I had to pinch myself. I've re-read it a hundred times and still can't really believe it.
The FDIC Trust Examiers Manual starts "quacking" about derivative investments as early as 1996. The profound problems of asset valuation being the primary reason listed for avoiding such schemes. Those were pretty innocent days, in 1996, and much has occured since.
Have you any sense of where the Department of Labor is going to position itself in regards to these potential violations of ERISA?
The Wall Street Journal wrote about Magnetar and others involved in “Wall Street Wizardry.” I was quoted in the article: http://online.wsj.com/article/SB119871820846351717.html
On January 14, 2008 WSJ explained Magnetar’s strategy in its article, “A Fund Behind Astronomical Losses” http://online.wsj.com/article/SB120027155742887331.html?mod=hpp_u
Magnetar’s David Snyderman was at Citadel in August 2004. His group asked me to work with them to create these deals. My 2003 book, Collateralized Debt Obligation explained “triggerless” CDOs (and more). The structure was already in use for mortgage loans in Europe. I declined to work with Snyderman's group. My book was meant to educate investors, not to be a manual for exploitation. They left Citadel within months. Snyderman moved on to Magnetar; the others scattered.
The key architects of the subprime debacle were the investment banks that underwrote the securities that provided the funding to mortgage lenders. If you cut off that funding, the process would have died. Investment banks are obliged to perform due diligence on the portfolios and the structures, in fact they are chiefly responsible for the structure of the CDOs.
Magnetar was a cog in the wheel, and many hedge funds were involved. For each CDO, there were multiple drivers including new special purpose vehicles, bond insurers, CDO managers, rating agencies, and many more. There were dozens of ways to pull off bad deals.
They also confused the market by not fully disclosing what they were doing as an equity investor in the CDOs. Many investors higher in the structure would not immediately assume that the equity holder was designing a deal in which it's equity would be wiped out.
The parties that information and did not disclose it properly were the CDO managers and Wall Street underwriters. This story is much more sordid than it appears in the the partial accounts you refer to in the WSJ.
The limiting factor on this ponzi scheme was that property prices started levelling and then falling (since eventually you run out of people to buy houses) and that set in motion the demise of the entire enterprise. Insiders knew that there was no cushion for house price drops in the system and started to go short before the rest of the world caught on. Magnatar invented a clever way to go short and take advantage of the system and rules and beliefs in place.
This story and other stories about mythical "quants" are out there to take everyone's eye off the core story which really should be "Who organised the housing ponzi scheme and when will they be brought to justice?" The core crime of predatory lending, organised and encouraged on a huge scale, is being obscured by these types of articles and books.
As Tavakoli has pointed out there were a lot of hedge funds involved, and last week on HuffPo she showed the connection between a toxic Citigroup CDO and the Bear Stearns hedge funds in a story about how the FCIC missed an opportunity to nail Citigroup's former officers. Tavakoli's Buffett book talks about a lot of other hedge funds, too. ProPublica and Smith are clouding the key issues by over-emphasizing what Tavakoli correctly calls a cog in the wheel.
During 2004, the financial services industry donated four times as much to Bush as to Kerry. http://usgovinfo.about.com/od/thepoliticalsystem/a/industrybucks.htm If financiers donated large amounts to Obama in 2008, it may have been because they recognized the disastrous implications of a McCain Presidency, rather than seeking to get Obama in their pockets.
The scope of proposed financial reform can be debated at length. but the insinuation that Rahm Emanuel or the Democrats had anything to do with the Magnetar Trade or its fallout has zero basis in fact.
I don't know what Rahm has or has not done, but he sure has some unhealthy acquaintances.
It's called jumping on the bandwagon. Financiers don't worry about "disastrous implications".
Your last paragraph sounds positively Clintonian - as in expertise on all things not illegal - but your implication is a staw man. For we are still talking about financiers jumping on bandwagons, in this case via the future Chief of Staff, and the kind of protection from scrutiny such investment seems to accomplish.
Hey folkes, you're on the wrong end of this rainbow...Americans are paying for the criminal activities of politicians & bankers while the criminals laugh all the way to the bank...
Financial Reform Bill will play out like the Health Insurance Bill.
One side has been hired to act like they're against it, the side with the majority of the votes gets it through - with as little regulation as possible.
Future bailout loopholes for financial firms will remain in tact.
Privatize the profits, socialize the losses and call it "reform".
Guess which one is master and which one is slave.
For Huffpo readers' listening pleasure, here is a song dedicated to MAgnetar :
http://www.huffingtonpost.com/2010/04/12/a-hedge-fund-show-tune-ma_n_534024.html
That's fascinating since OpenSecrets shows Litowitz as a $10,000 donor to the DCCC in 2003, which as I understand it, comes before 2005.
The author said in 2005 they started giving more exclusively to Rahm and his PACs.
$10,000 is significant. So spare me.
And since Litowitz gave a $10,000 donation to the DCCC before he started Magnetar and before Rahm Emanuel took over the DCC, the whole implication of a relationship between the start of the Magnetar deal and the start of the donations turns out to be nonsense.
This style of throwing together a bunch of random crap and then announcing that the Democrats are evil is tedious. It's bad enough when it comes directly from Luntz, but it's worse when it comes with this kind of breathless fake urgency.
1) Magnetar engaged in a completely legal trade
2) the losers were the biggest wall street banks - Magnetar was not taking advantage of widows and orphans.
3) Contrary to what Yves Smith writes, Litowitz started donating big money to the DCCC before Emanuel was running it and before he left Citadel. I found this on OpenSecrets.org in about 20 seconds.
4) There is no evidence that Yves Smith presents or even any reason to believe there is evidence that anyone who got this money did anything untoward. After all (a) the trade seems to have been legal and (b) the REPUBLICANS RAN THE ADMINISTRATION AND REGULATORS. Rahm Emanuel was not in a position to do anything when most of these trades were set up.
5) "Obama raised more money from financial services players than any previous presidential candidate, so it can hardly be a surprise that he and his minions are happy to give the industry a free pass." is just a smear - starting with the use of "minions" and continuing to the actual fact that Obama and "his minions" have introduced a variety of financial reform measures to Congress and these measures have been blocked by REPUBLICANS.