ProPublica, Planet Money, and radio show This American Life recently carried stories about Magnetar, a hedge fund that profited from the housing crisis. Unfortunately, many thought it was a fresh revelation. Magnetar wasn't a previously unknown hedge fund. Magnetar did not create the synthetic CDO structure, and the magnitude of Magnetar's role in the subprime crisis has been overblown.
The New York Times recently wrote that the synthetic CDO story has only begun to emerge in recent months, and referenced the ProPublica story. ("A Wall Street Invention Let the Crisis Mutate," April 16, 2010. I was mentioned as an early critic of synthetic CDOs.)
Yet, more than two years ago the Wall Street Journal featured Merrill Lynch, Magnetar, N.I.R. and others involved in a failed synthetic CDO called Norma in a PAGE ONE investigative report on December 27, 2007, and followed up with another article on Magnetar's strategy. Even earlier, on December 17, 2007, WSJ had a front page article in its markets section reporting a potential legal battle involving MBIA, Wachovia, Deutsche and UBS for the cash of Sagittarius, a synthetic CDO (in which Magnetar had also invested) that had declared an event of default. The Wall Street Journal had done many investigative articles on value-destroying CDOs, some even earlier.*
The Wall Street Journal did some brilliant investigative reporting in the fall of 2007, and Washington did nothing. The reports were early enough to plan for the worst, take corrective action, and minimize damage. The news appeared before Bear Stearns imploded in March 2008, and the financial crisis came to a head in September 2008.
[I was quoted in all the WSJ articles referenced in this commentary, which is why the links were handy. WSJ also published many other synthetic CDO exposes as did other financial media. See also my endnote on Magnetar.]
Classic and Massive Ponzi Scheme
My book on the financial crisis, Dear Mr. Buffett (Wiley 2009), explains how Wall Street banks were the key architects of the largest Ponzi scheme in the history of the capital markets. Phony debt packages (RMBS, CDOs) supplied the money for unwise--often predatory and fraudulent--mortgage lending. Banks had close business relationships with (and often direct investments in) mortgage lenders and mortgage loan servicers.
Wall Street banks stuffed bad loans and bad loan packages into even more complex packages--including synthetic CDOs--to disguise problems and continue to earn bonuses. As everything started to fall apart, banks accelerated the scheme. They produced the most complex value-destroying deals in the shortest period of time. These are the classic characteristics of a Ponzi scheme, which is illegal.
Washington Ignored Pre-Crisis Media Reports
Synthetic CDOs made the financial crisis worse. Many types of financial entities were involved, and the following media warnings are only two examples that should have spurred Washington and regulators to act.
In May 2007, ten months before Bear Stearns imploded, Business Week's cover story exposed value-destroying synthetic CDOs in Bear Stearns Asset Management's hedge funds. (Bloomberg News also covered the story). The hedge funds imploded in June 2007, and Bear Stearns absorbed the hedge funds' "assets." In March 2008, JPMorgan Chase bought Bear Stearns to save it from collapase. Citigroup created synthetic CDOs with the failed Bear Stearns hedge funds. Citigroup also gave the hedge funds a $200 million loan, so it's remarkable none of this came up in last week's FCIC hearings. [See embedded articles here: "Congress's FCIC Nearly Nailed Citigroup Executives to the Wall--Then Blew It"]
In a Wall Street Journal article in August 2007, I asserted AIG failed to write down losses for its credit derivatives linked to synthetic CDOs. In early October 2007, the Wall Street Journal wrote about a value-destroying synthetic CDO involving now-debased bond insurer MBIA. In the WSJ's January 14, 2008 article on Magnetar's strategy, Calyon was identified as the underwriter of a synthetic CDO called Cetus. Calyon was one of AIG's trading partners involved with other CDOs (unrelated to Magnetar)--including some done jointly with Goldman Sachs--that were purchased in the AIG bailout. AIG should never have been bailed out without pre-conditions. (see "Goldman Sachs: Spinning Gold")
Officials did nothing while the banks damaged the economy, but they acted very quickly when they needed to save the banks. In the months preceding the crisis, officials said the problem could be contained, but main stream media articles already showed they needed to perform investigations and institute financial reform.
The following video (C-Span April 2009) explains how cheap money, wide-spread bad (often predatory) lending, phony securities, credit derivatives, and Wall Street banks' massive over-borrowing led to our current financial crisis. Yet there is still no meaningful reform.
* The Wall Street Journal's Serena Ng and Carrick Mollenkamp wrote a front page about Merrill, Magnetar, and others involved in a CDO called Norma. "Wall Street Wizardry Amplified Credit Crisis," December 27, 2007 This was a PAGE ONE article. On January 14, 2008 the Wall Street Journal's Serena Ng and Carrick Mollenkamp explained Magnetar's strategy, "A Fund Behind Astronomical Losses."
The Wall Street Journal's Aaron Lucchetti wrote about the complexity of the final payouts for a value-destroying synthetic CDO called Sagittarius (MBIA (LaCrosse Financial Products), Deutsche, Wachovia, UBS ended up in a dispute over the cash): "CDO Battles: Royal Pain Over Who Gets What" December 17, 2007. This article appeared on the front page of the Markets (C1) section.
Susan Pulliam, Randall Smith, and Michael Siconolfi wrote a PAGE ONE article on serious CDO pricing issues including shenanigans such as trades with various hedge funds to inflate marks and gimmicks to temporarily disguise the risk (I was quoted in the article). This was before Lehman's famous gimmick of REPO 105. "Investors Face an Age of Murky Pricing," Wall Street Journal, October 11, 2007.
End Note: Synthetic CDOs were well-known to professionals years before Magentar got involved. Synthetic collateralized debt obligations, which use credit derivatives technology, made the mortgage crisis worse by enabling the cover-up of losses. In 2003, I wrote a book on the dangers of synthetic CDOs, called "Collateralized Debt Obligations & Structured Finance." It includes the structure used by Magnetar and other hedge funds in the recent mortgage debacle, but the example used corporate credit risk (Wiley, 2003, Chapter Pp. 181, 194-196 in particular, combined with short mezz Pp. 261-265). I don't know the first person to use that structure, but it wasn't new. The second edition released in 2008 explains the role of structured finance in the subprime crisis in more detail. Synthetic CDOs and many other new structures were used. [I sent gratis copies of each edition to the head of every branch of the Federal Reserve system when they were first published. I also sent a copy to the Chairman (Greenspan and later Bernanke) and received an acknowledgement.]
The first edition (2003) was written before subprime lending exploded. In subsequent years, I warned about new growing problems with subprime (ABS CDOs and synthetic CDOs) at CFA conferences, professional conferences, in numerous articles, in main stream media, and at the International Monetary Fund (April 2005). The 2008 edition consolidates some of those warnings and explains the deterioration in the financial markets due to many types of corrupt structured financial products.
One of the key people at Magnetar, David Snyderman, was in the structured products group at Citadel in August 2004 (and joined Magnetar in mid 2005). At that time, the group he headed asked me to meet with them after reading my CDO book. They said my book gave them the idea to apply the structure to the other loan markets, but banks had already approached many hedge funds with this trade to get around post-Enron accounting issues (among other reasons). The documentation for mortgage loans had already been developed, albeit ISDA didn't issue a template until June 2005; as usual it was behind market practitioners. As I recall, Snyderman did not attend his group's meeting on that day. I declined to get involved, since my book was written as a warning, not a manual for mischief. To the best of my knowledge, the entire group left Citadel shortly thereafter and scattered to various shops.
[In 1998, I wrote the first public book that explains problems with credit derivatives, Credit Derivatives (Wiley, 1998), before Long Term Capital Management blew up. Banks had a lot of risk to hedge funds using certain types of credit derivatives (total return swaps and esoteric credit derivatives), and I wrote that banks' exposure was too great, because hedge funds were overleveraged and could easily blow up. At the time, I sent gratis copies to the Fed heads.]