By Andrew Dittmer, a mathematician with hedge fund experience, and Richard Smith, a UK based capital markets IT consultant
Readers of this blog are by now familiar with the incredible story of how a single hedge fund (Magnetar) managed to play a shockingly extensive role in inflating the housing bubble in 2006-2007. The story was first broken seven weeks ago in Yves’ book ECONNED (completed in early October 2009). Despite the obvious importance of the Magnetar strategy, the media at large was still generally ignorant of what happened.
Earlier this month, though, this silence has been broken with an extensive report on the Magnetar trade prepared by the public interest research group ProPublica. The ProPublica piece contains a wealth of narrative detail and some useful links to documents including prospectuses of particular Magnetar CDOs. The official Magnetar responses (and refusals to comment) to particular questions from ProPublica are especially illuminating.
Of course, the ProPublica team had no way of knowing that Yves’ book would contain a chapter on the same material, and it might have been frustrating for them to see a story to which they had devoted so much effort first appear elsewhere. Still, they have every reason to feel proud – their article contains important information about the Magnetar trade that is not found in ECONNED, and remains valuable in its own right.
Given the intrinsic worth of the ProPublica piece, it is hard to understand why its authors felt it necessary to try to minimize the treatment of the Magnetar story in ECONNED. They write:
Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, “Econned,” that “Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.”
In other words, the ProPublica authors credit Yves for some “reporting” on the Magnetar trade and for a sound bite, while claiming to have been the only ones to have “assembled a full narrative.” A reader of the ProPublica piece would have no clue from this description that Yves’ book contains 22 pages of detailed description of the Magnetar trade, together with footnotes and an appendix that discuss even more technical details.
By far the most important consideration is to help make sure that the Magnetar and similar trading strategies become as well understood and widely known as possible. Since we believe that the ProPublica authors similarly put the public interest ahead of any worries about who gets the spotlight for the story, we are troubled by what looks like an attempt to diminish Yves’ role. Perhaps the authors were in a hurry to finish their piece and did not actually read ECONNED carefully enough to understand Yves’ contribution.
The most constructive response therefore seems to be to reiterate how important it is for people who genuinely care about financial reform to support one other, and then to discuss some of the differences between the two pieces, and how they complement one another.
The ProPublica piece is especially notable for containing
• information about how Magnetar sought CDO structures that were particularly congenial to its strategy (so-called “triggerless” structures).
• a list of 26 of the (purportedly) 30 CDOs in the Magnetar Constellation program, together with some information about those CDOs.
• a convenient timeline showing when these CDOs were created
• a study of how rapidly the Magnetar CDOs blew up compared to similar CDOs that were not sponsored by Magnetar.
• some information about who ended up with tranches of the Magnetar CDOs, although a great deal of work still remains to be done here by people who are interested in this issue.
• a case where another party (Ischus Capital Management), refused to do a deal with Magnetar.
One particularly interesting detail in the ProPublica piece is the account of how Magnetar offloaded some of the equity slices they had retained by stuffing 18 of them into a special CDO (Tigris) that through the usual miracles was rated by S&P and Fitch and then sold to the Japanese bank Mizuho.
Our own research is largely consistent with the list that ProPublica provides of 26 Magnetar CDOs. Specifically, the transaction detail we have worked out to date identifies 29 of perhaps as many as 50 Magnetar CDOs and supplies some information not given in the ProPublica piece. There are some cases where the ProPublica numbers for par value diverge from ours on the upside; knowledgeable readers are encouraged to weigh in, both to confirm numbers that disagree and to identify the mysterious “last” Magnetar CDO. See our spreadsheet on the transactions, developed with the input of market participants and prepared by Tom Adams and Andrew Dittmer, here.
What is regrettable is that the ProPublica piece does not emphasize the huge systemic role that the Magnetar strategy played in amplifying the impact of the subprime bubble. The authors begin their piece by pointing out that
In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.
Despite this promising beginning, the ProPublica authors never actually explain to the reader the connection between the Magnetar story and [emphasize] why, contrary to what should have been expected, the housing bubble swelled to massive proportions in 2006-2007. Even with the rating agencies’ colossal and deservedly criticized misratings, the subprime bubble would have died a much earlier, less costly death absent the way Magnetar’s strategy drove demand and multiplied the size of the total exposures in the toxic phase of the subprime bubble.
The fact that a single hedge fund, with a comparatively small amount of capital, could wreak such damage, indicates that the true leverage and costs of recent financial “innovations” are not well understood. Omitting the systemic importance of Magnetar risks turning the Magnetar story into a scandal about an individual firm, rather than what it truly is: an indictment of the financial system as a whole.
Some other important details about the Magnetar trades that are discussed in ECONNED include:
• How a seemingly small amount of BBB tranches from subprime bonds used in Magnetar’s CDOs, had a devastating impact on the subprime market. Consistently conservative analyses indicate that in the peak years of 2006 and early 2007, Magnetar’s program drove the demand for roughly 35% of subprime bonds. Industry sources have estimated that the number may be as high as 50% to 75%.
• Magnetar’s trade was imitated by other hedge funds and dealers, further increasing the systemic impact.
• The deals were mostly hybrids, typically with 20% cash bonds and 80% credit default swaps; why this structure was advantageous for Magnetar.
• The links between the demand for CDOs and the “negative basis trade” that was arguably a widespread form of bonus fraud. (When a AAA instrument was insured by an AAA guarantor, internal reports typically treated it as if all the expected income in future years was discounted to the present. As we know now, in the overwhelming majority of cases, bonuses were paid on income that was never earned. This mechanism was THE reason many banks would up holding so much AAA CDO inventory – it was more lucrative for the traders to retain and “hedge” it than sell it.)
• The masquerade of almost entirely BBB subprime risk as AAA suppressed CDS spreads on BBB subprime bonds, the most actively traded tranche of the original bonds. Via arbitrage, this also influenced subprime bond pricing, which in turn lowered the yield on the loans themselves. In this manner, the mezzanine CDO market directly influenced spreads in the subprime housing market.
There’s perverse irony at work here. The blogosphere often complains of having its scoops ignored or worse, stolen by the mainstream media. Here we have a case where an critical story presented via the absurd long lead time off books (the finalization deadline of early October 2009 versus a publication date of early March 2010) still beats MSM and blogosphere to the punch by six weeks, yet has been given less recognition that it would seem to deserve by both. And the side effect is serious, that the systemic impact of the Magnetar trade still remains largely under the radar.