Category Archives: Hedge funds

JP Morgan Pays $153.6 Million to Settle SEC Charges on Toxic Magnetar CDO

The SEC announced that JP Morgan has agreed to pay $153.6 million to settle charges related to a $1.1 billion heavily synthetic CDO called Squared which JP Morgan placed in early 2007 and was managed by GSC Partners, a now defunct CDO manager. The SEC has a cute but not all that helpful visual on the site, save it reflects the role of Magnetar as the moving force behind the deal.

Per the SEC’s complaint against JP Morgan, Magnetar provided $8.9 million in equity and shorted $600 million notional, or more than half the face amount of the CDO (this is consistent with our analysis, which had suggested that Magnetar, unlike Paulson, did not take down the full short side of its deals, since it like staying cash flow positive on its investments. The size of its short position was limited by the cash to be thrown off by the equity tranche). And needless to say, this was a CDO squared, meaning a CDO made heavily of junior tranches of other CDOs, so it was a colossally bad deal.

The complaints (one against JP Morgan and the other against GSC employee Edward Steffelin) make clear that the SEC had gotten its hands on some pretty damning e-mails. The core of the allegation against JPM was that all the marketing materials represented that the assets in the CDO were selected by GSC when they were in fact to a significant degree chosen by Magnetar.

Magnetar made clear that it regarded its equity position as “basically nothing” and really wanted to “buy some protection”, meaning get short and that Magnetar was actively involved in choosing the exposures for the deal.

Two Supreme Court Rulings Give Big Companies “Get Out of Liability Free” Cards

If you had any doubts that the US has become a corpocracy, two fresh rulings by the Supreme Court should seal any doubt. They are stunningly bad, in that they reduce or gut the reach of well-settled law over large companies, to the degree that it will take very little in the way of effort for companies to organize their affairs so as to escape liability for their actions in areas that affect large numbers of citizens.

The through line in both rulings is the creative and selective use of the notion of corporate “personhood”. That personhood has been the basis for the extension of a whole raft of rights to corporations, including, perversely, the Constitutional right of free speech. Yet the same notion which has been used to confer privileges that companies lack in other countries is at the same time being construed so as to vitiate accountability, when ordinary people find it mighty hard to escape the consequences of their actions. I’m certain the Founding Fathers, who were wary of concentrated power, would be spinning in their graves at the logic and effect of recent decisions on this front.

Magnetar Strikes Again: JP Morgan Negotiating Settlement with SEC on Toxic CDO

As longstanding readers of this blog presumably know, we broke the story of Magnetar, a Chicago-based hedge fund. Magnetar was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.

As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:

David Apgar: Is That a Horse’s Head Under the Sheets or Are You Just Happy to Fleece Me?

By David Apgar, the Director of ApgarPartners LLC, a new business that applies assumption-based metrics to the performance evaluation problems of development organizations, individual corporate executives, and emerging-markets investors, and author of Risk Intelligence (Harvard Business School Press 2006) and Relevance: Hitting Your Goals by Knowing What Matters (Jossey-Bass 2008). He blogs at WhatMatters. The […]

Shades of 2007: Synthetic Junk Bonds

Aha, the level of financial innovation spurred by super low interest rates is starting to have that “I love the smell of napalm in the morning” feel to it.

The Financial Times reports that there is a frenzy to create synthetic junk bonds, ostensibly to satisfy the desire of yield-hungry investors. Any time you see a lot of long money flowing into synthetic assets rather than real economy uses, it’s a sign that Keynes’ casino is open for business (“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”)

The author compare this development to that of the asset backed securities CDO market, one of our betes noirs which blew up spectacularly in the crisis. There are some similarities and differences.

Guest Post: The Price of Oil – Where the Outrage?

By Payam Sharifi, an economics Graduate Student at the University of Missouri-Kansas City

Here in the United States, discussions of our troubled times revolve around any of the following: the housing crisis, the federal debt, unemployment, the fiscal health of particular states, and sometimes even income inequality. Overseas, discussions can include these topics, as well as the plight of the Euro. One issue that I personally feel has gotten the short end of the stick is that of commodity prices, and in particular food and oil. There is a special significance to this issue: its ramifications affect nearly every human being in the world. As seen in prices on the NYMEX and other markets, oil and food prices are beginning to soar again, with the price of WTI futures hitting $90/barrel and Brent crude going over $100/barrel. This issue ought to be discussed again with a renewed interest – but the media and much of the populace at large have simply accepted high food and oil prices as an unavoidable fact of life, without any discussion of the causes of these price rises aside from platitudes. For example, a recent AP report quoted an opinion that gasoline was going to hit $4/$5 a gallon in 2011, but did not mention the possible relevance of speculation in the futures market. It seems that everyday observers (as well as even the financial media) find this issue so complex that they shrink from discussing it. I will now give my opinion on these issues, buttressed by what I have learned from a recent interview with commodities trader Daniel Dicker. His new book “Oil’s Endless Bid” is due out in April.

Questioning Goldman’s “Market Making” Defense

The notion underlying the Volcker rule is that too big to fail institutions have a government backstop and therefore their activities should be restricted to the types of intermediation that support the real economy. The taxpayer has no reason to fund “heads I win, tails you lose” wagers. Various firms, most notably “doing God’s work” Goldman, has tried to play up the social value of its role, whenever possible wrapping its conflict-of-interest ridden trading activities in the mantle of “market making”.

A big problem in taking about market making versus position trading is that, Goldman piety to the contrary, the two are closely linked. Even though all the major dealer banks created proprietary trading operations to allow top traders to speculate with the house’s capital, plenty of positioning also takes place on dealing desks. While dealers are obligated to make a price to customer (well, in theory, it’s amazing how many quit taking calls in turbulent markets), they are shading their prices in light of how they feel about holding more or less exposure at that time. And the dealing desks, just like the prop traders, are seeking to maximize the value of their inventories over time.

A Goldman discussion of risk management presented yesterday (hat tip reader Michael T) gives reason to question that much has changed on Wall Street regarding the role of position taking, now taxpayer supported, in firm profits.

Satyajit Das: Derivatives Regulation Dance

By Satyajit Das, the author of “Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives.” Cross posted from Wilmott

A question of values …

Derivative contracts are valued on a mark-to-market (“MtM”) basis. This requires valuation of the contracts based on the current market price.

OTC derivatives trade privately. Market prices for specific transactions are not directly available. This means current valuations rely on pricing models.

There are significant differences in the complexity of the models and the ability to verify and calibrate inputs. More complex products used sophisticated financial models, often derived from science or statistical methodology. There are frequently differences in choice, exact factorisation and even numerical implementation of the models. Different dealers may use different models.

Some required inputs for the models are available from markets sources. The nature of the OTC market and the limited trading in certain instruments mean that key input parameters must frequently be “estimated” or “bootstrapped” from available data. In certain products, the limited number of active dealers means that “market” prices are sometimes no more than the dealer’s own quote being fed back after being collated and “scrubbed” by an external data provider. This is referred to prosaically as “mark-to-myself”.

FCIC Report Misses Central Issue: Why Was There Demand for Bad Mortgage Loans?

By Tom Adams, an attorney and former monoline executive, and Yves Smith

In common with other accounts of the financial crisis, the Financial Crisis Inquiry Commission report notes that mortgage underwriting standards were abandoned, allowing many more loans to be made. It blames the regulators for not standing pat while this occurred. However, the report fails to ask, let alone answer, why standards were abandoned.

In our view, blaming the regulators is a weak argument.

A much more sensible explanation can be found by asking: what were the financial incentives for such poorly underwritten loans? Why would “the market” want bad loans?

All the report offers as explanation is that the “machine” drove it or “investors” wanted these loans. This is lazy and fails to illuminate anything, particularly when there are other red flags in the report, such as numerous mortgage market participants pointing to growing problems starting as early as 2003. Signs of recklessness were more visible in 2004 and 2005, to the point were Sabeth Siddique of the Federal Reserve Board, who conducted a survey of mortgage loan quality in late 2005, found the results to be “very alarming”.

So why, with the trouble obvious in the 2005 time frame, did the market create even worse loans in late 2005 through the beginning of the meltdown, in mid 2007, even as demand for better mortgage loans was waning?

FCIC Insiders Say Report Gives Wall Street a Free Pass, Simply Sought to Validate Conventional Wisdom About Crisis

From the very outset, the Financial Crisis Inquiry Commission was set up to fail. Its leadership, particularly its chairman, Phil Angelides, was seen as insufficiently experienced in sophisticated finance. The timetable was unrealistic for a thorough investigation of a crisis this complex, let alone one international in scope. Its budget and staffing were too small. The investigations were further hampered by the requirement that subpoenas have bi-partisan approval along with Its decision to hold hearings with high profile individuals, including top Wall Street executives, before much in the way of lower-level investigation had been completed. The usual way to get meaningful disclosure from a top executive is to confront him with hard-to-defend material or actions; interrogations under bright lights, while a fun bit of theater, generally yield little in the absence of adequate prep.

So with expectations for the FCIC low, recent reports that the panel urged various prosecutors to launch criminal probes were a hopeful sign that the commission might nevertheless come out with some important findings. But correspondence from insiders in the last few days suggests otherwise. One, for instance, wrote, “I’m still in the process of getting the stink out of my clothes.”

These ideologically-neutral sources close to the investigation depict the commissioners as having pre-conceived narratives and of fitting various tidbits unearthed during the investigation into these frameworks, with the majority focusing more on the problems caused by deregulation and the failure of the authorities to use even the powers they had, while the minority assigns blame to government meddling, particularly housing-friendly policies.

These insiders see both sides as wrong, and want to encourage investigative reporters to challenge both the majority and dissenting accounts. They contend that both versions help perpetuate the myth that Wall Street was as much a victim of the crisis as anyone else.

One of these sources sent this document in an effort to question the notion that any of the reports coming out of the FCIC were the result of a fact-based investigative process…

Roger Ehrenberg’s Prescription for Robbing a Bank (the TBTF Variety)

One of the continued frustrations of the post-crisis period is the lack of discussion of looting, which as described in a seminal paper by George Akerlof and Paul Romer, is when executives find it more profitable to gamble on bankruptcy, as in lever up their companies, pull out too much in cash (usually with the help of overly flattering accounting) and leave failed businesses in their wake. Akerlof and Romer noted that businesses with explicit or implicit guarantees were particularly well suited to this sort of extractive behavior, and they argued the savings and loan crisis was a prototypical example. In ECONNED, we argued that the producers and management of major capital markets players were engaged in a looting 2.0 in the runup to the crisis.

Roger Ehrenberg, who had a long career in derivatives and now runs an early stage venture firm. He describes how easy it is to, as he puts it, “rob a bank” or loot. His formula:

The Imagination Trade, or the Tinkerbell Market 2.0

I’ve refrained from discussing the stock market for quite some time, in part because this is not an investment website and in part because I find the netherworld of credit more interesting. But a big reason of late is that the stock market has become so utterly unhinged from fundamentals that anyone opining on it, other than momentum trades and technicians with particularly good crystal balls, is likely to look silly.

We seem to be in a toxic replay of what I called the Tinkerbell market in 2007 and 2008: if the officialdom can get enough people to applaud, the economy will live. They weren’t too successful back then, but the crisis has appeared to have upped the game of the Powers That Be in talking up the price of financial instruments. And having the Fed at ready to provide boatloads of liquidity should anything go awry appears to have put much of the world in “don’t fight the Fed” mode.

Market action is looking a tad manic, yet the dot-com mania proved that unwarranted optimism can persist far longer than cooler heads deem possible. Hedge fund leverage, for instance, is allegedly back to pre-crisis highs.

Is Incoming New York Attorney General Schneiderman Going to Be Too Soft on Bank Abuses?

An article in the Wall Street Journal says that the incoming New York state attorney general, Eric Schneiderman, is going to be nicer to Wall Street than his predecessors Eliot Spitzer and Andrew Cuomo. Given that Cuomo decided to take financial firm chicanery seriously only fairly late in his term of office, the Wall Street Journal assessment does not bode well for the prospect of tough enforcement.

The reason this matters is that the New York state AG has a particularly effective weapon, the Martin Act. One of the continuing frustrations I have as a writer and a citizen is the use of the word “fraud”. Activities that by any common-sense standard are fraudulent probably don’t meet the legal standard for fraud. In very crude terms, one of the hurdles that needs to be overcome is intent. If a perp can argue that he thought what he did was not improper (his attorneys or accountant blessed it, it never occurred to him it was an abuse, etc.) or he can claim it was a mistake, he can get off scot free. The very fact that Joe Cassano, the head of AIG’s Financial Products Group, has not been prosecuted serves as an illustration of difficulties involved.

NJ Public Pension Slugfest Reporting Omits 15 Years of Governors Stealing From Workers

If you live in the world according to the mainstream media, the row between state executives and unions is all about (by implication) greedy unions trying to preserve their perquisites when budget “realities” demand that they suffer. Consider this excerpt from a recent article New York Times article about the fight in New Jersey:

Across the nation, a rising irritation with public employee unions is palpable, as a wounded economy has blown gaping holes in state, city and town budgets, and revealed that some public pension funds dangle perilously close to bankruptcy.

And how exactly did the crisis “reveal” that some pension funds were close seriously under water? A more accurate rendition would be that, at least in New Jersey, the state has been raiding the pension kitty for over 15 years.