Magnetar -- Remember This Name

(c) 2010 F. Bruce Abel

This posting by James Kwak (skip over the Simon Johnson piece for the moment), is a must, must read.


The Baseline Scenario


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Greek Bailout, Lehman Deceit, And Tim Geithner

Posted: 13 Apr 2010 04:53 AM PDT

By Simon Johnson

We live in an age of unprecedented bailouts. The Greek package of support from the eurozone this weekend marks a high tide for the principle that complete, unconditional, and fundamentally dangerous protection must be extended to creditors whenever something “big” gets into trouble.

The Greek bailout appears on the scene just as the US Treasury is busy attempting to trumpet the success of TARP – and, by implication, the idea that massive banks should be saved through capital injections and other emergency measures. Officials come close to echoing what the Lex column of the Financial Times already argued, with some arrogance, in fall 2009: the financial crisis wasn’t so bad – no depression resulted and bonuses stayed high, so why do we need to change anything at all?

But think more closely about the Greek situation and draw some comparisons with what we continue to learn about how Lehman Brothers operated (e.g., in today’s New York Times).

The sharp decline in market confidence last week – marked by the jump in Greek yields – scared the main European banks, and also showed there could be a real run on Greek banks; other Europeans are trying to stop it all from getting out of hand. But there is no new program that would bring order to Greece’s troubled public finances.

It’s money for nothing – with no change in the incentive and belief system that brought Greece to this point, very much like the way big banks were saved in the US last year.

If anything, incentives are worse after these bailouts – Greece and other weaker European countries on the one hand, and big US banks on the other hand, know now for sure that in their respective contexts they are too big to fail.

This is “moral hazard” – put simply, it is clear a country/big bank can get a package of support if needed, and this gives less incentive to be careful. Fiscal management for countries will not improve; and risk management for banks will remain prone to weakening when asset prices rise.

If a country hits a problem, the incentive is to wait and see if things get better – perhaps the world economy will improve and Greece can grow out of its difficulties. If such delay means that the problems actually worsen, Greece can just ask Germany for a bigger bailout.

Similarly, if a too-big-to-fail bank hits trouble, the incentive is to hide problems, hoping that financial conditions will improve. Essentially the management finds ways to “prop up” the bank; on modern Wall Street this is done with undisclosed accounting manipulation (in some other countries, it is done with cash). If this means the ultimate collapse is that much more damaging, it’s not the bank executives’ problem any way – their downside is limited, if it exists at all.

The Greeks will now:

Lobby for a large multi-year program from the IMF. They’ll want a path for fiscal policy that is easy in the first year and then gets tougher.
When they reach the tough stage, can’t deliver on the budget, and are about to default, the Greek government will call for another rapid agreement under pressure – with future promises of reform. The eurozone will again accept because it feels the spillovers otherwise would be too negative.
The Greek hope is that the global economy recovers enough to get out, but more realistically, they will start revealing a set of negative “surprises” that mean they miss targets. If the surprises add to the feeling of crisis and further potential bad consequences, that just helps to get a bailout.
The Greek authorities will add a ground game against the European Central Bank, saying things like: “the ECB is too tight, so we need more funds”. We’ll see how that divides the eurozone.
In their space, big US banks will continue to load up on risk as the cycle turns – while hiding that fact. Serious problems will never be revealed in good time – and the authorities will again have good reason (from their perspective) to agree to the hiding of issues until they get out of control, just as the Federal Reserve did for Lehman Brothers. Moral hazard not only ruins incentives, it also massively distorts the available and disclosed information.

As for Mr. Geithner, head of the New York Fed in 2008 and Secretary of the Treasury in 2009: Those who cannot remember the bailout are condemned to repeat it.





The Cover-Up

Posted: 12 Apr 2010 06:59 PM PDT

By James Kwak

Wall Street is engaged in a cover-up. Not a criminal cover-up, but an intellectual cover-up.

The key issue is whether the financial crisis was the product of conscious, intentional behavior — or whether it was an unforeseen and unforeseeable natural disaster. We’ve previously described the “banana peel” theory of the financial crisis — the idea it was the result of a complicated series of unfortunate mistakes, a giant accident. This past week, a parade of financial sector luminaries appeared before the Financial Crisis Inquiry Commission. Their mantra: “No one saw this coming.” The goal is to convince all of us that the crisis was a natural disaster — a “hundred-year flood,” to use Tim Geithner’s metaphor.

I find this incredibly frustrating. First of all, plenty of people saw the crisis coming. In late 2009, people like Nouriel Roubini and Peter Schiff were all over the airwaves for having predicted the crisis. Since then, there have been multiple books written about people who not only predicted the crisis but bet on it, making hundreds of millions or billions of dollars for themselves. Second, Simon and I just wrote a book arguing that the crisis was no accident: it was the result of the financial sector’s ability to use its political power to engineer a favorable regulatory environment for itself. Since, probabilistically speaking, most people will not read the book, it’s fortunate that Ira Glass has stepped in to help fill the gap.

This past weekend’s episode of This American Life includes a long story on a particular trade put on Magnetar (ProPublica story here), http://www.propublica.org/feature/the-magnetar-trade-how-one-hedge-fund-helped-keep-the-housing-bubble-going a hedge fund that I first read about in Yves Smith’s ECONned. The main point of the story is to show how one group of people not only anticipated the collapse, and not only bet on it, but in doing so prolonged the bubble and made the ultimate collapse even worse. But it also raises some key issues about Wall Street and its behavior over the past decade.

This will require a brief description of what exactly Magnetar was doing. (If you know already, you can skip the next two paragraphs.) It’s now a cliche that a CDO is a set of securities that “slices and dices” a different set of securities. But it’s slightly more complicated than that. First there is a pile of mortgage-backed securities (or other bond-like securities) that are collected by an investment bank. The CDO itself is a new legal entity (a company) that buys these MBS from the bank; that’s the asset side of its balance sheet. Its liability side, like that of any company, includes debt and equity. There’s a small amount of equity bought by one investor and a lot of debt, issued in tranches that get paid off in a specific order, bought by other investors. The investment bank not only sells MBS to the CDO, but it also places the CDO’s bonds with other investors. Whoever buys the equity is like the “shareholder” of this company. There is also a CDO manager, whose job is to run the CDO — deciding which MBS it buys in the first place, and then (theoretically) selling MBS that go bad and replacing them by buying new ones. The CDO itself is like an investment fund, and the CDO manager is like the fund manager.

According to the story, in 2006, when the subprime-backed CDO market was starting to slow down, Magnetar started buying the equity layer — the riskiest part — of new CDOs. Since they were buying the equity, they were the CDOs’ sponsor, and they pressured the CDO managers to put especially risky MBS into the CDOs — making them more likely to fail. Then Magnetar bought credit default swaps on the debt issued by the CDOs. If the CDOs collapsed, as many did, their equity would become worthless, but their credit default swaps on the debt would repay them many, many times over.

The key is that Magnetar was exploiting the flaws in Wall Street’s process for manufacturing CDOs. Because the banks made up-front fees for creating CDOs, the actual human beings making the decisions did not particularly care if the CDOs collapsed — they just wanted Magnetar’s money to make the CDOs possible. (No one to buy the highly risky equity, no CDO.) Because the ratings agencies’ models did not particularly discriminate between the contents that went into the CDOs (see pages 169-71 of The Big Short, for example), Magnetar and the banks could stuff them with the most toxic inputs possible to make them more likely to fail.

Now, one question you should be asking yourself is, how is this even arithmetically possible? How is it possible that a CDO can have so little equity that you can buy credit default swaps on the debt at a low enough price to make a killing when the thing collapses? You would think that: (a) in order to sell the bonds at all, there would have to be more equity to protect the debt; and (b) the credit default swaps would have been expensive enough to eat up the profits on the deal. Remember, this is 2006, when several hedge funds were shorting CDOs and many investment banks were looking for protection for their CDO portfolios.

The answer is that nothing was being priced efficiently. The CDO debt was being priced according to the rating agencies’ models, which weren’t even looking at sufficiently detailed data. And the credit default swaps were underpriced because they allowed banks to create new synthetic CDOs, which were another source of profits. So here’s the first lesson: the idea that markets result in efficient prices was, in this case, hogwash.

By taking advantage of these inefficiencies, Magnetar made the Wall Street banks look like chumps. This American Life talks about one deal where Magnetar put up $10 million in equity and then shorted $1 billion of AAA-rated bonds issued by the CDO. It turned out that in this deal, JPMorgan Chase, the investment bank, actually held onto those AAA-rated bonds and eventually took a loss of $880 million. This was in exchange for about $20 million in up-front fees it earned.

But who’s the chump? Sure, JPMorgan Chase the bank lost $880 million. But of that $20 million in fees, about $10 million was paid out in compensation (investment banks pay out about half of their net revenues as compensation), much of it to the bankers who did the deal. JPMorgan’s bankers did just fine, despite having placed a ticking time bomb on their own bank’s balance sheet. Here’s the second lesson: the idea that bankers’ pay is based on their performance is also hogwash. (The idea that their pay is based on their net contribution to society is even more absurd.)

So who’s to blame? The first instinct is to get mad at Magnetar. But this overlooks a Wall Street maxim cited by TAL: you can’t blame the predator for eating the prey. Magnetar was out to make money for its limited partners; if it had bet wrong and lost money, no one would have bailed it out. Although I probably wouldn’t have behaved the same way under the circumstances, I have no problem with Magnetar.

I do have a problem with the Wall Street bankers in this story, however. Because losing $880 million of your own company’s money to make a quick buck for yourself is either incompetent or just wrong. And allowing Magnetar to create CDOs that are as toxic as possible — and then actively selling their debt to investors (that’s where the banks differ from Magnetar, in my opinion) — is either incompetent or just wrong. But even so, I don’t think the frontline bankers are ultimately at fault. Maybe they were simply incompetent. Or maybe, they were knowingly exploiting the system to maximize their earnings — only in this case the system they were exploiting was their own banks’ screwed-up compensation policies, risk management “systems,” and ethical guidelines.

In which case the real blame belongs to those who created that system and made it possible. And that would be the bank executives who failed at managing compensation, risk, or ethics, endangering or killing their companies in the process. And that would be the regulators and politicians who allowed these no-money down no-doc negative-amortization loans to be made in the first place; who allowed investment banks to sell whatever they wanted to investors, with no requirements or duties whatsoever; who allowed banks to outsource their capital requirements to rating agencies, giving them an incentive to hold mis-rated securities; who declined to regulate the credit default swaps that Magnetar used to amass its short positions; who allowed banks like Citigroup and JPMorgan Chase to get into this game with federally insured money; and who failed at monitoring the safety and soundness of the banks playing the game.

The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them — only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident.