Earlier this week I listened to a story on This American Life about how a single Chicago-based hedge fund may have very likely been the proximate cause of the financial meltdown that nearly destroyed the global economy. That company is called Magnetar, and it is a scandal that you’ve probably never heard of it.
Magnetar played a critical role in keeping alive the market for some of the riskiest investments in 2006 and 2007. By doing so, Magnetar drove demand for riskier and riskier investments throughout the financial industry and created a market for the risky mortgage-backed securities that were the foundation for the collapse of the housing market. Here’s how they did it:
One of the biggest, if not the biggest, causes of the financial collapse in 2008 was the combined effect of two interlocking securities instruments called Credit Default Swaps (CDSs) and Collateralized Debt Obligations (CDOs). CDOs are a type of asset-back security, similar to a bond, that pays investors from the proceeds of an underlying bundle of investments. In some cases, CDOs are issued based on mortgage-backed securities. If the underlying mortgages default, the CDOs can’t pay the investors, and the CDOs collapse in stages. Failed mortgages led to a cascading series of failure of CDOs throughout the financial industry and eventually to the failure of the financial system itself.
CDSs come into play because they are like insurance. If you make a large investment, you can buy a CDS to protect, or insure, you investment in case the investment fails. You can also, unbelievably, buy a CDS on an investment even if you’re not the investor. This is exactly like taking out a life insurance policy in a stranger. In other words, you can buy a CDS for a small amount on a bet that a large instrument will fail. If it does indeed fail, you get paid the full amount of the investment.
Magnetar’s scheme was to buy the riskiest portions of the CDOs, encourage the CDO manager to place riskier and riskier securities into the CDOs (making the CDO’s failure far more likely), then bet against the success of the CDO by purchasing CDSs that paid if the CDO failed. For example, Magnetar would spend $10 million on the risky portion of the CDO, would make the CDO virtually certain to fail, would buy a CDS that pays when the CDO fails, then collect $100 million or more when the CDO fails. It makes, by doing this $90 million on a $10 million “investment.”
To make matters worse, in 2005 the CDO market was starting to dry up. Money managers and investors were starting to realize that mortgage-backed securities were getting too risky, and there was a dwinding appetite for CDOs based on them. Magnetar, however, realized that it could make a killing if the CDO market stayed alive and therefore propped up the CDO market by strategically buying the riskiest portion of the CDOs. This not only propped up the CDO market, it fueled it into record growth. This meant that a housing market that would have likely cooled off without a bubble actually sped up and grew. Along the way tens of thousands of Americans got mortgages they never should have gotten in order to supply the demand for mortgage-backed securities. When the housing bubble burst and the CDOs failed, Magnetar made billions.
The final outrage is that much of the Bush Bail Out Money went to stabilize institutions who made bad decisions in issuing CDSs. Undoubtedly some (or a lot) of Magnetar’s huge profits came from the US Government, via AIG and other financial firms.
In the final analysis, Magnetar seems to have created a scheme for huge profits based on the misfortunes of tens of thousands of Americans and the generosity of the American Taxpayer. You and I paid taxes so that Magnetar and other firms could get paid on bets that they new were sure to pay off because they had gamed the system. This is outrageous.
Please take a minute to watch this video, made by the good folks at This American Life. It sums up the story in about two minutes. CLICK HERE.
Also, please visit this page at Pro Publica CLICK HERE. They are the team of reporters who have broken the story and who have put this all together.