Hedging? or Rigging the Market?

Last week’s episode of This American Life was a super-interesting deep dive into some of the players that caused the financial meltdown.  They started with the premise that the oft-repeated phrase “no one saw this coming” was unacceptable.  Wall Street is supposedly filled with these financial wiz kids, and can we really believe that no one saw the risk?  No one is responsible for the creation of so many worthless assets?

Because the podcast is an hour long, and WAY to dry for most normal humans, I’ll try to sum up some key findings here.

Once upon a time, there was an evil hedge fund called Magnetar. Magnetar, like all hedge funds, are looking for huge gains. In the middle of a slowing housing market in 2005, when investors were slowing the rate of investment in mortgage-backed secuirites, Magnetar flooded the system with new money and new mortgage-backed security instruments and then — this is the good part — hedged against them. Yes, Magnetar created these CDOs and encouraged the worst types of mortgages to be securitized in them, then they purchased credit default swaps (like an insurance policy) to hedge against their own bet.

Quoting a bit from the Pro Publica Article:

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations — CDOs. If housing prices kept rising, this would provide a solid return for many years. But that’s not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.

Magnetar says it was “market neutral,” meaning it would make money whether housing rose or fell. (Read their full statement.) Dozens of Wall Street professionals, including many who had direct dealings with Magnetar, are skeptical of that assertion. They understood the Magnetar Trade as a bet against the subprime mortgage securities market. Why else, they ask, would a hedge fund sponsor tens of billions of dollars of new CDOs at a time of rising uncertainty about housing?

I’ve always been a little suspicious of hedge funds. How can a hedge fund post a 75% growth rate when the market is only growing at 3-5% overall? The only way to do this is through financial manipulation.

In a brilliant stroke, the folks at This American Life compared it to the musical The Producers, where two broadway producers hatch a scheme to make more money with a theatrical flop than they would with a hit.

This is exactly what Magnetar did. That they posted HUGE gains by trickery is infuriating, but to add insult to injury, know this: the bankers who dealt with Magnetar, yes the same banks that the public had to bail out, took millions and millions of dollars in bonuses from the fees on the crappy securities.

So, while the rest of America is recovering from lost jobs and obliterated retirement funds, the ‘good ole boys club’ are all still living like kings off of the millions of dollars they personally banked during this time. by selling each other dying milk cows.

How’s that for the American way? Save your own assets first…

This American Life certainly had the best outro of any financial news piece I’ve heard: they composed a broadway rendition of what happened and how these people made millions of dollars betting against the American Dream.

This little bit of poetry almost counterbalances Litowitz’s (Magnetar’s creator) own piece of poetry: a “magnetar” is a celestial body, a collapsed and dying star whose magnetic field is akin to a black hole.

Thanks, Litowitz. Thanks for creating a huge black hole in the middle of our economy, you turd.