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The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going
by Jesse Eisinger and Jake Bernstein
ProPublica,
April 9, 2010, 1 p.m.
A hedge fund, Magnetar, helped create arcane mortgage-based instruments, pushed for risky things to go inside them and then bet against the investments. (Ethan Miller/Getty Images)
Update October 29th, 2010: This story has been corrected in response to a recent letter from Magnetar. Read their letter, along with our response [1].
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.
At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund [2] helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages.
Get ProPublica's Top Stories and Major Investigations Delivered to Your Inbox [3]When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers.
Yet the hedge fund, named Magnetar for the super-magnetic field created by the last moments of a dying star, earned outsized returns in the year the financial crisis began.
How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade [4]. Nearly all of those approached by ProPublica declined to talk on the record, fearing their careers would be hurt if they spoke publicly. But interviews with participants, e-mails [5], thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street.
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 [6] it never selected the assets that went into its CDOs.
Magnetar says [7] it was "market neutral," meaning it would make money whether housing rose or fell. (Read their full statement. [8]) 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?
Key details of the Magnetar Trade remain shrouded in secrecy and the fund declined to respond to most of our questions. Magnetar invested in 30 CDOs from the spring of 2006 to the summer of 2007, though it declined [9] to name them. ProPublica has identified 26 [10].
An independent analysis [11] commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs. The study [11] was conducted by PF2 Securities Evaluations, a CDO valuation firm. (Magnetar says defaults don't necessarily indicate the quality of the underlying CDO assets.)
From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn't cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.
Magnetar says it invested in 30 CDOs from the spring of 2006 to the summer of 2007. At least nine banks helped the hedge fund hatch these deals, and Merrill Lynch, UBS and Citi all did multiple deals. (From left: Daniel Barry/Getty Images; Jonathan Fickies/Bloomberg News; Seokyong Lee/Bloomberg News)
At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses [10], the banks didn't disclose to CDO investors the role Magnetar played.
Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.
Some bankers involved in the Magnetar Trade now regret what they did. We showed one of the many people fired as a result of the CDO collapse a list of unusually risky mortgage bonds included in a Magnetar deal he had worked on. The deal was a disaster. He shook his head at being reminded of the details and said: "After looking at this, I deserved to lose my job."
Magnetar wasn't the only market player to come up with clever ways to bet against housing. Many articles and books, including a bestseller by Michael Lewis [12], have recounted how a few investors saw trouble coming and bet big. Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.
Magnetar's approach had the opposite effect -- by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn't alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.
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," [13] 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."
Magnetar Gets Started
Magentar founder Alec Litowitz speaks at a private equity conference held at Kellogg School of Management at Northwestern University in February 2007. (Nathan Mandell)
The guiding force behind Magnetar was Alec Litowitz, a triathlete, astronomy buff and rising star in the investing world. In 2003, Litowitz retired from a Chicago-based hedge fund, Citadel, one of the most successful in the world, where he had spent most of his career and became a top executive. He promised to stay out of the business for two years.
As he waited for his non-compete agreement to expire, Litowitz and his wife traveled through Europe collecting antiques to stock a big house they were building on the shores of Lake Michigan.
By spring 2005, Litowitz's wait was over. Then 38 years old, Litowitz quickly raised money to start his own hedge fund. The fund, Magnetar, attracted $1.7 billion from investors and opened in April.
Litowitz, who declined to be interviewed, had an approach to investing that emphasized scale and simplicity. He told those he hired: "Figure out a way to make money and figure out how to repeat it and do it over and over again," according to a former employee. The firm handed out T-shirts emblazoned with a confident slogan: "Very Bright, Very Magnetic." Employees privately joked about working for a fund named after something like a black hole.
Litowitz brought on board David Snyderman. A New Yorker with a serious mien, Snyderman, in his mid-30s, began hunting for investment opportunities in Wall Street's burgeoning market in mortgage-backed securities.
It didn't take them long to find something promising.
Snyderman and Magnetar focused on Wall Street's mortgage assembly line, which had been super-charged during Litowitz's time away from the business. Banks bundled pools of mortgages into large bonds, which they combined to create even larger investments. These were the now-infamous collateralized debt obligations. Each month, homeowners paid their mortgages. Each month, payments flowed to investors. (Here is an excellent video explaining CDOs [14].)
Large investors across the globe snapped up the CDOs, which took the hottest investment around -- the U.S. housing market -- and transformed it into something that supposedly had little or no risk. Wall Street preached that the risk had been diluted because it was spread out over such large collections of mortgage bonds. (CDOs can also be based on side bets that rise and fall with the value of other mortgage bonds. These are known as "synthetic" CDOs. Magnetar’s deals were largely synthetic.)
Just as they did with mortgage-backed securities, investment banks divided CDOs into different layers, called tranches. As the mortgages were paid, money flowed to investors holding the top tranche. Since they were the first to get paid, and thus took the least amount of risk, they earned low interest rates. Next came the middle levels -- the so-called mezzanine tranches.
Last in line for money were investors in what's known as the equity. In return for being at the bottom, equity investors got the highest returns, sometimes 20 percent interest -- money they would receive only as long as the vast majority of mortgage holders made their payments.
Even back then, Wall Street insiders called the equity "toxic waste," and as anxiety built in late 2005 that the housing boom was over, investment banks struggled to find takers.
To Magnetar, the toxic waste was an opportunity.
At a time when fewer investors were stepping up to buy equity, the little-known hedge fund put out the word that it wanted lots and lots of it. Magnetar concentrated in a particularly risky corner of the CDO world: deals that were made up of the middle, or mezzanine, slice of subprime mortgage-backed bonds. Magnetar CDOs were big [10], averaging $1.5 billion, about three times the size of earlier deals built on subprime mortgages.
Magnetar's purchases solved a crucial problem for the banks. Since the equity was so risky and thus difficult to sell, banks didn't like to create new CDOs unless someone committed to buy them. Indeed, such buyers were so crucial that Wall Street referred to them as the CDOs' "sponsors."
Without sponsors, Wall Street's mortgage bond assembly line could grind to a halt, and with it bank profits and banker bonuses. A top CDO banker could earn $3 million to $4 million annually on the CDOs he created and sold.
Usually, investment banks had to go out and find buyers of the equity. With Magnetar, the buyer came right to the bank's doorstep. Wall Street was overjoyed.
"It seemed like a miracle," says one mortgage market investment banker, because "no one" had been buying equity.
"By the end of 2005, the general sense was that the CDO market would slow down. These trades continued to fuel the fire," says Bill Tomljanovic, who worked for a firm that helped build a Magnetar CDO. Magnetar was "a driving force in the market."
According to JPMorgan data, Magnetar's deals amounted to somewhere between a third and half the total volume in the particularly risky corner of the subprime market on which the fund focused.
Outsiders thought Magnetar was piling in at exactly the wrong time. A March 2007 Business Week article [15] titled "Who Will Get Shredded?" would later put Magnetar near the top of its list. The hedge fund, said the magazine, "showed bad timing."
How could Magnetar hope to make money on such risky stuff? It had a second bet that was known only to insiders.
At the same time it was investing in the equity, the fund placed bets that many of the same CDOs it had helped create would actually blow up. It did that using one of the most opaque corners of the investment world: credit default swaps, which function as a kind of insurance on CDOs and other types of bonds.
Credit default swaps work roughly like an insurance policy: You pay a small premium regularly, on any bond you want -- whether you own it or not -- and if it goes bust, you get paid off in full.
Nobody but Magnetar knows the full extent of its bets. Hedge funds are private and they don't disclose the details of their trades. Also, credit default swaps are mostly unregulated and not publicly disclosed. Magnetar says it didn't bet only against its own CDOs. The majority of its credit default swaps, says Magnetar, were on other CDOs. (Update April, 9:We have added additional detail [16] from Magnetar’s response in which the hedge fund says it was “net long” on its own CDOs, an assertion on which the fund has declined to elaborate.)
Since it was the sponsor, Magnetar had privileges. Placing the risky equity was so important to banks that they typically gave those who bought it a say in how the deal was structured. Like all investors, equity buyers had to weigh risk and reward, the goal being to maximize returns while minimizing the chances that your investment will blow up.
But people involved in Magnetar's deals say the hedge fund took a different tack, pushing for riskier bonds to go inside its CDOs. Doing that would make it more likely that Magnetar's bets against the CDO would pay off.
The equity bought by Magnetar represented just a tiny fraction of the overall CDO. If it costs, say, $50 million, an entire CDO could be 20 times that, $1 billion. And if the CDO begins to go south and you're smart enough to have taken out enough insurance, you can make hundreds of millions of dollars. That, of course, would take a bit of the sting out of losing your original $50 million investment in the equity.
Magnetar Does Its First Deal
As Magnetar set up its CDO shop, the hedge fund hired Jim Prusko, a smart and affable investor who had worked previously at the Boston money-manager Putnam Investments. He would shoulder much of the work of courting Wall Street bankers and managers who worked with the hedge fund. He operated out of Magnetar's office in midtown Manhattan around the corner from Saks Fifth Avenue. In an office of 20-somethings, Prusko, then 40 years old, stood out as the "old man."
Prusko and his boss at Magnetar, Snyderman, began approaching investment banks, offering to buy the riskiest, highest-yielding portion of CDOs. They always wanted a middleman, known as a CDO manager, on their deals. Many CDOs are operated day to day by such independent firms, who are often brought in by investment banks.
The managers also played a vital role in creating deals. When an investment bank created a CDO, it would often give what amounted to blueprints to the managers, who would then go out and find the exact bundles of bonds to fill the CDO. The managers had a fiduciary duty to represent the CDO fairly to all investors, ensuring investors got accurate and equal information.
Magnetar's deals were numerous and big, and just like for investment banks, the bigger the deal, the larger the fee for managers.
"Prusko's job was to butter up the CDO managers and the bankers," said one banker who dealt with him.
By relying on a manager rather than managing the deal itself, Magnetar had no legal obligations to the CDO or others who bought it.
A guard stands outside the New York headquarters of Deutsche Bank in Lower Manhattan on April 8, 2010. An internal investment fund within Deutsche Bank bought the risky equity along with Magnetar in the hedge fund's maiden CDO. (Dan Nguyen/ProPublica)
Magnetar completed its first deal in May 2006. In what became a habit, it named the CDO after a constellation, in this case, "Orion," known for the trio of stars that form the mythological Greek hunter's belt. For its maiden CDO, Magnetar enlisted a partner to buy risky equity alongside it, an internal investment fund within Deutsche Bank.
Deutsche and Magnetar didn't reach for a Wall Street powerhouse to put the deal together. Instead the investors worked with Alex Rekeda, a young Ukrainian immigrant who was then working for Calyon, the investment banking arm of the French bank Crédit Agricole.
Magnetar and Deutsche were deeply involved in creating Orion. "We want to make sure we control the deal," a banker who worked on it recalls them emphasizing.
One person involved in Orion recalls Deutsche's point person, Michael Henriques, and Magnetar's Prusko pressuring the CDO manager, a division of the Dutch bank NIBC, to include specific lists of bonds in the deal.
Prusko and Henriques told this person that the investors "needed more spread in the portfolio." More "spread" means more return and more risk.
This person recalled Magnetar asking, "Would you consider these bonds?" Their suggestions were invariably for riskier bonds. "Let's just say we didn't think their suggestions made a lot of sense," the person said.
He said the CDO manager refused Magnetar's requests to put riskier bonds in the deal. Still, it was an eye-opening experience. "I began to realize there were things you had to defend yourself against," he said.
Magnetar and Deutsche declined to comment on Orion specifically [9]. Magnetar says it made suggestions about the general outlines of the CDOs. But, the hedge fund says, it "did not select the underlying assets of the CDO at any time prior to or subsequent to transaction issuance."
Other buyers of the CDO could have figured out they were getting relatively risky bonds, but they would have had to look hard at the minutiae of the deal. By this point in market history, the ratings had less and less meaning. Two sets of bonds rated AA could have very different levels of risk. Most investors chose not to dig too deeply.
One investor in Orion was a fund affiliated with IKB, a small German bank. Eventually, it invested in at least four more Magnetar deals. In mid-2007, because of the disastrous investments in subprime securities, the German government was forced to bail out IKB. The failure of the bank was an early warning sign of the global financial crisis.
Deutsche's Henriques would later quit the bank and join Magnetar.
Orion lost value but never defaulted. That was better than every subsequent CDO that Magnetar helped create, according to ProPublica's research.
Magnetar's (Nearly) Perpetual Money Machine
By buying the risky bottom slices of CDOs, Magnetar didn't just help create more CDOs it could bet against. Since it owned a small slice of the CDO, Magnetar also received regular payments as its investments threw off income.
With this, Magnetar solved a conundrum of those who bet against the market. An investor might be confident that things are heading south, but not know when. While the investor waits, it costs money to keep the bet going. Many a short seller has run out of cash at the gates of a big payday.
Magnetar could keep money flowing -- via its small investments in CDOs -- and could use that money to pay for its bets against CDOs.
Similar, commonly traded, assets appeared in multiple Magnetar CDOs. Experts say the benefit of that overlap to Magnetar was that when the hedge fund bet against non-Magnetar CDOs, the CDOs still had similar characteristics to the ones Magnetar had invested in.
Soon enough, bankers and CDO managers had a sense of how it worked. "Everyone knew," said one person who managed Magnetar CDOs. "They used the equity to fund the shorts."
Magnetar further increased its odds by insisting that the CDOs it helped create had an unusual construction. Typically, cash flowing to the last-in-line equity buyers is cut off at the first signs of trouble -- such as a rise in mortgage delinquencies. Those at the top of the CDO -- who accepted lower returns for less risk -- received that cash, leaving none for the high-risk holders.
Magnetar wanted its deals to be "triggerless," meaning lacking these cash-flow dams. When the market turned shaky and homeowners began to default, money kept flowing down to the risky slices that Magnetar owned.
Even today, bankers and managers speak with awe at the elegance of the Magnetar Trade. Others have become famous for betting big against the housing market. But they had taken enormous risks. Meanwhile, Magnetar had created a largely self-funding bet against the market.
E-mails Give Glimpse of How Magnetar Worked
[5]By the fall of 2006, housing prices had already peaked and Magnetar's assembly line started producing, helping to create CDOs it would bet against. The hedge fund's appetite seemed insatiable. The deals were the talk of CDO desks across Wall Street.
Between the end of September and the middle of December 2006, Magnetar had a hand in spawning at least 15 CDOs [10], worth an estimated $23 billion. Among the banks involved with those deals were Citigroup, Lehman Brothers and Merrill Lynch.
E-mails [5] obtained by ProPublica from that time suggest Magnetar's clout. The firm was involved at the start of deals and pushed for riskier bonds to be included.
After Magnetar expressed interest in buying the equity, the French bank Société Générale began to build the CDO, and selected a New York-based manager, Ischus Capital Management, which would choose the exact bonds to go into the CDO.
Magnetar wanted to name the CDO after a small constellation in the southern sky called Hydrus, which means "male water snake." But by late September, Magnetar and Ischus began sparring over the composition of the deal.
Magnetar pressed Ischus to buy lower-quality assets for the deal, according to three people familiar with Hydrus. In an e-mail to bankers at Société Générale and Ischus executives, Magnetar's CDO specialist, Jim Prusko, wrote on Sept. 29, 2006 [17], "The original portfolio target spreadsheet that I have... had a strangely low spread target. That of course would not at all be beneficial to us. I have attached the target portfolio that I would like for this deal with target spreads."
The portfolio Magnetar outlined didn't list specific bonds, but executives at the CDO manager Ischus felt that they understood what Prusko wanted. A request for higher-spreading assets means more risk in the deal.
Andrew Shook, an Ischus executive, answered forcefully on Oct. 3 [18], "We will not assemble a portfolio we are not proud of and feel strongly about in the name of a spread target."
Prusko dialed down the pressure, responding within an hour. "Of course, the actual security selection is totally your purview," he wrote [18]. "I just wanted to make sure the overall portfolio characteristics worked for our strategy."
Shook declined to comment on the e-mail exchange. Magnetar says that the deal as originally conceived wouldn't have been profitable and that it was merely trying to get a higher return -- a higher "spread" -- to balance out the risk it was taking in owning the bottom-rated slice of the CDO.
The two sides subsequently drifted apart, partly over Ischus's unease with Magnetar's pressure, and the deal was never completed.
Concerns About 'Reputational Risks'
As part of the big business Magnetar was doing in the fall of 2006, the hedge fund put together a CDO with Lehman Brothers named for the constellation Libra. John Mawe, a banker who worked on Libra, remembers that "there was a back-and-forth fight" about the assets between the bank's CDO manager and Magnetar, with the hedge fund pushing for riskier assets.
Mawe says Lehman's CDO in-house-management arm, which handled the deal, never put assets into Libra that it thought were bad investments.
Among the other banks that Magnetar approached during that time was Deutsche Bank, with whom it had teamed up to do its first deal months earlier. Deutsche Bank was anxious for business in order to maintain its standing as one of the top CDO banks, according to one of its bankers. Deutsche recommended CDO manager State Street Global Advisors.
The State Street managers were "highly skeptical" of doing a deal with Magnetar, according to one participant. "State Street wanted their deals to do well," said the participant, and with Magnetar, there was "a lot of reputational risk to be concerned about."
Hoping to close the deal, Magnetar's master salesman Jim Prusko drove up from his home in the New York suburbs to State Street's headquarters in Boston, to mollify executives in the management team. After the meeting, the deal went forward. As one banker explained, "there were other managers who were dying to do this deal" and get the millions in fees.
After subprime losses, State Street closed the business that managed its CDOs in late 2007. Frank Gianatasio, who worked in State Street's CDO business says, "We were comfortable with every transaction we put into our CDOs."
Deutsche, Magnetar and State Street called the $1.6 billion CDO they created Carina, a constellation whose name in Latin means a ship's keel. In November 2007, Carina had the distinction of being the first subprime CDO of its kind to be forced into liquidation.
State Street and Magnetar declined to comment [19] on their negotiations over Carina.
A Lawsuit Suggests Merrill Lynch's Role
By early 2007, the mortgage market was falling apart. Lenders were reporting big losses [20], delinquencies were mounting [21] -- and Magnetar's business was booming.
Between late February and April, banks rolled out five Magnetar-sponsored deals, with a value of about $7.2 billion. Among them was a $1.5 billion CDO named Norma. Following Magnetar's branding convention, Norma is a constellation in the Southern Hemisphere named for the Latin word for "normal." This CDO was anything but.
Details about Norma, which was created by Merrill Lynch, have emerged through an ongoing lawsuit between Merrill and Dutch bank Cooperatieve Centrale Raiffeisen-Boerenleenbank, known commonly on Wall Street as Rabobank. (The Wall Street Journal had the first detailed report [22] of Norma, in late 2007.) The dispute involves a side transaction that Rabobank made with Merrill involving Norma. Magnetar is not a party to the litigation. Yet the allegations are scathing in their depiction of how the CDO was developed.
"Merrill Lynch teamed up with one of its most prized hedge fund clients -- an infamous short seller that had helped Merrill Lynch create four other CDOs -- to create Norma as a tailor-made way to bet against the mortgage-backed securities market," the complaint reads. (Emphasis in the original.)
"[T]o facilitate the selection of assets that would allow Norma to operate as a hedging instrument rather than an investment vehicle, Merrill Lynch hand-picked a beholden collateral manager that was willing to ignore its fiduciary duties to Norma's investors."
The manager for Norma was a small shop out of Long Island, N.Y., called NIR Capital Management. Run by Corey Ribotsky, the firm's primary line of business before entering CDOs was speculating in penny stocks.
NIR brought in a team of experienced bankers to run its CDO business. The firm also had a variety of other ventures. At one point, they put money into a documentary called "American Cannibal," that profiled the aborted launch of a reality television show in which contestant were stranded on an island and goaded into cannibalism. (The New York Times found it "absorbing." [23]) Ribotsky is now under investigation by federal authorities for misleading clients about its investment returns. NIR and Merrill Lynch declined to comment on dealings with Magnetar; Merrill Lynch denies liability in the litigation. Magnetar declined [24] to comment.
Norma began to suffer setbacks even before the deal closed in March 2007. According to the lawsuit, by the time Norma was completed, its value had already declined by more than 20 percent.
JPMorgan Gets Into the Game -- And Loses
Despite the bad news in the mortgage market, Magnetar continued to find a few willing bankers to do CDOs, including a new one: JPMorgan Chase.
JPMorgan had avoided many of the complex financial transactions that decimated the banking industry. As the market grew frothier, JPMorgan pulled back from the CDO business. In 2005, the men who ran JPMorgan's CDO unit told their bosses that they couldn't see how to complete a CDO without sticking the bank with the large top tier, which would not appeal to investors because of its low returns. Other banks dealt with this problem by retaining these CDO layers on their books.
But by mid-2006, JPMorgan joined the herd. It hired bankers to expand its CDO team and got to work.
A few months later -- in early 2007 -- Magnetar and JPMorgan banged out a deal. Unlike the earlier CDOs Magnetar helped create, this one wasn't named after a constellation. Instead, the deal was called “Squared,” after the term for a CDO that was made up of other CDOs. Squared was filled in part with other CDOs Magnetar had helped create.
According to a person familiar with how the deal came together, Magnetar committed to purchase $10 million worth of Squared's equity. Magnetar's purchase allowed JPMorgan to create and sell a $1.1 billion CDO. As it had on previous deals, Magnetar pushed the bankers to select riskier bonds. "They really cared about it," said the person involved in the deal. "They wouldn't pull punches. It was always going to be crappier."
The hedge fund requested that Squared have slices from many Magnetar CDOs, including Auriga, Carina, Libra, Pyxis and Virgo. They all went into the deal. Magnetar also successfully pushed for Squared to include slices from one of the Abacus deals, a group of CDOs that, as the New York Times later reported [25], Goldman Sachs had created and bet against.
JPMorgan earned $20 million in creating Squared, according to the person involved in the deal.
JPMorgan's sales force fanned out across the globe. It sold parts of the CDO to 17 institutional investors, according to a person familiar with the transaction. The deal closed in May 2007, nearly a year after housing prices had peaked. Within eight months, Squared dropped to a fraction of its initial value.
Just about everybody lost out, including Thrivent Financial for Lutherans, a Minnesota-based not-for-profit fraternal organization, whose $10 million investment was wiped out. Thrivent declined to comment.
Small pieces of Squared, as well as Magnetar's CDO Norma, also ended up in mutual funds run by Morgan Keegan, a regional investment bank based in Memphis, Tenn.
The funds, advertised as conservative investments, cratered after betting on various exotic assets. Morgan Keegan was sued by individual investors who claimed that they were misled about the risks. Among the investors was former Chicago Bulls player Horace Grant, who was awarded $1.4 million in arbitration. This week, the SEC accused [26] two Morgan Keegan employees of misleading fund investors about the value of its holdings in CDOs. Morgan Keegan called the charges "factually inaccurate" and promised to defend itself "vigorously." Morgan Keegan did not respond to a request for comment on the specifics of the two Magnetar CDOs.
The biggest loser was JPMorgan Chase itself, which had kept the large, supposedly safe top slices of Squared on its books, without hedging itself. The bank lost about $880 million on the CDO. JPMorgan declined to comment on the details of the transaction.
Magnetar came out a winner. The fund earned about $290 million on its bet against Squared, according to a person familiar with the deal. Magnetar declined [27] to comment.
Magnetar's Exit: A Deal so Bad Even a Credit-rating Agency Balked
Prusko was buoyant as Magnetar's trades began to make money as its short bets rose in value. One friend recalls Prusko ribbing him: "What are you going to do after this blows up?" (Magnetar declined to comment on the exchange.)
In the spring of 2007, Magnetar began to have a problem: The hedge fund was sitting on hundreds of millions of dollars' worth of CDO equity and other low-rated portions of its deals. With the decline of housing prices accelerating, off-loading these pieces would be very hard.
Magnetar needed a buyer and some deft financial engineering. It found the answer through its former partner, Alex Rekeda, who had been the banker on Magnetar's first CDO. Rekeda now worked at Mizuho, one of Japan's biggest banks. Mizuho was eager to get into the CDO world. It hired Rekeda in part because he could bring Magnetar's business, according to one CDO manager who worked with him.
Rekeda and Magnetar came up with a remarkable CDO. They took their risky portions of 18 CDOs they had helped created -- and repackaged them to sell them to others. Bundling up the dregs of a CDO was rare, if not unprecedented.
This deal, Tigris, which closed in March 2007, tied together $902 million of Magnetar's risky assets. Rekeda convinced two rating agencies, Standard & Poor's and Fitch, to rate it. Fitch designated $259 million of it as triple A, the highest rating. S&P rated nearly $501 million as triple A. (When contacted for this article, S&P said it was comfortable rating Tigris; Fitch didn't respond to questions about the deal.)
In a highly unusual move, the third major rating agency, Moody's, refused to rate Tigris. Rekeda lobbied Moody's for a rating, according to a person familiar with the deal. But Moody's then-head of CDOs, Eric Kolchinsky, wouldn't budge.
Magnetar got $450 million from Mizuho, which in return received income from assets in Tigris, according to several people familiar with the transaction. It was what's known as a non-recourse loan: If things went wrong, Mizuho could only lay claim to what was in Tigris.
In response to ProPublica's questions about this deal, Magnetar said [28] the fund "as a matter of general practice, and as do most hedge funds, enters into non-recourse financing on specific assets in its portfolio."
By September, just six months after Tigris had been created, Fitch downgraded most of the CDO's slices. By the end of January 2008, the CDO had gone into default. The Japanese ended up with the paper, which was worthless. Mizuho eventually wrote Tigris off, as part of about $7 billion in total losses from its subprime missteps. Mizuho declined to comment, as did [28] Magnetar.
Just as with a refi gone bad, when Tigris was wiped out, the hedge fund walked away from the house -- in this case its collateral. A person who worked on Tigris boasted about how innovative the deal was. If it hadn't blown up, he says, it would have been "deal of the year." For Magnetar, it may have been.
Records it shared with investors show Magnetar had a spectacular 2007. Founder Alec Litowitz pulled down $280 million, according to Alpha Magazine [29]. That spring, a trade journal awarded Prusko and Snyderman "Investor of the Year" honors. The Magnetar Constellation Fund, the firm's fund that had the most exposure to the CDO trades, was up 76 percent in 2007, according to a presentation Magnetar gave to investors in early 2009. The main fund, the Magnetar Capital Fund, was up 26 percent that year. By the end of 2007, Magnetar had $7.6 billion under management, up from the $1.7 billion it began with two years earlier. Magnetar declined [30] to comment on its performance.
ProPublica has learned that the SEC has been looking into how the Magnetar deals were created, but it's not clear how much progress the investigation has been made or who might be the target. In a statement yesterday, Magnetar said:
Our understanding is that for some time, the SEC staff has been looking broadly at the sales, marketing, and structuring of CDOs. In connection with that inquiry, the SEC staff has from time to time requested information from Magnetar and other market participants, and Magnetar has been cooperating and responding to the requests. We are not aware that this inquiry is focused on any particular person or firm.
ProPublica Research Director Lisa Schwartz and researcher Kitty Bennett contributed to this story. ProPublica’s Ryan Knutson also helped with research. Finally, a big thanks to This American Life’s Alex Blumberg.
New Documents Show Hedge Fund Magnetar Influenced Deal, Despite Denials
by Jesse Eisinger and Jake Bernstein
ProPublica, Jan. 27, 2011, 4:08 p.m.
A Financial Crisis Inquiry Commission document shows [2] the hedge fund Magnetar selected hundreds of millions of dollars' worth of assets that went into a billion dollar Merrill Lynch mortgage securities deal, despite having long asserted otherwise.
As we reported last year [3], Magnetar helped Wall Street investment banks create at least $40 billion worth of mortgage securities deals known as collateralized debt obligations, or CDOs. The hedge fund also bet against many of those CDOs as part of an investment strategy that paid off handsomely when the housing market crashed and those CDOs collapsed. (Our story was done in collaboration with NPR's Planet Money [4] and Chicago Public Radio's This American Life [5].)
The hedge fund has consistently denied that it selected assets for the CDOs in which it invested and often bet against. Last April, in response to questions from ProPublica, the hedge fund said that "Magnetar did not choose the assets in any CDO. [6]" ProPublica's story on the Magnetar trade detailed how the fund had an active role in building these CDOs and in choosing assets that were riskier than might have otherwise been chosen.
The Financial Crisis Inquiry Commission released its final report [7] today on the causes of the financial and economic crisis in the United States. The report quotes from a letter in a lawsuit that contradicts Magnetar's assertion.
Magnetar used a CDO called Norma to create a $600 million bet against subprime mortgage securities, according to the document. The CDO itself took the other side of the bet, and ultimately cost investors in Norma hundreds of millions of dollars. Merrill Lynch underwrote and marketed the $1.5 billion Norma.
According to the commission report, Magnetar made the selections without the knowledge of the manager legally charged with picking the assets for the CDO or the risk department of the bank that helped create the deal.
The collateral manager, NIR Capital Management, was paid to manage the deal and was supposed to be independent of the investment bank and act in the interests of the CDO as a whole. The Norma offering document says that NIR would select the assets that went into the CDO, and no mention is made of other parties' roles in asset selection.
"When one Merrill employee learned that Magnetar had executed approximately $600 million in trades for Norma without NIR's apparent involvement or knowledge, she e-mailed colleagues, 'Dumb question. Is Magnetar allowed to trade for NIR?' " according to the report.
The Merrill employee was one of the risk managers in charge of policing the firm's CDO business.
"NIR abdicated its asset selection duties to Magnetar with Merrill's knowledge," the FCIC report states.
The e-mails relating to Magnetar's selections of assets for Norma were revealed as part of a lawsuit between Netherlands-based Rabobank and Merrill Lynch. After the e-mails and other documents were produced during discovery, Merrill Lynch settled the lawsuit for an undisclosed amount.
The e-mails were quoted in a letter from Rabobank's lawyer, and they provide new evidence that Magnetar stood to gain substantially more from its bets against the CDO, or short positions, than from its investment in the CDO. And Merrill Lynch was aware of the hedge fund's motivations.
"Merrill recognized that such short positions were more important to Magnetar than its long investments," states the letter.
Magnetar's investment in Norma totaled less than $50 million, according to the letter. "This meant that Magnetar stood to make 10 times more from its $600 million short position if Norma failed than Magnetar had invested in equity."
Interestingly, Magnetar received $4.5 million [8] in what a Merrill document described as the CDO's "expenses." According to the FCIC report, Merrill failed to disclose that to other investors. Magnetar's counsel explained [9] the $4.5 million to the FCIC as "a rebate" on the hedge fund's purchases.
Magnetar and NIR didn't immediately respond to requests for comment.
The FCIC ran into a roadblock in its investigation of the Norma transaction. Bank of America, which now owns Merrill Lynch, "failed to produce documents related to this issue requested by the FCIC," the report says.
Bank of America's counsel told the FCIC that it was "a common industry practice" for equity investors to have input during the collateral selection process and that the collateral manager had the ultimate decision regarding asset selection. A spokesman for Bank of America declined to comment to us on the specifics of the Norma deal.
http://www.propublica.org/article/new-documents-show-hedge-fund-magnetar-influenced-deal-despite-denials
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Sovereign Debt and the Dividend Investor:
What We Know and When We Know It
By Roger S. Conrad1/7/2011Dividend Investing
An unprecedented US government default, spiking interest rates, the loss of “millions” of American jobs, damage to the US dollar and halted payments to millions of Social Security recipients, veterans and active US troops: That’s the dire warning issued by Treasury Secretary Tim Geithner this week, should Congress fail to raise the federal debt ceiling quickly.
Meanwhile, in Europe investors are demanding prices on credit default swaps--which ensure against failure to meet loan obligations--on sovereign debt that suggest at least several countries’ credit ratings should be junk level. That’s no great surprise for the so-called PIG countries: Portugal, Ireland and Greece. Greece, for example, already has a junk rating from both S&P and Moody’s.
What’s considerably more ominous is that credit default swaps for much larger AA rated Spain and A+ rated Italy are priced at levels commensurate with B and BB rated debt, respectively. Even Belgium, which hasn’t been in the news, has credit default swaps in line with a BB rating, rather than its AA+ S&P debt rating.
Moving back to this side of the Atlantic, the US municipal bond market is, more than ever, feeling the strain of busted state and local government budgets. California’s problems are well known. The latest flash point, however, is Illinois, the fifth-largest issuer of municipal bonds and a state plagued with a $13 billion deficit.
Even Canada has its doubters these days. One popular blogger/columnist is making the rounds with the theory that Canada’s banks are only healthy because “the Bank of Canada has assumed nearly all the default risk on Canada’s massive property bubble.” Not everyone agrees, of course, but even Bank of Canada Governor Mark Carney has taken to warning Canadians against debt “complacency,” stating “low rates today do not necessarily mean low rates tomorrow.”
Finally, rumor has it that China is concerned about over-leverage resulting from its loose monetary policy and is looking to tighten again. That’s fueling fears that its double-digit economic growth rate will drop precipitously, with dire economic consequences for countries digging out of recessions by exporting to it.
This last is a major reason the rally in stocks and commodities we saw at the beginning of the week has stalled. And to the extent it becomes reality at least, it will continue to cast a pall over the markets in the coming weeks.
Good News
Now for the good news: If you’re a serious income investor, none of this means beans. In fact, the only significance will be if enough investors get worried and sell, pushing prices of top-quality dividend-paying stocks back into a bargain range.
First off, prognostications of economic doom are increasingly at odds with reality. Even in the long-lagging US unemployment is now dropping, and the Conference Board’s Leading Economic Index is indicating much faster growth in 2011.
We’ve heard warnings of a China slowdown repeatedly over the past couple years. But the fact remains that country can’t afford to tighten much as it accommodates rapid urbanization. And time and again, authorities have shown themselves capable of managing the task of cooling things off just enough to keep them growing. Until they noticeably fail, that’s the bet to make.
The problems of US state and local governments are the result of rising unemployment the past two years, which has depressed tax receipts and increased demand for social services. There are some high-profile situations that could conceivably lead to crises. More likely, however, officials will continue to deal with the shortfalls, which again will disappear as the US economy gains ground.
Europe’s sovereign debt problems are real, as is their challenge to European unity and the euro currency. As we saw clearly during the 2008-09 crisis, however, prices of credit default swaps are a far better gauge of investor sentiment than of real balance sheet strength. And the greater the worry, the more prices will actually over-state the risk of the investment.
That doesn’t mean rising credit default swap prices won’t push up a company’s or government’s borrowing costs. And that in turn will push up interest costs. There is, however, a huge difference between the European debt crisis and the 2008 credit crunch/crash.
Mainly, everyone knows what governments owe now, while no one knew where all the bad mortgage backed securities were back in 2008. The crisis that year got so bad in large part because of the extreme uncertainty that created. No one knew where all the bombs were. That kind of uncertainty just doesn’t exist today.
Finally, Mr. Geithner’s comments notwithstanding, odds of a real US government default from not raising the debt ceiling are slim to none. Rather, what we’re seeing is a direct political challenge from the Obama administration to the incoming Republican leadership in the US House of Representatives. The unmistakable message: Compromise on the budget or risk being blamed for a far worst catastrophe than the 1995 government shutdown/standoff between then-President Bill Clinton and Speaker of the House Newt Gingrich.
Politicians aren’t brain surgeons, or even economists. And it’s very possible for them to do incredibly stupid things, even this far from an election. Much more likely, however, is we’ll see action taken to reduce future US budget deficits and raise the debt ceiling, with minimal disruption to the real economy.
The only important action for investors is always on the company level. Back in 2008, many companies suffered from suddenly restricted credit, as banks pulled in their horns, corporate bond yields soared and plunging stock prices made the cost of issuing equity prohibitively high. The results were falling earnings, dividend cuts and bankruptcies, particularly in leveraged industries like mortgage finance.
The best news in early 2011 is we’re further away from a reprise of that than ever. The biggest contrast is the corporate bond market remains red-hot. Even after a percentage-point back-up in so-called benchmark 10-Year Treasury yield, investment-grade and junk credits alike are still issuing bonds at the lowest interest rates since the 1950s.
After a week of trading in 2011 corporate bond issuances are on the same pace as 2010’s first week. And that year--the most robust for volumes since 1995, according to Dealogic--was pumped up by extremely pent up demand, resulting from the credit crunch of the year before.
Hefty new issue volumes and near record-low borrowing rates present a picture of credit markets 180 degrees distant from the worries swirling around government debt described above. And since we’re buying stocks here, they’re infinitely more relevant as well. Simply, as long as these conditions continue--or anything close to them--there is no credit crunch in corporate America, or debt worries for dividend-paying stocks.
Now for the clincher: Even if credit conditions should tighten sharply in US corporate lending over the next couple months, there would be little if any impact, even if the crunch extended for a year or more.
The reason is companies across the board have taken advantage of extremely favorable borrowing conditions over the past year to dramatically reduce future borrowing needs. Even if rates spiked and demand for debt issues dried up, they can simply pull in their horns and wait for better conditions.
Many of the biggest bond buyers are institutions that are compelled under charter to replenish their portfolios. Sooner or later, they’ll be forced to come back to the market. The result will be another shift in sellers’ favor, and a return of better conditions for new issues, i.e. lower interest rates.
We saw this happen last spring when the first rumblings of Europe’s debt crisis temporarily tightened US credit markets. Now, after another half year of issuing bonds at low rates, companies’ near-term refinancing needs are lower than ever. And because the new debt is far cheaper than what it refinanced, interest costs are lower as well. That means more cash flow, which all else equal means less need to borrow.
Utility companies are one group that’s benefitted immensely. They’ve been able to refinance debt at much lower interest rates and lock in low-cost capital for their ongoing capital spending boom.
Master limited partnerships (MLP) have perhaps been even bigger beneficiaries. Before rates fell, they were forced to rely on lines of credit for their needs. Over the past year, however, they’ve been able to refinance this borrowing with long-dated debt and to lock in low-cost capital to fund further expansion.
A Secretive Banking Elite Rules Trading in Derivatives
By LOUISE STORY
Published: December 11, 2010
On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.
The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.
Drawn from giants like JPMorgan Chase, Goldman Sachs and Morgan Stanley, the bankers form a powerful committee that helps oversee trading in derivatives, instruments which, like insurance, are used to hedge risk.
In theory, this group exists to safeguard the integrity of the multitrillion-dollar market. In practice, it also defends the dominance of the big banks.
The banks in this group, which is affiliated with a new derivatives clearinghouse, have fought to block other banks from entering the market, and they are also trying to thwart efforts to make full information on prices and fees freely available.
Banks' influence over this market, and over clearinghouses like the one this select group advises, has costly implications for businesses large and small, like Dan Singer's home heating-oil company in Westchester County, north of New York City.
This fall, many of Singer's customers purchased fixed-rate plans to lock in winter heating oil at around $3 a gallon. While that price was above the prevailing $2.80 a gallon then, the contracts will protect homeowners if bitterly cold weather pushes the price even higher.
But Singer wonders if his company, Robison Oil, should be getting a better deal. He uses derivatives like swaps and options to create his fixed plans. But he has no idea how much lower his prices — or his customers' prices — could be, he says, because banks don't disclose fees associated with the derivatives.
''At the end of the day, I don't know if I got a fair price, or what they're charging me," Singer said.
Derivatives shift risk from one party to another, and they offer many benefits, like enabling Singer to sell his fixed plans without having to bear all the risk that oil prices could suddenly rise. Derivatives are also big business on Wall Street. Banks collect many billions of dollars annually in undisclosed fees associated with these instruments — an amount that almost certainly would be lower if there were more competition and transparent prices.
Just how much derivatives trading costs ordinary Americans is uncertain. The size and reach of this market has grown rapidly over the past two decades. Pension funds today use derivatives to hedge investments. States and cities use them to try hold down borrowing costs. Airlines use them to secure steady fuel prices. Food companies use them to lock in prices of commodities like wheat or beef.
The marketplace as it functions now "adds up to higher costs to all Americans," said Gary Gensler, the chairman of the Commodity Futures Trading Commission, which regulates most derivatives. More oversight of the banks in this market is needed, he said.
But big banks influence the rules governing derivatives through a variety of industry groups. The banks' latest point of influence are clearinghouses like ICE Trust, which holds the monthly meetings with the nine bankers in New York.
Under the Dodd-Frank financial overhaul, many derivatives will be traded via such clearinghouses. Gensler wants to lessen banks' control over these new institutions. But Republican lawmakers, many of whom received large campaign contributions from bankers who want to influence how the derivatives rules are written, say they plan to push back against much of the coming reform. On Thursday, the commission canceled a vote over a proposal to make prices more transparent, raising speculation that Gensler did not have enough support from his fellow commissioners.
The Department of Justice is looking into derivatives, too. The department's antitrust unit is actively investigating "the possibility of anticompetitive practices in the credit derivatives clearing, trading and information services industries," according to a department spokeswoman.
Indeed, the derivatives market today reminds some experts of the Nasdaq stock market in the 1990s. Back then, the Justice Department discovered that Nasdaq market makers were secretly colluding to protect their own profits. Following that scandal, reforms and electronic trading systems cut Nasdaq stock trading costs to 1/20th of their former level — an enormous savings for investors.
''When you limit participation in the governance of an entity to a few like-minded institutions or individuals who have an interest in keeping competitors out, you have the potential for bad things to happen. It's antitrust 101," said Robert E. Litan, who helped oversee the Justice Department's Nasdaq investigation as deputy assistant attorney general and is now a fellow at the Kauffman Foundation. "The history of derivatives trading is it has grown up as a very concentrated industry, and old habits are hard to break."
Representatives from the nine banks that dominate the market declined to comment on the Department of Justice investigation.
Clearing involves keeping track of trades and providing a central repository for money backing those wagers. A spokeswoman for Deutsche Bank, which is among the most influential of the group, said this system will reduce the risks in the market. She said that Deutsche is focused on ensuring this process is put in place without disrupting the marketplace.
The Deutsche spokeswoman also said the banks' role in this process has been a success, saying in a statement that the effort "is one of the best examples of public-private partnerships."
ESTABLISHED, BUT CAN'T GET IN
The Bank of New York Mellon's origins go back to 1784, when it was founded by Alexander Hamilton. Today, it provides administrative services on more than $23 trillion of institutional money.
Recently, the bank has been seeking to enter the inner circle of the derivatives market, but so far, it has been rebuffed.
Bank of New York officials say they have been thwarted by competitors who control important committees at the new clearinghouses, which were set up in the wake of the financial crisis.
Bank of New York Mellon has been trying to become a so-called clearing member since early this year. But three of the four main clearinghouses told the bank that its derivatives operation has too little capital, and thus potentially poses too much risk to the overall market.
The bank dismisses that explanation as absurd. "We are not a nobody," said Sanjay Kannambadi, chief executive of BNY Mellon Clearing, a subsidiary created to get into the business. "But we don't qualify. We certainly think that's kind of crazy."
The real reason the bank is being shut out, he said, is that rivals want to preserve their profit margins, and they are the ones who helped write the membership rules.
Kannambadi said Bank of New York's clients asked it to enter the derivatives business because they believe they are being charged too much by big banks. Its entry could lower fees. Others that have yet to gain full entry to the derivatives trading club are the State Street Corp., and small brokerage firms like MF Global and Newedge.
The criteria seem arbitrary, said Marcus Katz, a senior vice president at Newedge, which is owned by two big French banks.
''It appears that the membership criteria were set so that a certain group of market participants could meet that, and everyone else would have to jump through hoops," Katz said.
The one new derivatives clearinghouse that has welcomed Newedge, Bank of New York and the others — Nasdaq — has been avoided by the big derivatives banks.
ONLY THE INSIDERS KNOW
How did big banks come to have such influence that they can decide who can compete with them?
Ironically, this development grew in part out of worries during the height of the financial crisis in 2008. A major concern during the meltdown was that no one — not even government regulators — fully understood the size and interconnections of the derivatives market, especially the market in credit default swaps, which insure against defaults of companies or mortgages bonds. The panic led to the need to bail out the American International Group, for instance, which had CDS contracts with many large banks.
In the midst of the turmoil, regulators ordered banks to speed up plans — long in the making — to set up a clearinghouse to handle derivatives trading. The intent was to reduce risk and increase stability in the market. Two established exchanges that trade commodities and futures, ICE Trust, part of the InterContinentalExchange, and the Chicago Mercantile Exchange, set up clearinghouses, and, soon afterward, so did Nasdaq.
Each of these new clearinghouses had to persuade big banks to join their efforts, and they doled out membership on their risk committees, which is where trading rules are written, as an incentive.
None of the three clearinghouses would divulge the members of their risk committees when asked by a reporter. But two people with direct knowledge of ICE's committee said the members are: Thomas J. Benison of JPMorgan Chase & Company; James J. Hill of Morgan Stanley; Athanassios Diplas of Deutsche Bank; Paul Hamill of UBS; Paul Mitrokostas of Barclays; Andy Hubbard of Credit Suisse; Oliver Frankel of Goldman Sachs; Ali Balali of Bank of America; and Biswarup Chatterjee of Citigroup.
Through representatives, these bankers declined to discuss the committee or the derivatives market. Some of the representatives noted that the bankers have expertise that helps the clearinghouse.
Many of these same people hold influential positions at other clearinghouses, or on committees at the powerful International Swaps and Derivatives Association, which helps govern the market.
Critics have called these banks the "derivatives dealers club," and they warn that the club is unlikely to give up ground easily.
"The revenue these dealers make on derivatives is very large and so the incentive they have to protect those revenues is extremely large," said Darrell Duffie, a professor at the Graduate School of Business at Stanford University, who studied the derivatives market earlier this year with Federal Reserve researchers. "It will be hard for the dealers to keep their market share if everybody who can prove their creditworthiness is allowed into the clearinghouses. So they are making arguments that others shouldn't be allowed in.
Perhaps no business in finance is as profitable today as derivatives. Not making loans. Not offering credit cards. Not advising on mergers and acquisitions. Not managing money for the wealthy.
The precise amount that banks make trading derivatives isn't known, but there is anecdotal evidence of their profitability. Former bank traders who spoke on condition of anonymity because of confidentiality agreements with their former employers said their banks typically earned $25,000 for providing $25 million of insurance against the risk that a corporation might default on its debt via the swaps market. These traders turn over millions of dollars in these trades every day, and credit default swaps are just one of many kinds of derivatives.
The secrecy surrounding derivatives trading is a key factor enabling banks to make such large profits.
If an investor trades shares of Google or Coca-Cola or any other company on a stock exchange, the price — and the commission, or fee — are known. Electronic trading has made this information available to anyone with a computer, while also increasing competition — and sharply lowering the cost of trading. Even corporate bonds have become more transparent recently. Trading costs dropped there almost immediately after prices became more visible in 2002.
Not so with derivatives. For many, there is no central exchange, like the New York Stock Exchange or Nasdaq, where the prices of derivatives are listed. Instead, when a company or an investor wants to buy a derivative contract for, say, oil or wheat or securitized mortgages, an order is placed with a trader at a bank. The trader matches that order with someone selling the same type of derivative.
Banks explain that many derivatives trades have to work this way because they are often customized, unlike shares of stock. One share of Google is the same as any other. But the terms of an oil derivatives contract can vary greatly.
And the profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That's because the seller also is told only the amount he will receive. The difference between the two is the bank's fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.
It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.
AN ELECTRONIC EXCHANGE?
Two years ago, Kenneth C. Griffin, owner of the giant hedge fund Citadel Group, which is based in Chicago, proposed open pricing for commonly traded derivatives, by quoting their prices electronically.
Citadel, which is based in Chicago, oversees $11 billion in assets, so saving even a few percentage points in costs on each trade can add up to tens or even hundreds of millions of dollars a year.
But Griffin's proposal for an electronic exchange quickly ran into opposition, and what happened is a window into how banks have fiercely fought competition and open pricing.
To get a transparent exchange going, Citadel offered the use of its technological prowess for a joint venture with the Chicago Mercantile Exchange, which is best-known as a trading outpost for contracts on commodities like coffee and cotton. The goal was to set up a clearinghouse as well as an electronic trading system that would display prices for credit-default swaps.
Big banks that handle most derivatives trades, including Citadel's, didn't like Citadel's idea. Electronic trading might connect customers directly with each other, cutting out the banks as middlemen.
The banks responded in the fall of 2008 by pairing with ICE, one of the Chicago Mercantile Exchange's rivals, which was setting up its own clearinghouse. So the banks attached a number of conditions on that partnership, which came in the form of a merger between ICE's clearinghouse and a nascent clearinghouse that the banks were establishing. These conditions gave the banks significant power at ICE's clearinghouse, according to two people with knowledge of the deal. For instance, the banks insisted that ICE install the chief executive of their effort as the head of the joint effort. That executive, Dirk Pruis, left after about a year and now works at Goldman Sachs. Through a spokesman, he declined to comment.
The banks also refused to allow the deal with ICE to close until the clearinghouse's rulebook was established, with provisions in the banks' favor. Key among those were the membership rules, which required members to hold large amounts of capital in derivatives units, a condition that was prohibitive even for some large banks like the Bank of New York.
The banks also required ICE to provide market data exclusively to Markit, a little-known company that plays a pivotal role in derivatives. Backed by Goldman, JPMorgan and about a dozen other banks, Markit provides crucial information about derivatives, like prices.
Kevin Gould, who is the president of Markit and was involved in the clearinghouse merger, said the banks were simply being prudent and wanted rules that protected the market and themselves.
"The one thing I know the banks are concerned about is their risk capital," he said. "You really are going to get some comfort that the way the entity operates isn't going to put you at undue risk."
Even though the banks were working with their competitor, Citadel and the CME continued to move forward with their own exchange. They, too, needed to work with Markit, because it owns the rights to certain derivatives indexes. But Markit put them in a tough spot by basically insisting that every trade involve at least one bank, since the banks are the main parties that have licenses with Markit.
This demand from Markit effectively secured a permanent role for the big derivatives banks since Citadel and the CME could not move forward without Markit's agreement. And so, essentially boxed in, they agreed to the terms, according to the two people with knowledge of the matter and Gould of Markit. (A CME spokesman said last week that the exchange did not cave to Markit's terms.)
Still, even after that deal was complete, the Chicago Mercantile Exchange soon had second thoughts about working with Citadel and about introducing electronic screens at all. The CME backed out of the deal in mid-2009, ending Griffin's dream of a new, electronic trading system.
With Citadel out of the picture, the banks agreed to join the Chicago Mercantile Exchange's clearinghouse effort. The exchange set up a risk committee that, like ICE's committee, was mainly populated by bankers.
It remains unclear why the CME ended its electronic trading initiative. Two people with knowledge of the Chicago Mercantile Exchange's clearinghouse said the banks refused to get involved unless the exchange dropped Citadel and the entire plan for electronic trading.
Kim Taylor, the president of Chicago Mercantile Exchange's clearing division, said "the market" simply wasn't interested in Griffin's idea.Critics say the banks have an edge because they have had early control of the new clearinghouses' risk committees.
Taylor at the Chicago Mercantile Exchange said the people on those committees are supposed to look out for the interest of the broad market, rather than their own narrow interests. She likened the banks' role to that of Washington lawmakers who look out for the interests of the nation, not just their constituencies.
''It's not like the sort of representation where if I'm elected to be the representative from the state of Illinois, I go there to represent the state of Illinois," Taylor said in an interview.
Officials at ICE, meantime, said they solicit views from customers through a committee that is separate from the bank-dominated risk committee.
''We spent and we still continue to spend a lot of time on thinking about governance," said Peter Barsoom, the chief operating officer of ICE Trust. "We want to be sure that we have all the right stakeholders appropriately represented."
Griffin said last week that customers have so far paid the price for not yet having electronic trading. He puts the toll, by a rough estimate, in the tens of billions of dollars, saying that electronic trading would remove much of this "economic rent the dealers enjoy from a market that is so opaque."
''It's a stunning amount of money," Griffin said. "The key players today in the derivatives market are very apprehensive about whether or not they will be winners or losers as we move towards more transparent, fairer markets, and since they're not sure if they'll be winners or losers, their basic instinct is to resist change."
IN, OUT AND AROUND HENHOUSE
The result of the maneuvering of the past couple years is that big banks dominate the risk committees of not one, but two of the most prominent new clearinghouses in the United States.
That puts them in a pivotal position to determine how derivatives are traded.
Under the Dodd-Frank bill, the clearinghouses were given broad authority. The risk committees there will help decide what prices will be charged for clearing trades, on top of fees banks collect for matching buyers and sellers, and how much money customers must put up as collateral to cover potential losses.
Perhaps more important, the risk committees will recommend which derivatives should be handled through clearinghouses, and which should be exempt.
Regulators will have the final say. But banks, which lobbied heavily to limit derivatives regulation in the Dodd-Frank bill, are likely to argue that few types of derivatives should have to go through clearinghouses. Critics contend that the bankers will try to keep many types of derivatives away from the clearinghouses, since clearinghouses represent a step towards broad electronic trading that could decimate profits.
The banks already have a head start. Even a newly proposed rule to limit the banks' influence over clearing allows them to retain majorities on risk committees. It remains unclear whether regulators creating the new rules — on topics like transparency and possible electronic trading — will drastically change derivatives trading, or leave the bankers with great control.
One former regulator warned against deferring to the banks. Theo Lubke, who until this fall oversaw the derivatives reforms at the Federal Reserve Bank of New York, said banks do not always think of the market as a whole as they help write rules.
''Fundamentally, the banks are not good at self-regulation," Lubke said in a panel last March at Columbia University. "That's not their expertise, that's not their primary interest."
Gold Is a Credit Default Swap
by Jack Sparrow
Gold is the ultimate Credit Default Swap. It’s meltdown insurance taken out against Federal Reserve Inc. and the global financial system at large. And the best part is, with this CDS you never have to worry about your counterparty.
That simple observation is a worthy retort to all those who yammer on about how “gold has no intrinsic value”… how gold is worthless because “it offers no yield, no return on investment” and so on.
When was the last time you heard someone complaining about the fire insurance policy on their house — the fact that it “offered no yield” etcetera?
When it comes to insurance, yield isn’t the point…
There is a speculative component too, of course. You can make a ton of money buying fire insurance on houses you don’t own. John Paulson taught us that, via his multi-billion-dollar CDS score when the housing bubble turned to bust.
The CDS analogy also applies in that you don’t need armageddon to turn a profit. A company (or a country for that matter) doesn’t need to implode for long CDS to pay off.
All we need to see is a rise in the perceived risk of default — an increase in the statistical probability, however small, that the worst-case scenario could occur.
And this of course explains why the financial establishment hates gold. Ben Bernanke is the CEO of Federal Reserve Inc., and gold is a CDS bet that the organization is flailing and management has lost control.
Let’s keep exploring this parallel. Apart from the recent cycle, when was the last big heyday for gold? The mid to late 1970s — no coincidence the Fed had lost control then too.
(By the way, did you know there was a massive housing bubble in the 1970s, on a scale to rival the latest one?)
Those who pooh-pooh gold do so on the basis of knee-jerk historical recency bias. They point to the extended doldrums of the post-1980 period as evidence of how worthless the yellow metal is.
Reaching into their memory banks and bringing forth the good times of the Reagan-Bush-Clinton years, they mistake a roughly 20-year historical time window for a permanent state of affairs.
Yet once again, the CDS analogy — gold as a bet against Federal Reserve Inc. — sheds light on this mistake.
Not to put too fine a point on it, Paul Volcker was “the man.” He helped the Fed get its shit together in the late 70s / early 80s. His ability and willingness to do that laid the groundwork for the long period of increasingly leveraged prosperity that followed.
So it’s no wonder that gold went into dormancy after “Tall Paul” broke the back of inflation. Through the actions of an extraordinary leader, the financial system cleansed itself of excess and facilitated a path to healing — exactly the type of environment in which a CDS “meltdown” bet would peak out and decline.
But that was then and this is now. Today we’re on the far side of the leverage and debt supercycle, with unaddressed problems mounting and no competent leadership in sight.
Question: You see any “cleansing of excess” going on in 2010? I don’t. I see a bunch of theory-drunk gamblers (disguised as academics) hooked on double-down martingale strategy.
“If this desperation bet doesn’t work, we’ll just up the size of the next one…”
As a side note, it’s instructive to recall that Volcker was exactly what a Fed Chairman (and perhaps a CEO) should be. Gruff, hard-nosed, determined. A loner type, not a flesh-pressing people-pleaser. Someone who could stoically sit back and take it when outraged homebuilders, crushed by interest rate hikes, started sending 2×4 planks to Volcker’s office with hate notes attached. Someone with the testicular fortitude to do what needed to be done in the face of deafening public outcry.
Volcker, in other words, stands in direct and nearly absolute contrast to that lily-livered, mealy-mouthed, glad-handing cheerleader pantywaist, Alan Greenspan.
When “the Maestro” dared to utter the words “irrational exuberance” in the mid-1990s, the political fallout from a swooning stock market scared him so badly he might as well have had his spine surgically removed the very next day. Mr. “I just want to be loved” never again challenged the bullish orthodoxy after that. (Or at least, not until he retired and started craving missed attention…)
And now we have Ben Bernanke, a cowed academic after Greenspan’s own heart. We recently saw the full extent to which “the Ben Bernank” would go to please all manner of masters, and gold surged on the reveal.
The Fed’s solution — MOAR STIMULUS! MOAR PRINT! MOAR! — would be hilarious were it not so tragic. (Come to think of it, it’s darkly hilarious anyway.)
Thus gold, the ultimate CDS, remains a powerful insurance bet that Federal Reserve Inc., under Keystone Cops management, has screwed things up badly and is in danger of making things worse.
And of course, if you like gold, it’s hard not to like gold stocks…
Cool grub!
Post #666
Actually woogs, I believe I was 6 months pregnant so probably wouldn't have been a good date....hahaha
lol_ where were you Summer of 1994?
I bet you were still in school somewhere learnin algebra..haha!
As I recall, no one had the foggiest idea what a credit default swap was_ they had lickored the entire convention by day and liberally haliboranged 800 of us at night! that was one wild convention!! good times (xcpt for all the nasty Boca STD's going around!!
I feel so betrayed!
you mean the woogster didn't take you with him? ... shame shame!
Did you send the invite because I never got it.
you were invited as I recall
A LAST WORD FROM THE MAD COMMIE
America must face up to the dangers of derivatives
George Soros | Financial Times | April 22, 2010
The US Security and Exchange Commission’s civil suit against Goldman Sachs will be vigorously contested by the defendant. It is interesting to speculate which side will win; but we will not know the result for months. Irrespective of the eventual outcome, however, the case has far-reaching implications for the financial reform legislation Congress is considering.
Whether or not Goldman is guilty, the transaction in question clearly had no social benefit. It involved a complex synthetic security derived from existing mortgage-backed securities by cloning them into imaginary units that mimicked the originals. This synthetic collateralised debt obligation did not finance the ownership of any additional homes or allocate capital more efficiently; it merely swelled the volume of mortgage-backed securities that lost value when the housing bubble burst. The primary purpose of the transaction was to generate fees and commissions.
This is a clear demonstration of how derivatives and synthetic securities have been used to create imaginary value out of thin air. More triple A CDOs were created than there were underlying triple A assets. This was done on a large scale in spite of the fact that all of the parties involved were sophisticated investors. The process went on for years and culminated in a crash that caused wealth destruction amounting to trillions of dollars. It cannot be allowed to continue. The use of derivatives and other synthetic instruments must be regulated even if all the parties are sophisticated investors. Ordinary securities must be registered with the Securities and Exchange Commission before they can be traded. Synthetic securities ought to be similarly registered, although the task could be assigned to a different authority, such as the Commodity Futures Trading Commission.
Derivatives can serve many useful purposes, but they also contain hidden dangers. For instance, they can pile up hidden imbalances in supply or demand which may suddenly be revealed when a threshold is breached. This is true of so-called knockout options, used in currency hedging. It was also true of the portfolio insurance programs that caused the New York Stock Exchange’s Black Monday in October 1987. The subsequent introduction of circuit breakers tacitly acknowledged that derivatives can cause discontinuities, but the proper conclusions were not drawn.
Credit default swaps are particularly suspect. They are supposed to provide insurance against default to bondholders. But because they are freely tradable, they can be used to mount bear raids; in addition to insurance they also provide a license to kill. Their use ought to be confined to those who have a insurable interest in the bonds of a country or company.
It will be the task of regulators to understand derivatives and synthetic securities and refuse to allow their creation if they cannot fully evaluate their systemic risks. That task cannot be left to investors, contrary to the diktats of the market fundamentalist dogma that prevailed until recently.
Derivatives traded on exchanges should be registered as a class. Tailor-made derivatives would have to be registered individually, with regulators obliged to understand the risks involved. Registration is laborious and time-consuming, and would discourage the use of over-the-counter derivatives. Tailor-made products could be put together from exchange-traded instruments. This would prevent a recurrence of the abuses which contributed to the 2008 crash.
Requiring derivatives and synthetic securities to be registered would be simple and effective; yet the legislation currently under consideration contains no such requirement. The Senate Agriculture Committee proposes blocking deposit-taking banks from making markets in swaps. This is an excellent proposal which would go a long way in reducing the interconnectedness of markets and preventing contagion, but it would not regulate derivatives.
The five big banks which serve as marketmakers and account for over 95 per cent of the US’s outstanding over-the-counter transactions are likely to oppose it because it would hit their profits. It is more puzzling that some multinational corporations are also opposed. The only explanation is that tailor-made derivatives can facilitate tax avoidance and manipulation of earnings. These considerations ought not to influence the legislation.
The writer is chairman of Soros Fund Management
Nice party to be at, too bad I missed it.
THIS IS NOW
Wall Street Shrinks From Credit Default Swaps Before Rules Hit
By Shannon D. Harrington and Christine Harper - Nov 29, 2010 12:00 AM ET
Trading in credit-default swaps, Wall Street’s fastest-growing business before the credit crisis, has tumbled 40 to 60 percent from three years ago as banks prepare for new regulation of derivatives.
The declines estimated by executives at four of the biggest dealers of swaps means lower profits at firms that used to get as much as two-thirds of credit-market trading revenue from the derivatives. Moody’s Investors Service says pending rules may translate into job cuts of as much as 50 percent in groups that trade the contracts.
Investors are avoiding strategies that contributed to $1.82 trillion in writedowns and losses amid the worst financial crisis since the Great Depression. The net amount of credit swaps outstanding globally has fallen 20 percent from October 2008, the earliest figures disclosed by the Depository Trust & Clearing Corp. in New York.
“This was a major profit center for a lot of banks,” said Hal Scott, a Harvard Law School professor who also is director of the Committee on Capital Market Regulation, a nonpartisan group of academics and business executives that in May 2009 called for measures to reduce the risks derivatives pose. “It’s part of a bigger picture of reduced financial activity due to uncertainty and regulatory reform.”
$62 Trillion
While JPMorgan Chase & Co. created credit swaps in the 1990s as a way for investors to protect themselves against loans going bad, trading soared after the industry began developing standard terms by 2003.
The contracts, in which a seller of protection is paid an annual premium for agreeing to cover the buyer’s losses should the underlying borrower default, ballooned to more than $62 trillion at the peak in 2007 on a gross notional amount from $632 billion in 2001.
In October 2008, Richard Fuld, then chief executive officer of Lehman Brothers Holdings Inc., blamed his firm’s collapse partly on “destabilizing” forces including the escalating cost of swaps on the investment bank’s debt. Hedge fund manager George Soros called the market “unsafe,” and billionaire investor Warren Buffett once likened derivatives to “financial weapons of mass destruction.”
Unlike with Treasuries and corporate bonds, dealers don’t disclose historical trading volumes in swaps. The four banks provided estimates on the condition they not be named. Derivatives are contracts whose value is tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
Fed Data
The five biggest dealers -- JPMorgan, Goldman Sachs Group Inc., Morgan Stanley, Citigroup Inc. and Bank of America Corp. - - bought a net $430 billion of credit protection as of Sept. 30, down 38 percent from $689.9 billion in March 2009, filings with the Federal Reserve Bank of New York show.
Barclays Plc analyst Roger Freeman in New York estimates that before and during the credit crisis, Goldman Sachs generated two-thirds of its credit-trading revenue from derivatives. The contracts now likely contribute about a third, with the rest coming from bonds, he said. Michael DuVally, a spokesman at Goldman Sachs in New York, declined to comment.
Average daily trading in U.S. corporate bonds fell 12 percent the past six months compared with a year earlier, according to the Securities Industry & Financial Markets Association, a trade group.
While Freeman expects a rebound once regulators meet their July deadline to write market rules, the changes will likely squeeze profit margins and prompt bank executives to cut more trading jobs.
‘Growing Comfort’
“There seems to be growing comfort over the structure of this market and how it’s going to evolve,” Freeman said in a telephone interview. “So I’d say we and people in this business are cautiously optimistic it grows from here.”
Credit-derivatives departments were some of the hardest hit when the U.S. securities industry slashed more than 80,000 jobs after the financial crisis, according to Michael Karp, the chief executive officer of Options Group, a recruitment firm in New York. Banks that employed 20 to 30 people in credit derivatives sales and trading in 2006 and 2007 now have between 5 and 10.
The Dodd-Frank financial overhaul, signed by President Barack Obama in July, is intended partly to curb risks to the economy from swaps. It will require most trades to go through clearinghouses that are capitalized by the banks and demand uniform amounts of collateral backing the trades.
To reduce opacity that Commodity Futures Trading Commission Chairman Gary Gensler says gives banks an information advantage, trades will have to be done on systems that make dealers compete over pricing and may automate some transactions now done by phone. The deals also will be reported publicly.
Declining Margins
The changes may drive down pre-tax profit margins for credit swaps to 22 to 23 percent from about 35 percent, said Sanford C. Bernstein & Co. analyst Brad Hintz, ranked by Institutional Investor as the top analyst covering brokerage firms.
“That’s a big drop,” he said. “But it doesn’t mean the business goes away. It just becomes a cash business like the equities cash business or a corporate bond business.”
Goldman Sachs Chief Executive Officer Lloyd Blankfein described such a scenario at a Nov. 16 conference sponsored by Bank of America. After changes in equities markets drove commission rates down and volume up for the bank, the firm invested in new computerized stock-trading platforms and was able to slash half the department’s 5,000 trading jobs, he said.
Regulation of the over-the-counter “derivatives market will drive greater transparency and automation,” Blankfein said at the conference. “While transparency can reduce margins, it also introduces new opportunities in the form of greater client participation and product innovation.”
Fed Clamps Down
While the creation of swaps in the 1990s freed up capital to allow banks to make more loans, they also made it easier to bet on or against a borrower’s creditworthiness.
Trading in the contracts grew so fast that banks struggled to keep up with the paperwork. Former Federal Reserve Chairman Alan Greenspan complained at an industry forum in May 2006 that dealers often recorded trades on “scraps” of paper, calling the practice “appalling.” Concerned that a backlog of unconfirmed contracts could trigger a loss of confidence, the Federal Reserve Bank of New York forced dealers to clean up their recordkeeping.
Hedge funds and banks started using the contracts to speculate on the ability of companies, governments and even homeowners to repay debt they didn’t hold. American International Group Inc., once the world’s largest insurer, needed a $182.5 billion government bailout because of credit swaps it sold that guaranteed payment of subprime mortgages.
Rules in Flux
Congress considered banning investors from buying swaps if they didn’t own the underlying debt they were insuring. Though that proposal died, the threat contributed to the slowdown in trading. Would-be users of the derivatives are staying out of the market until they determine how stringent the final rules will be once regulators impose them next year, Hintz said.
“No one’s going to enter into a credit-default swap when you don’t know what the rules are going to be going forward,” Hintz said.
Before 2008, as much as half of the trades in the market were done to create and protect against losses from so-called synthetic collateralized debt obligations that investors bought to bet on the creditworthiness of companies and countries.
The market for CDOs, which are securities made up of bonds sliced into different levels with varying degrees of risk and returns, is in decline, with $72 billion of the securities created this year, down from the record $503 billion in 2006, according to Morgan Stanley.
Less Hedging
Money managers who bought swaps protecting against plunging asset prices in 2008 unwound those hedges in 2009 as markets rebounded, said Andy Hubbard, head of U.S. structured credit trading at Credit Suisse Group AG in New York.
“Now that we’ve recovered, people aren’t as worried about credit risk and there’s not the same degree of hedging happening,” Hubbard said.
Banks have more than made up for the loss of revenue from dealing in credit swaps by trading the underlying bonds. Institutions that once derived about 70 percent of debt-market trading revenue from swaps and the rest from bonds have largely reversed the ratio, said Alexander Yavorsky, a securities firm credit analyst at Moody’s in New York.
A surge in bond trading helped drive Goldman Sachs’s revenue from buying and selling securities and derivatives in the fixed-income, commodities and currencies markets to a record $23.3 billion last year, according to company statements.
New Products
With volume in that business declining, fixed-income revenue at Goldman Sachs, JPMorgan, Citigroup, Morgan Stanley, Credit Suisse, Bank of America, Deutsche Bank AG and Zurich- based UBS AG slipped an average 12 percent during the first nine months of 2010 from the same period in 2009, regulatory filings, investor presentations and Bloomberg data show. Only Morgan Stanley and UBS reported a gain.
To make up for lost revenue, banks are considering products they rebuffed three years ago: futures contracts that would be tied to benchmark credit indexes and traded on exchanges such as CME Group Inc.
Goldman Sachs, Deutsche Bank, Morgan Stanley and Barclays are among dealers coordinating with credit swaps index owner Markit Group Ltd. to potentially offer exchange-traded futures linked to the Markit CDX indexes, people familiar with the discussions said last month.
The contracts would open the market to small hedge funds, equity investors and money managers that don’t trade the contracts enough to justify the cost of negotiating two-party agreements with banks, said the people, who declined to be identified because the talks are private.
“The world’s changing and the regulatory pressures are changing the rules of the game,” Andy Nybo, head of derivatives at research firm Tabb Group LLC in New York, said in a telephone interview. “The dealers are adapting and looking to remain relevant and create the products that their clients want and need.”
To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Christine Harper in New York at charper@bloomberg.net.
THAT WAS THEN
The Monster That Ate Wall Street
How 'credit default swaps'—an insurance against bad loans—turned from a smart bet into a killer
They're called "Off-Site Weekends"—rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe. Think yacht parties, bikini models, $1,000 bottles of Cristal. One 1994 trip by a group of JPMorgan bankers to the tony Boca Raton Resort & Club in Florida has become the stuff of Wall Street legend—though not for the raucous partying (although there was plenty of that, too). Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone? By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?
What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves.
The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return. "I've known people who worked on the Manhattan Project," says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. "And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important."
Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster. Today, the economy is teetering and Wall Street is in ruins, thanks in no small part to the beast they unleashed 14 years ago. The country's biggest insurance company, AIG, had to be bailed out by American taxpayers after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and scores of other entities. So much of what's gone wrong with the financial system in the past year can be traced back to credit default swaps, which ballooned into a $62 trillion market before ratcheting down to $55 trillion last week—nearly four times the value of all stocks traded on the New York Stock Exchange. There's a reason Warren Buffett called these instruments "financial weapons of mass destruction." Since credit default swaps are privately negotiated contracts between two parties and aren't regulated by the government, there's no central reporting mechanism to determine their value. That has clouded up the markets with billions of dollars' worth of opaque "dark matter," as some economists like to say. Like rogue nukes, they've proliferated around the world and now lie hiding, waiting to blow up the balance sheets of countless other financial institutions.
It didn't start out that way. One of the earliest CDS deals came out of JPMorgan in December 1997, when the firm put into place the idea hatched in Boca Raton. It essentially took 300 different loans, totaling $9.7 billion, that had been made to a variety of big companies like Ford, Wal-Mart and IBM, and cut them up into pieces known as "tranches" (that's French for "slices"). The bank then identified the riskiest 10 percent tranche and sold it to investors in what was called the Broad Index Securitized Trust Offering, or Bistro for short. The Bistro was put together by Terri Duhon, at the time a 25-year-old MIT graduate working on JPMorgan's credit swaps desk in New York—a division that would eventually earn the name the Morgan Mafia for the number of former members who went on to senior positions at global banks and hedge funds. "We made it possible for banks to get their credit risk off their books and into nonfinancial institutions like insurance companies and pension funds," says Duhon, who now heads her own derivatives consulting business in London.
Before long, credit default swaps were being used to encourage investors to buy into risky emerging markets such as Latin America and Russia by insuring the debt of developing countries. Later, after corporate blowouts like Enron and WorldCom, it became clear there was a big need for protection against company implosions, and credit default swaps proved just the tool. By then, the CDS market was more than doubling every year, surpassing $100 billion in 2000 and totaling $6.4 trillion by 2004.
And then came the housing boom. As the Federal Reserve cut interest rates and Americans started buying homes in record numbers, mortgage-backed securities became the hot new investment. Mortgages were pooled together, and sliced and diced into bonds that were bought by just about every financial institution imaginable: investment banks, commercial banks, hedge funds, pension funds. For many of those mortgage-backed securities, credit default swaps were taken out to protect against default. "These structures were such a great deal, everyone and their dog decided to jump in, which led to massive growth in the CDS market," says Rohan Douglas, who ran Salomon Brothers and Citigroup's global credit swaps research division through the 1990s.
Soon, companies like AIG weren't just insuring houses. They were also insuring the mortgages on those houses by issuing credit default swaps. By the time AIG was bailed out, it held $440 billion of credit default swaps. AIG's fatal flaw appears to have been applying traditional insurance methods to the CDS market. There is no correlation between traditional insurance events; if your neighbor gets into a car wreck, it doesn't necessarily increase your risk of getting into one. But with bonds, it's a different story: when one defaults, it starts a chain reaction that increases the risk of others going bust. Investors get skittish, worrying that the issues plaguing one big player will affect another. So they start to bail, the markets freak out and lenders pull back credit.
The problem was exacerbated by the fact that so many institutions were tethered to one another through these deals. For example, Lehman Brothers had itself made more than $700 billion worth of swaps, and many of them were backed by AIG. And when mortgage-backed securities started going bad, AIG had to make good on billions of dollars of credit default swaps. Soon it became clear it wasn't going to be able to cover its losses. And since AIG's stock was one of the components of the Dow Jones industrial average, the plunge in its share price pulled down the entire average, contributing to the panic.
The reason the federal government stepped in and bailed out AIG was that the insurer was something of a last backstop in the CDS market. While banks and hedge funds were playing both sides of the CDS business—buying and trading them and thus offsetting whatever losses they took—AIG was simply providing the swaps and holding onto them. Had it been allowed to default, everyone who'd bought a CDS contract from the company would have suffered huge losses in the value of the insurance contracts they hadpurchased, causing them their own credit problems.
Given the CDSs' role in this mess, it's likely that the federal government will start regulating them; New York state has already said it will begin doing so in January. "Sadly, they've been vilified," says Duhon, who helped get the whole thing started with that Bistro deal a decade ago. "It's like saying it's the gun's fault when someone gets shot." But just as one might want to regulate street sales of AK-47s, there's an argument to be made that credit default swaps can be dangerous in the wrong hands. "It made it a lot easier for some people to get into trouble," says Darrell Duffie, an economist at Stanford. Although he believes credit default swaps have been "dramatically misused," Duffie says he still believes they're a very effective tool and shouldn't be done away with entirely. Besides, he says, "if you outlaw them, then the financial engineers will just come up with something else that gets around the regulation." As Wall Street and Washington wring their hands over how to prevent future financial crises, we can only hope they re-read Mary Shelley's "Frankenstein."
Next WikiLeaks leak: Bank of America?
By Ariana Eunjung Cha
The financial world is abuzz with guesses about which bank's secret documents Wikileaks has gotten hold of.
In an interview with Forbes published this week, WikiLeaks' Julian Assange promised to release a trove of documents in early 2011 that "could take down a bank or two." He said the documents will show "flagrant violations" and "unethical practices" at the executive level.
While Assange declined to name names, last year in an interview with Computer World he offered hints at what he has. "At the moment, for example, we are sitting on 5GB from Bank of America, one of the executive's hard drives," Assange said, according to a piece published Oct. 9, 2009.
Here are key excerpts from his Forbes interview:
So do you have very high impact corporate stuff to release then?
Yes, but maybe not as high-impact...I mean, it could take down a bank or two.
That sounds like high impact.
But not as big an impact as the history of a whole war. But it depends on how you measure these things.
...
These megaleaks, as you call them, we haven't seen any of those from the private sector.
No, not at the same scale as for the military.
Will we?
Yes. We have one related to a bank coming up -- that's a megaleak. It's not as big a scale as the Iraq material, but it's either tens or hundreds of thousands of documents depending on how you define it.
Is it a U.S. bank?
Yes, it's a U.S. bank.
One that still exists?
Yes, a big U.S. bank.
The biggest U.S. bank?
No comment.
When will it happen?
Early next year. I won't say more.
What do you want to be the result of this release?
[Pauses] I'm not sure.
It will give a true and representative insight into how banks behave at the executive level in a way that will stimulate investigations and reforms, I presume.
Usually when you get leaks at this level, it's about one particular case or one particular violation. For this, there's only one similar example. It's like the Enron emails. Why were these so valuable? When Enron collapsed, through court processes, thousands and thousands of emails came out that were internal, and it provided a window into how the whole company was managed. It was all the little decisions that supported the flagrant violations.
This will be like that. Yes, there will be some flagrant violations, unethical practices that will be revealed, but it will also be all the supporting decision-making structures and the internal executive ethos that cames out, and that's tremendously valuable. Like the Iraq War Logs, yes there were mass casualty incidents that were very newsworthy, but the great value is seeing the full spectrum of the war.
You could call it the ecosystem of corruption. But it's also all the regular decision making that turns a blind eye to and supports unethical practices: the oversight that's not done, the priorities of executives, how they think they're fulfilling their own self-interest. The way they talk about it.
China, Russia quit dollar
By Su Qiang and Li Xiaokun (China Daily)
Updated: 2010-11-24 08:02
St. Petersburg, Russia - China and Russia have decided to renounce the US dollar and resort to using their own currencies for bilateral trade, Premier Wen Jiabao and his Russian counterpart Vladimir Putin announced late on Tuesday.
Chinese experts said the move reflected closer relations between Beijing and Moscow and is not aimed at challenging the dollar, but to protect their domestic economies.
"About trade settlement, we have decided to use our own currencies," Putin said at a joint news conference with Wen in St. Petersburg.
The two countries were accustomed to using other currencies, especially the dollar, for bilateral trade. Since the financial crisis, however, high-ranking officials on both sides began to explore other possibilities.
The yuan has now started trading against the Russian rouble in the Chinese interbank market, while the renminbi will soon be allowed to trade against the rouble in Russia, Putin said.
"That has forged an important step in bilateral trade and it is a result of the consolidated financial systems of world countries," he said.
Putin made his remarks after a meeting with Wen. They also officiated at a signing ceremony for 12 documents, including energy cooperation.
The documents covered cooperation on aviation, railroad construction, customs, protecting intellectual property, culture and a joint communiqu. Details of the documents have yet to be released.
Putin said one of the pacts between the two countries is about the purchase of two nuclear reactors from Russia by China's Tianwan nuclear power plant, the most advanced nuclear power complex in China.
Putin has called for boosting sales of natural resources - Russia's main export - to China, but price has proven to be a sticking point.
Russian Deputy Prime Minister Igor Sechin, who holds sway over Russia's energy sector, said following a meeting with Chinese representatives that Moscow and Beijing are unlikely to agree on the price of Russian gas supplies to China before the middle of next year.
Russia is looking for China to pay prices similar to those Russian gas giant Gazprom charges its European customers, but Beijing wants a discount. The two sides were about $100 per 1,000 cubic meters apart, according to Chinese officials last week.
Wen's trip follows Russian President Dmitry Medvedev's three-day visit to China in September, during which he and President Hu Jintao launched a cross-border pipeline linking the world's biggest energy producer with the largest energy consumer.
Wen said at the press conference that the partnership between Beijing and Moscow has "reached an unprecedented level" and pledged the two countries will "never become each other's enemy".
Over the past year, "our strategic cooperative partnership endured strenuous tests and reached an unprecedented level," Wen said, adding the two nations are now more confident and determined to defend their mutual interests.
"China will firmly follow the path of peaceful development and support the renaissance of Russia as a great power," he said.
"The modernization of China will not affect other countries' interests, while a solid and strong Sino-Russian relationship is in line with the fundamental interests of both countries."
Wen said Beijing is willing to boost cooperation with Moscow in Northeast Asia, Central Asia and the Asia-Pacific region, as well as in major international organizations and on mechanisms in pursuit of a "fair and reasonable new order" in international politics and the economy.
Sun Zhuangzhi, a senior researcher in Central Asian studies at the Chinese Academy of Social Sciences, said the new mode of trade settlement between China and Russia follows a global trend after the financial crisis exposed the faults of a dollar-dominated world financial system.
Pang Zhongying, who specializes in international politics at Renmin University of China, said the proposal is not challenging the dollar, but aimed at avoiding the risks the dollar represents.
Wen arrived in the northern Russian city on Monday evening for a regular meeting between Chinese and Russian heads of government.
He left St. Petersburg for Moscow late on Tuesday and is set to meet with Russian President Dmitry Medvedev on Wednesday.
In late 2008 Michael Lewis wrote a Portfolio article (“The End“) weaving together a story line concerning a then-recent lunch between himself and John Guttfreund of Salomon Brothers and Liar’s Poker fame (thus, arguably, nemeses), and another concerning Steve Eisman, a money manager who bet heavily against the MBS market. The climax of the Eisman story runs as follows:
“That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. ‘They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,’ Eisman says. ‘They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?’”
OT:
Just in case anyone missed George Soros taking shit from Glen Beck. Soros, allegedly a long time favorite jewish anti-semetic nazi finally gets his dirt (?) aired:
(talk about yer media deep capture!!, Doc!! This one is the best yet!)
Beck's bizarre, dangerous hit at Soros By Michael Wolraich,
Editor's note: Michael Wolraich is a founder of the political blog dagblog.com and the author of "Blowing Smoke: Why the Right Keeps Serving Up Whack-Job Fantasies about the Plot to Euthanize Grandma, Outlaw Christmas, and Turn Junior into a Raging Homosexual."
New York -- Creepy medieval puppets hung from the ceiling on the set of the "Glenn Beck Program" -- a conquistador, a squire, a witch, and a bearded guy who looked like a cross between Santa Claus and the Fiddler on the Roof.
"Make no mistake, we are watching a show," Beck gravely told his audience. That much was obvious enough, but Beck did not mean his own television program. "You have to see who's behind the puppets," he continued, "Who is choosing the puppets and the players? Who's the puppetmaster? George Soros."
George Soros is an 80-year-old Jewish billionaire. Born in Hungary in 1930, he survived the Holocaust and eventually immigrated to the United States, where he made a fortune as a currency speculator and became an international philanthropist. After the Iron Curtain collapsed, Soros donated generously to Hungary and other Eastern Bloc countries, funding scholarships, university endowments, and science grants.
In return for his generosity, anti-Semites in the new Hungarian parliament accused him of participating in an international Jewish conspiracy to bankrupt Hungary in order to restore communist rule -- despite the fact that Soros had been an ardent opponent of Hungary's communist regime
Anti-Sorosism first arrived in the United States in the late 1990s, courtesy of renowned crackpot Lyndon LaRouche LaRouche had the Federal Bureau of Prisons (BOP) register number 15204-083. LaRouche has published a number of articles in his comically misnamed journal, the Executive Intelligence Review, accusing Soros of devious manipulations ranging from an attempt to start World War III to running drugs for Queen Elizabeth II's drug cartel.
But LaRouche's audience is small, and most Americans paid little attention to George Soros. In 2003, everything changed. Infuriated by the policies of George W. Bush, Soros sent his philanthropy homeward, donating $23 million to political action groups during the 2004 election. Suddenly, George Soros became the most powerful, evil mastermind in the world.
First, the influential conservative magazine NewsMax ran a story that cribbed LaRouche's conspiracy theories and accused Soros of secretly plotting a "regime change" in the United States. Then Fox News host Bill O'Reilly discovered that Soros' foundation had donated to the ACLU and therefore reasoned that the billionaire and the civil liberties organization were conspiring to destroy Christmas.
When former Republican majority leader Tom DeLay ran into trouble for ethics violations, he blamed Soros for masterminding critical coverage by the New York Times, the Washington Post, the L.A. Times, Time magazine, and Newsweek. And former speaker of the House Dennis Hastert insinuated to an incredulous Chris Wallace on "Fox News Sunday" that Soros got his money from drug operations. (Hastert did not mention Queen Elizabeth II, however.)
Glenn Beck, as usual, trumped them all. He told his audience that Soros has a five-step plan:
1. Create a "shadow government" under the guise of humanitarian aid.
2. Take control of the media.
3. Destabilize the state by building anti-government sentiment. (Yes, Beck attacked his opponent for building anti-government sentiment.)
4. Subvert the American electoral system.
5. Take over the world, of course.
Glenn Beck's conspiracy theories are no less bizarre and inflammatory than those of LaRouche, but his nightly audience numbers in the millions. Earlier this year, Americans voted Beck their second favorite television personality after Oprah Winfrey.
In consequence, he is far more dangerous. It must be a great sorrow to George Soros, who having survived the Holocaust now finds himself the subject of the same kind of conspiracy theories that the Nazis used to demonize the Jews.
The big bad "Jewish masterminds" of Hitler's day were the Rothschilds, a family of bankers who have featured prominently in anti-Semitic conspiracy theories since the 1800s. Like Soros, they have been accused of controlling the media, instigating war, overthrowing governments, and of course, taking over the world.
But in 21st century America, a popular television host cannot outright espouse anti-Semitic ideas. Thus, Glenn Beck took pains to present himself as a friend of the Jews. According to Beck, it was George Soros who was the anti-Semite.
Soros had survived the Holocaust by, at 14, pretending to be the godson of a non-Jewish Hungarian official. Since the official's responsibilities included confiscating Jewish properties, Beck implied that Soros had cooperated with the Nazis. This accusation too echoes Lyndon LaRouche, who has published articles calling Soros "a small cog in Adolf Eichmann's killing machine" and "a Nazi beast-man seizing Jewish properties."
Welcome to the "Glenn Beck Program," where Jews are Nazis and those who exploit ancient anti-Semitic conspiracy narratives are friends of the Jews.
Beck himself said it best,
"There are a few working parts to a puppet show. There is the puppet master. Here. There is a stage. There's the audience. There are the strings to each puppet. And then there's the story. There is also why? Why is the story? Why is the show happening? What is the puppet master? What is his motivation? Is it for the money? Is it for entertainment? Is it personal gain? What is it?"
What is it, Mr. Beck?
The opinions expressed in this commentary are solely those of Michael Wolraich.
Credit Default Swaps: What's All the Fuss About?
The cost of insuring Irish government bonds against default rose sharply this week—as it did for the bonds of other governments—in what was widely reported as a harbinger of doom for the continent's weaker economies.
These costs reflect what's happening in the over-the-counter market for credit default swaps. But the emphasis on the costs of default protection in this market raises questions about how much importance should be attached to its day-to-day price gyrations.
One way of assessing their significance is to look at statistics from the Depository Trust & Clearing Corp., the New York clearinghouse through which a vast majority of global CDS trades are directed.
The figures are released after a significant lag and don't say anything about prices, but they tell you about market volumes. And although sovereign CDS are more actively traded than all but a few corporate names, mainly banks, most aren't traded very actively at all.
In the three months ended June 20, the most active sovereign CDS market in Europe was in Spanish debt, where an average 34 trades a day took place. Greece, facing a repayments crisis that was relieved only by a bailout from its euro-zone partners, was the third most active name with 26 daily trades. Ireland, the focus of this week's activity, occupied eighth place with an average eight trades a day.
So how much is at stake in these trades? The notional volumes of debt insured are on the face of it higher: some $500 million on average per day in the case of Spain; $575 million of Italian debt, $325 million of Greek debt and $150 million of Irish debt. But even these nominal sums are of the order of a thousandth or less of the total debt outstanding of these governments. At the end of 2009, according to the latest figures from Eurostat, the total government debt of Spain was €561 billion, of Italy €1.76 trillion; of Greece €273 billion and of Ireland €105 billion.
And banks, hedge funds and other users of the market stake only fractions of the notional sums insured. For example, according to Markit, a company that tracks the CDS market and produces indexes of market movements, the cost of insuring $10 million of five-year Spanish government bonds for one year was being quoted Thursday afternoon at about $220,000.
According to Gavin Nolan, a Markit credit research analyst, premiums in the market are conventionally paid quarterly.
In other words, a buyer would put $54,000 down immediately to insure $10 million worth of bonds for three months. Assuming Spanish CDS trading volumes are about the same as in the second quarter, that suggests sentiment in the half-a-trillion euro market for Spanish government paper is being influenced by people staking around $2.5 million a day.
Mr. Nolan says that some names are barely traded—with barely a handful of dealers offering quotes—but that in recent days the market in Irish CDS has been fairly active. One conventional measure of trading depth is the spread between price a dealer will offer to sellers and that offered to sellers. In the case of Ireland Thursday, the bid price was $590,000 and the offer $610,000, a relatively narrow spread, he said.
He said trading volumes in the underlying Irish government debt market are currently very low—with few if any buyers. (One reason for this, apart from a lack of buyer appetite, is related to the fact that most bonds are traded actively only soon after they are issued and then are usually locked up in portfolios. Neither Ireland nor Greece are currently issuing new bonds.) In these circumstances, he said, the CDS market could be offering price signals that are at least as important as those being sent by the underlying bond market, if not more so.
Pessimism over the prospects for weaker euro-zone economies to surmount the crisis without a debt default has undoubtedly grown over the past week, fueled probably by last week's decision of European Union governments to examine ways of making bond restructurings an essential element of future government rescue packages. However, a closer look at the sovereign CDS market suggests its day-to-day price movements, and sometimes even daily price shifts in the underlying bond markets, should not be invested with too much significance.
Write to Stephen Fidler at stephen.fidler@wsj.com
“monetizing the debt”
stephan.schulmeister.wifo.ac.at/fileadmin/homepage_schulmeister/files/GlobalizationWithoutGlobalMoney.pdf
“monetizing the debt” must be based on the Fed’s motive for increasing the money supply. If Fed buys bonds for its normal monetary policy operations, it is not monetization of debt. However, there is a problem trying to differentiate between motivation aspect versus actions taken by the Fed.
It is difficult to determine whether debt purchases are solely driven by the Fed’s policy. Second, the Fed increases the monetary base whenever it purchases any asset—not only when it purchases government debt.
This increase in monetary base could be used by private sector to purchase govt debt. So a central bank does not really need to buy govt debt to monetize it. It can do it via indirect ways as well.
Oscar-nominated director Charles Ferguson‘s 'Inside Job' , a documentary on the financial crisis The financial crisis is at the heart of the Cannes Film Festival this year. After Oliver Stone’s "Wall Street: Money Never Sleeps", Oscar-nominated documentary director Charles Ferguson brings us an insider's look at what, and who, caused the world’s financial crisis.
http://www.france24.com/en/20100517-financial-crisis-cannes-film-festival-charles-ferguson-inside-job-wang-xiaoshuai-chongqing-blues-jackson
'Inside Job' is a shocking look at the 2008 financial meltdown
"Inside Job" turns a lens on Henry Paulson, Ben Bernanke and Timothy Geithner, among others who were in power during the runup to the 2008 financial crisis.
By Ann Hornaday
Friday, October 22, 2010; 1:55 AM
If Oliver Stone's recent "Wall Street" sequel exploited the 2008 financial meltdown for all its theatrical excess, Charles Ferguson's documentary "Inside Job" mines the crisis for its most shocking nonfictional drama. If you think you've absorbed all you could about subprime mortgages, credit default swaps and the arcana of elaborate derivatives, think again. "Inside Job" traces the history of the crisis and its implications with exceptional lucidity, rigor and righteous indignation.
What's more, Ferguson actually breaks news, uncovering the shady world of academic economists who, as paid consultants for the very banks they write seemingly objective research papers about, are part of the revolving door between Wall Street and Washington.
Filmgoers might remember Ferguson for his 2007 documentary "No End in Sight," about the American occupation of Iraq. That astonishing debut was deservedly nominated for an Oscar, but some skeptics thought maybe the tech millionaire - he founded Vermeer Technologies, which Microsoft bought for a bundle - simply had beginner's luck. Wonder no longer: Ferguson is the real thing, as evidenced by "Inside Job's" taut, laser-focused narrative, which manages to infuse real tension into a story most viewers know all too well. Shot by Svetlana Cvetko with crisp, bold digital imagery and set to Peter Gabriel's "Big Time" and other trenchant pop numbers, "Inside Job" isn't a tutorial as much as a trip: swift, scary and at times as mind-bending as Alice's sojourn behind the looking glass.
After a brief prologue in economically ravaged Iceland, Ferguson takes viewers back to post-Depression times, when tight financial regulation coincided with a period of uninterrupted growth. When Ronald Reagan came to power in the 1980s, a spate of deregulation began that only metastasized under Bill Clinton. If the savings and loan crisis of the 1980s and 1990s was a harbinger of things to come, it was all but ignored by such financial kingpins as Robert Rubin, Alan Greenspan and others for whom regulation was ideological anathema.
As meticulously laid out by Ferguson, the implosion two years ago was inevitable, and claims that no one saw it coming are patently false, as economists Raghuram Rajan and Nouriel Roubini are happy to tell you. Ferguson himself can frequently be heard confronting the officials who deign to talk with him, often countering their blithe denials of culpability with "You can't be serious" or its rhetorical equivalent. Tellingly, several of those who were recently or are still in power in Washington - Larry Summers, Ben Bernanke, Timothy Geithner, Henry Paulson - declined to be interviewed.
Summers is revealed as a particularly galling character in "Inside Job," and not only because as deputy Treasury secretary he bullied Commodity Futures Trading Commission chief Brooksley Born out of regulating derivatives back in 1998. As the former president of Harvard and chief economic adviser to President Obama, he embodies the egregious conflicts of interest among academia, the financial services industry and government "regulators" that Ferguson so skillfully exposes. (Although we're denied the pleasure of seeing Summers on the hot seat, Ferguson's grilling of Columbia University Business School Dean Glenn Hubbard, which ends with Hubbard sputtering in high dudgeon when his potential conflicts are revealed, represents the art of muckraking at its finest.)
Still, as brilliant as "Inside Job" is, it leaves the viewer with a pronounced feeling of helplessness. None of the principals in the financial meltdown was arrested, indicted or even forced to admit wrongdoing; indeed, many of them weren't even fired but were allowed to resign with hefty platinum parachutes. "Inside Job" joins such recent documentaries as "The Tillman Story" and "Casino Jack and the United States of Money" as an infuriating chronicle of the abuse of power with little or no push-back from the criminal justice system or Congress. Sure, they're all terrific films. But they're no substitute for genuine accountability.
rrr½ PG-13. At area theaters. Contains drug- and sex-related material. 108 minutes
'Inside Job' dissects the meltdown
By Christy Lemire | 2010-10-31 |
You don't have to know the difference between a credit default swap and a collateralized debt obligation to feel enraged anew by "Inside Job," Charles Ferguson's dissection of the economic collapse of 2008.
As he did with his first documentary, the Oscar-nominated "No End in Sight" about the US occupation of Iraq, Ferguson takes an unwieldy topic and makes it accessible - regardless of whether viewers are already well-versed or can't stand to follow developments. "Inside Job" is about a financial crisis that has touched every American's life and reverberated around the world. Ferguson's reach likewise is global, featuring stories, footage and expert interviews from Iceland, France, Singapore and points between.
Still, it's a daunting topic, but with the help of user-friendly graphics and Matt Damon's narration, Ferguson breaks down the meltdown into digestible terms without ever condescending. At the same time, he's managed to make a potentially dry, headache-inducing subject cinematic: "Inside Job" is gorgeous to look at, shiny and crisp with gleaming cinematography. His title sequence, featuring aerial shots of the Manhattan skyline with Peter Gabriel's "Big Time" blaring behind them, starts things out on a catchy, splashy note. The film as a whole moves well, too, with pristinely flattering lighting even for the wonky talking heads. Among the dozens of experts he speaks with - insiders and watchdogs alike - are billionaire philanthropist George Soros; NYU economics professor Nouriel Roubini (known as "Dr Doom" for predicting this crisis in 2006); French Finance Minister Christine Lagarde; US Representative Barney Frank, chairman of the House Financial Services Committee; and Eliot Spitzer, who sued all big investment banks when he was New York State Attorney General.
Their information fuels Ferguson's points and helps build a mounting sense of outrage at the sheer gall of it all - the complicated structures and unchecked greed that ultimately caused millions to lose their homes and jobs. But some find themselves on the hot seat, with Ferguson asking calm but pointed questions. Former Bush chief economic adviser Glenn Hubbard, now dean of Columbia University's business school, grows so defensive, he snarls: "You have three more minutes. Give it your best shot."
Still others declined to be interviewed, which is telling - including US Treasury Secretary Timothy Geithner; Federal Reserve Chairman Ben Bernanke; his predecessor, Alan Greenspan; and Larry Summers, President Obama's chief economic adviser.
Ferguson stays off-camera: We only hear his voice, and he's a quick and educated questioner.
He's also bipartisan in assigning blame, tracing the collapse to deregulation of the financial sector that began in the Reagan administration in the 1980s and continued under presidents Bill Clinton and George W. Bush. The advent of derivatives added risk, as did subprime lending.
It's all depressing, well-documented stuff. "Inside Job" pulls it together and into one eye-opening, jaw-dropping package. You may think you don't want to see this. But you should.
Read more: http://www.shanghaidaily.com/article/?id=453208&type=Feature#ixzz13uB21878
Proposed Rule on Financial Resources Requirements for DCOs and SIDCOs
The Commodity Futures Trading Commission is proposing financial resources requirements for derivatives clearing organizations (DCOs) and systemically important DCOs (SIDCOs).
Commodity Exchange Act (CEA)
Commodity Exchange Act, Section 5b(c)(2): Sets forth core principles with which a DCO must comply to be registered and to maintain registration as a DCO.
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act)
Section 725(c) of the Dodd-Frank Act amends Section 5b(c)(2) of the CEA by revising certain core principles and adding new ones. The Dodd-Frank Act also allows the Commission to adopt implementing rules and regulations for the core principles pursuant to its rulemaking authority under Section 8a(5) of the CEA.
Section 805(a) of the Dodd-Frank Act allows the Commission to prescribe regulations for those DCOs that the Financial Stability Oversight Council has determined are systemically important.
Core Principle B
Core Principle B, as amended by the Dodd-Frank Act, requires a DCO to possess financial resources that, at a minimum, exceed the total amount that would enable the DCO to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO in extreme but plausible market conditions; and enable the DCO to cover its operating costs for a period of 1 year, as calculated on a rolling basis.
Default resources
The proposed rule would require a DCO to maintain sufficient financial resources to meet its financial obligations to its clearing members notwithstanding a default by the clearing member creating the largest financial exposure for the DCO in extreme but plausible market conditions. For purposes of determining the largest financial exposure, the exposures of affiliated clearing members would be combined and treated as those of a single clearing member.
Because the failure of a SIDCO to meet its obligations would have a greater impact on the financial system than the failure of other DCOs, the proposed rule would require a DCO that is also a SIDCO to maintain sufficient financial resources to meet its financial obligations to its clearing members notwithstanding a default by the clearing members creating the two largest financial exposures for the SIDCO in extreme but plausible market conditions.
Financial resources that a DCO would be permitted to use to meet the requirement include: (1) margin of a defaulting clearing member; (2) the DCOfs own capital; (3) guaranty fund deposits; (4) default insurance; and (5) potential assessments for additional guaranty fund contributions.
At appropriate intervals, but not less than quarterly, a DCO would have to compute the current market value of each financial resource. Haircuts would have to be applied as appropriate and evaluated on a quarterly basis.
The value of assessments would be subject to a 30 percent haircut, and a DCO would only be permitted to count the value of assessments, after the haircut, to meet up to 20 percent of the requirement. A DCO that is also a SIDCO would not be able Commodity Futures Trading Commission . Office of Public Affairs . 202-418-5080
Commodity Futures Trading Commission . Office of Public Affairs . 202-418-5080
to count the value of assessments to meet the obligations arising from a default by the clearing member creating the single largest financial exposure; it could however count the value of assessments, after the 30 percent haircut, to meet up to 20 percent of the obligations arising from a default by the clearing member creating the second largest financial exposure.
The financial resources allocated to meet the requirement would have to be sufficiently liquid to enable a DCO to fulfill its obligations during the settlement cycle. A DCO would be allowed to take into account a committed line of credit or similar facility for the purpose of meeting the liquidity requirement. A DCO also would be required to have sufficient cash to meet the average daily settlement variation pay per clearing member over the last fiscal quarter.
A DCO would be required, on a quarterly basis, to perform stress testing that would allow it to make a reasonable calculation of the financial resources needed to meet the requirement.
Operating resources
The proposed rule would also require a DCO to maintain sufficient financial resources to cover its operating costs for at least one year, calculated on a rolling basis. Financial resources that a DCO would be permitted to use to meet the requirement include the DCOfs own capital and any other financial resource deemed acceptable by the Commission.
At appropriate intervals, but not less than quarterly, a DCO would have to compute the current market value of each financial resource. Haircuts would have to be applied as appropriate and evaluated on a quarterly basis.
The financial resources allocated to cover operating expenses for one year would have to include unencumbered, liquid financial assets (i.e., cash and/or highly liquid securities) equal to at least six monthsf operating costs. A DCO would be allowed to take into account a committed line of credit or similar facility for the purpose of meeting the liquidity requirement.
A DCO would be required, on a quarterly basis, to make a reasonable calculation of its projected operating costs over a 1-year period.
Reporting
Each fiscal quarter, or at any time upon Commission request, a DCO would be required to report to the Commission:
.
The amount of financial resources necessary to meet the regulatory requirements;
.
The value of each financial resource available;
.
For guaranty fund deposits, the value of each individual clearing memberfs guaranty fund deposit; and
.
A written explanation of the methodology used to compute its financial requirements.
A DCO also would have to provide the Commission with a financial statement, including the balance sheet, income statement, and statement of cash flows, of the DCO or its parent company
Is the DTCC Too Big To Fail?
Submitted by rc whalen on 02/09/2010 08:06 -0500
"In order to streamline securities settlement, Congress ordered that shares traded on exchanges be immobilized, which obviates both physical delivery of certificates and registration of transfer because the shares usually remain registered in the name of a depository or its nominee. This process creates a discrepancy between ownership of the share (economic or beneficial ownership) and the legal status as shareholder (registered stockholder).
The more of a market's securities that are registered in the name of a central depository, the greater the number of transactions that can be carried out on its books. The ultimate goal in this model is for all issuers to cede control over all shareholder data to a single entity, which would then conduct all of the market's transactions on its books, just as if all securities in circulation on the market had been dematerialized. Today, in fact, it is likely that a listed company will have only one registered shareholder, appropriately named "Cede & Company", the nominee of the Depository Trust Company (DTC), which is a subsidiary of the Depository Trust and Clearing Company (DTCC), the entity whose group clears and settles almost all securities transactions entered into on organized markets in the United States. The rules of DTC require that Cede be registered as holder for all deposited securities."
"The Rise and Effects of the Indirect Holding System: How Corporate America Ceded its Shareholders to Intermediaries"
Theodor Baums
Andreas Cahn
Working Paper No.68
Institute for Law and Finance
Frankfurt, Germany
09/2007
At our firm we frequently receive calls from clients and readers asking about the likelihood of the passage by the Congress in Washington of reform legislation regarding over-the-counter (OTC) derivatives, financial regulation and/or mortgage securitization. Our answer is small to none given the political trends and the state of the lobbies in Washington, most specifically the large bank lobby that protects the Sell Side monopoly in OTC derivatives and securities. The fact that Senator Richard Shelby (R-AL) is still apparently not comfortable with the entirely watered down House proposal to reform OTC derivatives, for example, tells you all you need to know. Stick a fork in it.
Regarding OTC derivatives, for example, the proposed reforms already are so feeble and ineffectual that whether they pass the Congress or not hardly matters. Financial services reform, you see, is less important that innovation in today's global marketplace, innovations such as centralized clearing for OTC derivatives and quantitative easing for fixing the related problem of widespread global insolvency. And the pace of innovation in the world of OTC markets is accelerating with or without the consent of the Congress thanks to the hard work of the economists who populate the Federal Reserve Board's division of supervision and regulation.
The latest signs of "innovation" on Wall Street can be seen in the announcement last week by the Fed Board of Governors approving the application by something called The Warehouse Trust Company LLC to become a Fed member bank. Warehouse Trust proposes to operate a central trade registry for credit default swap (CDS) contracts and to offer related services, including the processing of lifecycle events for the contracts and facilitation of payments settlement. The membership status becomes effective when Warehouse Trust purchases shares in the Federal Reserve Bank of New York.
Warehouse Trust is a wholly owned subsidiary of DTCC Deriv/SERV LLC (Deriv/SERV), which in turn is a wholly owned subsidiary of The Depository Trust & Clearing Corporation (DTCC). When it opens for business, Deriv/SERV's Trade Information Warehouse (TIW), which currently matches 95% of all CDS trades, will be transferred to Warehouse Trust.
DTCC, in case you are not familiar, clears most of the cash securities volume in the free world. DTC is a limited-purpose trust company organized under the New York banking law, and is a member of the Federal Reserve System. It is owned by the banks that it serves. DTC, and Fixed Income Clearing Corporation and National Securities Clearing Corporation are registered as clearing agencies with the Securities and Exchange Commission.
Got it?
The creation of Warehouse Trust as a Fed member bank marks the latest attempt by the large dealer banks and the DTCC to cover the retrograde OTC derivatives market in the clothes of modern respectability. The solution to all things bad in the world of OTC derivatives, you see, is centralized clearing. DTCC has lent its considerable credibility to the large bank cause because, after all, its clients are large banks. Indeed, if you listen to the folks at the Fed, the DTCC and the large OTC dealer banks, the advent of centralized clearing is just barely less momentous than the second coming of the Messiah.
One of the benefits of spending a lot of time talking and writing about centralized clearing as the solution to all known troubles and woes in the world of OTC derivatives and especially in CDS contracts is that it keeps the attention of the Big Media, the Congress and the regulators away from the front office and the process of creating and selling complex structured securities and derivatives. It is in the front office where the true problems reside, but notice that none of the OTC reform proposals nor the Volcker Rule go anywhere near the sales and trading desks at the large banks.
Based on our study of the Volcker Rule, which proposes to strip all of the largest banks of their proprietary trading arms, we know that solving the problem is not the real object of financial reform in Washington. Just as the Volcker Rule does no violence to the sales and syndicate function of the largest Sell Side banks, the proposed OTC derivatives reform legislation leaves the dealer monopoly in OTC intact and just barely improves the degree of regulatory oversight of these closed, private markets.
In technology terms, fixing the back office issues of OTC derivatives or securitizations with innovations like Warehouse Trust is akin to announcing a new venture to build cars with internal combustion engines. The evolution of DTCC into the de facto back office of an equally de facto market known as OTC is nothing more than recreating the wheel of multilateral exchanges and joint and several liability of clearing members, albeit one inch at a time.
The advantage of slow motion innovation is that the large dealer banks get to extend the date of true reform of OTC markets by years and pretend to be dealing with the systemic issues created by these unregulated, deliberately opaque OTC instruments, all the while harvesting supra-normal returns from these high-risk, high margin activities. Consider that all of the activities now conducted by TIW and that will be assumed by Warehouse Trust are considered routine at any of the multilateral exchanges, but at the Fed and among the large dealer banks, this is called innovation.
The sad fact is that a great deal of the "reforms" imposed on the OTC markets over the past several years have done nothing to improve price transparency or lessen the monopoly market power of the OTC dealers. To the contrary, under Tim Geithner, first at the Fed of New York and now the Treasury, the thrust of US policy has been to protect and enhance the monopoly position of the OTC dealers, all the while limiting "novation" or assignment of contracts (and thus secondary market trading) and price discovery.
None of the technical issues that drove the Geithner OTC reforms are even issues on a multilateral exchange. Indeed, since the Fed of New York began to focus attention on the back office issues surrounding OTC markets, the dealer grip on the OTC markets has arguably gotten tighter. When a customer faces a dealer instead of an open outcry market, the situation is unfair by definition and goes against basic American practice and experience, and the law, when it comes to the organization of financial markets.
To us, the whole object of the strategy pursued by the OTC dealers and abetted by the DTCC is to adopt enough of the operational attributes of a multilateral exchange to blunt criticisms of the OTC markets with respect to systemic risk issues, but leave in place the dealer monopoly and odious front office sales practices, the rape and pillage mentality that thrives today among Sell Side firms operating in the CDS markets. Just read the Sunday New York Times article by Louise Story and Gretchen Morgenson, "Testy Conflict With Goldman Helped Push A.I.G. to Edge," to understand the relationship between American International Group (AIG) and its OTC dealer bank counterparties.
http://www.nytimes.com/2010/02/07/business/07goldman.html?_r=1
The aspects of the OTC markets which remain off the reform table includes the bilateral relationship between the client and dealer regarding credit and collateral, the lack of complete market price transparency and the lack of any significant secondary market trading, all to maintain the monopoly rents that the large OTC dealers earn from this activity. Today's OTC markets have all of the attributes of a 1920s bucket shop and now the hub of this closed monopoly market is the DTCC, especially as the clearing house evolves inevitably into a central counterparty for all OTC trades.
And now the DTCC, through OTC derivatives market evolutions such as the creation of Warehouse Trust, is become the single point of failure in the world's financial system by virtue of its role in the OTC derivatives market. Both DTCC and Warehouse Trust are Fed member banks, but the former is not considered a bank holding company because neither entity takes deposits and are thus not FDIC members.
However, in the approval order by the Fed, DTCC commits to submit to Warehouse Trust to Fed prudential supervision as though it were an FDIC insured bank. What a shame that the Fed did not instead require DTCC and Warehouse Trust to be FDIC members and thus subject them to the discipline of the joint and several liability of being federally insured depositories. That would put the entire banking industry on notice that they are on the hook for the OTC shell game rising atop the infrastructure of the DTCC. Duh!
The Fed does, after all, does have a legal responsibility to ensure the sound operation of member banks regardless of their status as deposit takers. The order states that "Warehouse Trust will be well capitalized at the time it commences operations, and it will maintain capital that is sufficient to allow for an orderly wind-down if confronted with the need to cease operations." This is what economists call a "living will" by the way. The only trouble with the Fed's thinking is that if Warehouse Trust ever had to be unwound, then the DTCC itself probably would be in trouble as well.
Since the Fed has allowed the Warehouse Trust application to be approved without imposing the de facto cross-guarantee of FDIC membership on DTCC and all of its affiliates, it seems reasonable to ask just how the Fed would unwind this new member bank without destroying the entire western financial system. More important, why has the Fed put the entity that clears every cash equity and bond trade in the civilized world at risk to also be the central nexus and perhaps eventually even the counterparty for all OTC derivatives?
As the DTCC evolves from a record-keeper today and into a central counterparty for OTC derivatives and particularly CDS in the future, the question seems to be begged: Is the Warehouse Trust and DTCC now "too big to fail?" In the DTCC and Warehouse Trust, have we arrived at the functional equivalent of a multilateral exchange, via unauthorized public bailouts and the monetization of debt by our independent central bank, but in a decidedly sloppy and haphazard fashion?
Or as one former Treasury official told The IRA: "You can't reiterate enough the point that DTCC is owned by the dealer firms and thus the NY Fed is actively and purposefully aiding and abetting the continued OTC monopoly at the expense of real reform."
We'll be talking about this further and look forward to your comments.
Are you watching?
Here's the Second Shoe
A new US mortgage meltdown?Karen Maley
Published 6:56 PM, 21 Oct 2010 Last update 10:08 AM, 22 Oct 2010
Fears that the US banking system is about to be engulfed in 'subprime crisis part two' have been fuelled by recent media reports that a group of powerful institutional investors is seeking to force Bank of America to repurchase soured mortgages.
According to the reports, a group including PIMCO (the world’s largest bond fund), BlackRock (the world’s largest money manager), and the Federal Reserve of New York (which acquired its bonds as a result of its 2008 bailout of Bear Stearns and AIG) have written a legal letter to the Bank of America, objecting to the handling of 115 bond deals issued by the California-based lender Countrywide (which was acquired by Bank of America in 2008). The investors reportedly claim to hold about $16.5 billion, or more than 25 per cent of the $47 billion of mortgage-backed securities created by these deals.
The letter alleges that Countrywide, which was the servicer of the bonds, has failed to inform investors that various mortgages backing their bonds are in breach of representations and warranties made when the bonds were first sold. And the originator of the bonds – again Countrywide – has not been required to buy back the problem mortgages, even though it is obliged to do so when their quality of the mortgages falls short.
Now, this is an interesting development in the sub-prime saga, because it demonstrates that the big institutional investors are extremely keen to try and shift losses from their mortgage bonds back onto the banks. And it puts Bank of America in a somewhat tricky situation, because some of these huge institutional investors undoubtedly rank among its top clients.
Still, faced with the prospect that they will be flooded with demands to buy-back defaulted mortgages, the big US banks have little choice but to strenuously fight investor claims.
The banks are arguing that they are only required to buy back mortgages that didn’t meet the representations and warranties that they provided when they sold the loans. They’re not required to buy back mortgages that soured because borrowers lost their jobs in the economic downturn, and stopped meeting their mortgage payments. This makes it much harder for investors to put back large numbers of defaulted mortgages to the banks.
In addition, investors have to demonstrate breaches on a loan-by-loan case, which means they’ll have to spend huge amounts of money hiring experts to comb through the loan files, in an endeavour to uncover the faulty mortgages.
At this stage, no-one knows just how big a problem this is going to be for the banks.
Some argue that the standard of mortgages packaged into MBS frequently failed to meet the banks' warranties, either because the values of the properties were over-stated, or else the borrowers didn’t have the income that was claimed. As a result, they predict banks will incur heavy losses as a result of having to buy back large numbers of problem mortgages. And they’ll also run up huge legal costs because they’ll have to spend years in the courts fighting claims of breaches from investors.
Others estimate that the problems for the US banking sector will be much less severe – amounting to several tens of billions of dollars, which can be spread over a number of years.
Whatever the outcome, the latest flurry of fear demonstrates that US investors are all too aware that the banks did not fully shed their risk when they bundled up all their low doc mortgages and flogged them to investors.
As a result, the big banks continue to be haunted by the spectre of lurking sub-prime losses.
Did you say something?
I think we got zapped when I was sleeping
or was that a mosquito bite :)
A brother in law of Wayne King!!
Omg woogs! I should not be allowed to have a lot of caffeine after dinner. I giggle easily anyways but...
Ok we're having after dinner coffee and I hear, "Dick Wanker party of two"
OMG I broke out into non stop giggles!
And they were right in front of us!!
The guy turned red and the woman he was with, you could tell was holding back laughing as well (must not be married)
Well there you are!!!
I was getting a little worried about you but figured you had to be traveling some place fun.
Glad to see you're ok!
getting my groove back for the other shoe
seen AU ?:)
you better be sailing some place nice with the duchess!!
Amazing, isn't it?
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