Michael Lewis wrote the cult classic "Liar's Poker", a must read for all budding and inspiring investment bankers. The short, and relatively fast reading, book was very entertaining and did a good job setting up the stage of the 1980 meltdown as well as explaining complex financial transactions in layman terms.
The same cannot be said about "Bonfire of the Vanities". I have yet to finish the book. The book is more of a trashy romance drama and character development than an interesting way of digesting our financial history.
The most interesting part of reading the book is realizing that history does repeat itself. The same housing market crisis, different players. Instead of savings and loans we now have major banks involved, and the stakes are bigger than before. Within the complex financial instruments and the tower of cards that "no one could have foreseen was going to come crashing down", there was a small group of bankers who saw the risk.
Propublica wrote a scathing article of some of these very intelligent individuals who leveraged this knowledge for them to make millions. Individually, the banks that were involved (and we later had to bail out) made millions as well. Although the banks (household names like Deutsche Bank, JP Morgan , Merrill Lynch, UBS, Lehman Brothers, and CitiBank) then the taxpayers, ultimately had to pay the price when they were left with CDOs (Collateralized Loan Obligations) they couldn't sell, the individuals who set up these transactions came away with millions. In other words, although there were many losers in this game of musical chairs, none of them were the individuals who received millions of dollars in bonuses for setting up the transactions. One of the culprits of this was a hedge fund named Magnetar. We have to all understand that what they did was legal, and it shows how vulnerable our financial system is to failure. These individuals saw a weakness in the marketplace that they exploited.
Hedge funds make money by investing and shorting various investments in order to make the most money for their investors. Shorting can be helpful to serve as a counterweight to keep bubbles from expanding. Unfortunately, this tool can also be leveraged in a more malicious manor. Individuals can also short, or best against, the very investments they are helping create. The parallel is like someone marking sure a team makes it to the final four in March Madness only to ensure the whole team gets food poisoning before the final game. These individuals bet against that "food poisoning" to make their money. The transaction was so common towards the end of the real estate boom that it was actually called the Magnetar Trade.
How did the Magnetar Trade work? Magnetar agreed to buy the most risky "equity" part of the CDO that helped facilitate the remainder of the CDO to be created.
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.
Because the equity part of the CDO is a very small percentage of the overall CDO created, this involved a relatively small investment ($10 million or less). The remainder of the CDO was deemed to be very low risk and investment grade (we later would learn that all CDOs were crap).
So how did the Magnetar Trade work and how did Magnetar expect to make money out of what many consider to be the riskiest part of the investment (so risky was this investment tranche that they were called "sponsors" of a CDO)? They made counter bets, or shorts, by buying credit default swaps betting the exact same investment they helped create was going to go bad. As a "sponsor", Magnetar had the added benefit of influencing how the deal was structured, and encouraged these CDOs to have a higher mix of riskier mortgages.
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.
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.
When the housing market started collapsing in 2007 Magnetar was in line to make hundreds of millions of dollar on the CDOs defaulting. All of a sudden, these insurance claims, or credit default swaps, became extremely valuable. Even then, Magnetar wanted to get out of their position for their remaining CDO equity.
They engineered an unprecedented sale of these risky equity assets in a newly bundled CDO to a Japanese bank named Mizuho.
This deal, Tigris, which closed in March 2007, tied together $902 million of Magnetar's risky assets. Magnetar 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. We now know that these were worth as much as junk bonds in the 1980s.
What is the lesson learned here? Investment banks such as JP Morgan, Lehman Brothers, Merrill Lynch, CitiBank as well as rating agencies are only the vehicles that facilitate the process. It is not the company's fault, but the individuals who work there that out of greed created the problem we are paying for today. These individuals walked away with hundreds of millions of dollars in their pocket while leaving an empty shell remaining to be rescued.
As far as these individuals are concerned, their pockets are lined, who cares about the company? Good point, huh?
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