In 2004 I was talking to a customer who just had her house appraised for $400,000. I didn’t think the house was worth 300k, but I was just the loan officer so it didn’t matter. She had a $250k mortgage, owed about 60k in credit card debt, and was asking me if she could take another 20k to put in a pool. Although I would have made more money I wasn’t sure she should do it. I didn’t last too long in that industry.
A couple of years later I was talking to a friend who had also been in the mortgage industry and we were waiting for the bubble to burst. We talked about how we wished we could short the housing market because a decline was imminent. Today I realize most of the unique, one of a kind, amazing ideas I have are already being thought about and acted upon. This was no different.
In 2004, a couple years before my brilliant idea a man named Alec Litowitz had the same idea. Except Alec had a little more experience in the financial industry. Alec, with the help of some other Chicago financiers, created a hedge fund called Magnetar. In late 2005 the housing market was slowing down and the financial boom seemed to be over. One of the main reasons for this slowdown was a confusing term you may have heard on the news recently called collateralized debt obligations or CDO’s.
A CDO is a group of different mortgages or debt. The different mortgages are grouped according to their rating and based on the risk of the mortgage. These are grouped together to make a mortgage security. Basically, if you have poor credit and you didn’t put a lot of money down on your house you were considered risky. If you have stellar credit and put 20% or more down you were in an A borrower. So basically you had these CDO’s made up of three layers. The first layer was made up of the people with stellar credit A+ mortgages. The second layer wasn’t stellar but it wasn’t super risky either, somewhere in between. The bottom layer was people with risky mortgages that had the highest percentage of foreclosure.
In late 2005 no one wanted to buy these CDO’s because of their second and third layers. The writing was on the wall and no one in their right mind would buy them. The financial slowdown was imminent. Then along came Magnetar. They not only wanted to buy them but, they wanted to buy a ton. Fourty plus billion, according to This American Life’s Inside Job piece. According to Yves smith, author of Econned, Magnetar’s CDO’s drove over 50% of the demand for subprimes and as high as 65%. They also were buying the riskiest CDO’s urging managers of the securities to add more of the bottom layer or the riskiest securities. Making the CDO’s more likely to fail. Why would these financial savvy gurus do such a thing?
Magnetar took insurance on these CDO’s. They took so much insurance, in some cases they would make as much money or more if the CDO’s failed as opposed to if they were successful. By 2008, according to Pro Publica, 96% of Magnetar’s deals were in default, compared with 68% for comparable CDO’s. Good thing they took those insurance bets.
I think you know the rest of the story. They made billions. Just on transaction fees alone Merrill, Citigroup, JP morgan, and UBS among other bankers made millions on these deals. Goldman Sachs did buy some of these CDO’s as well, presumably for the same reason. However, Magnetar did it on a much bigger industrialized scale. It should have been Litowitz instead of Loyd Blankfein (Goldmans CEO) and other Magnetar exec’s when they testified to congress a couple weeks back.
The worst part of all this is that Magnetar did nothing illegal, but the specifics of these CDO deals remain shrouded in secrecy by Magnetar. Last I checked there was no congressional oversight committees being put together to investigate them. I haven’t heard a peep from any of the news networks ever mentioning Magnetar. In fact if I didn’t hear NPR’s, This American Life, a few weeks ago I would have no idea about Magnetar. The definition ironically of a Magnetar is the super magnetic field created by the last moments of a dying star. I guess Litowitz and company knew what was going on before they ever created it. Scary stuff.
So the next time I have a brilliant idea to bet against the market I’m going to do it. Oh who am I kidding? I’ll talk about it with a friend, say I told you so a few years later, and then write something about it long after the fact.
References and more on this subject
I don’t think that we can blame people like Magnetar who made money off these securities (CDOs) of bad loans by shorting them. They saw an opportunity and they took it.
It is fit and right to charge Goldman in court because they refused to compromise even a tiny bit on this issue. Ordinarily their lawyers (and apparently they have the best of best) would be able to get Goldman off with a small fine and with very little acknowledgment of misconduct. Goldman blames the victims of this fraudulent scheme for their own losses in the market. Essentially, they’re saying there’s a sucker born every minute and Goldman’s job is to optimize their profits by creating and selling CDOs to these investors by whatever means– including getting false high ratings for these securities– and themselves making a small profit by getting rid of their own CDOs and shorting some of their own by creating and arranging credit default swaps for other investors as well to hedge their own bets ( “investments” ) in CDOs.
They were able to accomplish all of this by the lack of transparency in this market and the trust of investors in the integrity of Goldman. IIRC Goldman is reported to make about $15 million by shorting but they made a lot more money brokering these fraudulent deals. Throughout all of this, they avoided oversight by the govt for example, by claiming that the credit default swaps were not investment insurance (which they were).
Their own emails make it pretty clear that the guilty parties at Goldman were well rewarded for their misconduct while others who saw the crookedness of this and other Goldman investment schemes were kicked out of the company. I think that the transparency brought about by the new law will sour this market for Goldman, and hopefully the consumer protection agency created by the new law will be able to detect new Goldman schemes to cheat their clients.
Under the new law, we will have fewer bubbles, but I suspect that Goldman will still lobby the govt and corrupt the regulators and Goldman’s lawyers will be able to game the system and create new loopholes in the laws. That’s why the law provides for “nationalization” of the too big to fail companies and the govt action will at least not cost tax payers too great a loss. Investors in the big companies will lose big time under the new law.
Comment by Al — May 23, 2010 @ 10:56 pm
I just saw this. Very well-written, Christian!
I appreciate your desire to keep the writing focussed. But you asked the question why Goldman got all the attention and everyone is ignoring Magnetar. The answer appears to be in the second article you provided a link to:
The CEO of Magnetar focussed ALL of his campaign contributions on Rahm Emanuel! Yet another indication Rahm is the Devil’s Spawn.
Seriously folks, if you want to predict the behavior of this administration, stop wondering “What Would Obama Do”? That will only mislead you. Even I have to admit I get lulled by Obama and I know better. It’s like dealing with a vampire: “Don’t look into his eyes!” Instead, focus on Rahm Emanuel. What would Rahm do? 90% of the time, you will be right!
BTW, Christian, you mentioned how you had the brilliant idea of selling short in the housing market, but didn’t follow up. When Bush was running against Gore, a friend asked me how that would affect the Market. WTH do I know? But I had just heard an analysis by investment consultants. The gist of it was, buy stock in oil companies and military contractors. I thought that sounded a bit too much like a crude Marxist stereotype. But WOW! It would have made me rich if I had followed it.
I passed this onto another friend who DID have money to invest. He ignored it and thanked me a few years latter. His net worth had shot up tremendously. How? He listened to my warnings about Bush, figured the world would go into the tank and bought gold. By the time we talked about it several years later, his initial investment had tripled in value.(I’m still hoping he’ll buy me a beer).
Comment by Bart — June 7, 2010 @ 3:17 pm
Thanks Bart.
With what BP is getting away with with this Oil spill and the weak financial reform legislation being proposed unfortunately you may be right. The Obama admin is compromising. The old status quo at a time where we could really have some real change. I keep telling myself that it’s steps in the right direction.
Comment by Christian — June 8, 2010 @ 9:25 pm
I realized after I wrote my comment about thee price of gold that it was careless of me to write that without checking to see if I was exaggerating. It turns out my friend was accurate. And that I was not mis-remembering.
Here is a page with charts of the historical price of gold:
http://www.goldprice.org/gold-price-history.html
Scroll down to the 15 year chart for some perspective.
Comment by Bart — June 10, 2010 @ 10:01 pm
Perhaps you may want to go into gold at this point, but it’s too late because it seems way overpriced. OTOH the economy seems to be slowly expanding so that there are a lot of potential winners and a lot of good buys which are slowly increasing– say like about 6-10% including dividends.
I’m hopeful with the Obama talk today and Congressional testimony. It’s good that BP has tried many different things. Testimony from the other companies is that they don’t have any better ideas so it seems that BP has done whatever any other company would have done. At some point, the Federal experts may provide more guidance. For example, it seems that there was a lot of pressure from the experts to not use a dispersant. I also think that the two side-hole drillings now have a greater chance to succeed because so many are doing the calculations and design that make success more certain. It can still fail but only for some cause that they did not anticipate.
Obama also expects that 95% of the upwelling oil will now be captured before it can spread. That’s real progress. Plans and actions for cleaning marshland and beaches are also good for the region. Since BP will pay for this and the drilling rigs that are in a 6 month moratorium, the economy of the region will be saved even if the environment will not. Hopefully, BP will learn from this failure and be prepared for the next disaster when it happens. I like one of the other company responses that there should be no need response to loss of well-head secureness because it wont happen if they are careful. It’s so typical of denial of the inevitable.
Comment by Al — June 15, 2010 @ 11:32 pm