This American Debacle

The outstanding reporting (and show tune!) by Planet Money, This American Life, and ProPublica is not getting enough attention. Their recent report on Magnetar’s role in the financial crisis is incredibly revealing. It explains how the CDO market grew so big despite the clear dangers.

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 helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages. …

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. …

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.

I actually like that Magnetar exploited a market inefficiency. I don’t like that it contributed to the re-inflation (or further inflation) of a bubble. An increase in short selling (which is essentially what Magnetar was doing) is a signal of overpriced assets. The problem here is that the signal was not getting through. Instead of being amplified by increased short selling incentives were to muffle it by lack of transparency, disclosure, and financial instrument complexity. That I do not like.

It isn’t likely Magnetar was the only player in this game. The SEC says Goldman Sachs was in on it too.

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