ProPublica’s report on the hedge fund Magnetar — which had a hand in stuffing CDOs with crap mortgages and then shorting said CDOs — is attracting a fair amount of predictable outrage. On the surface the details make the fund look scummy.
(For a quick refresher, read Courtney Comstock’s bulleted version here.)
Casually, it sounds like their strategy was: Put together a stacked deck, and then find some sucker to play cards with.
The story is told as though they saw this big crisis coming, and that it was just a matter of finding the most efficient way to take advantage of everyone else’s misery.
But Magnetar (like Paulson, etc.) didn’t see a huge crisis coming. What the story shows is that they thought a very specific, and ultimately narrow, slice of mortgage-related assets would go very bad.
After all, if they’d actually seen this crisis coming, all they’d have to have done was short Citigroup or something like that, a bet that would have required far less work or salesmanship. (This is a point Holman Jenkins made in his Hoover Institute report published last summer.)
Again, the reason they didn’t put on a wholesale short of the financial system is that it didn’t occur to them this would prove very profitable.
Basically, they were looking for a leveraged way to bet against housing, and so they figured that the best way to do that was to bet against the very riskiest slices of this market. Obviously such bets weren’t readily available. Fortunately for funds like Magnetar, there were yield-hungry buyers (thank you demographics and Alan Greenspan) willing to make the opposite bet (plus ratings agencies that weren’t very forward looking).
It’s easy to think in retrospect that a bet against subprime was implicitly a bet on the entire system collapsing, but that’s ex-post facto thinking. Well after folks became aware of the subprime issue, the general thinking was that subprime itself was too small to cause major waves.
Take for example this post from Yves Smith written on July 10, 2007, responding to Chuck Prince’s lack of major concern about subprime. And bear in mind that Yves is now known as someone who was critical of Wall Street before it was cool:
[The] subprime meltdown in and of itself isn’t an event of sufficient magnitude to cause a full blown credit contraction. But there are events on other fronts that are pointing to lessening liquidity: the Japanese finally showing some concern about the carry trade; India, another liquidity provider, going through several rounds of interest rate rises to staunch domestic inflation that has resulted from buying US dollars (buying dollars increases the domestic money supply unless the government “sterilizes” it by issuing domestic bonds to soak up liquidity); the Chinese and Gulf states showing signs of domestic inflation and reluctance to keep buying more dollars.
So even someone like Yves, a leading critic, figured that subprime issue was too small, but that the undoing of Wall Street could come from Japan, India, or possibly the Gulf states.
As we know now, subprime turned out to be the seed of a massive crisis that’s still with us, but that just obvious even as late as the summer of 2007 (and arguably it wasn’t obvious even in the summer of 2008).
Had Magnetar known of the huge crisis coming, it would have just bet against Citi (or certainly Countrywide). Instead, it saw a narrow problem unfolding and sought the proper security for that. And that’s all.
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