The Heart of Darkness – Part III

The following is an excellent excerpt from the book “ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism” by Yves Smith from Chapter 9: “The Heart of Darkness: The Shadow Banking System Self-Destructs” on page 251 and I quote:

“During the late nineties, investors naively came to believe that double digit stock market returns were normal.  While many portfolio managers had assumed unrealistic future returns, those with long time horizons, like life insurance companies and pension funds, were in a particularly acute bind, since many had fallen below their targets.  As a result, they were under considerable pressure to boost returns.  And because their funds simultaneously were expected to invest primarily in safe assets, the return needed on the rest was particularly high.  In the low interest rate environment of 2001 and after, the problems became even worse.

As it happened, investors managed to convince themselves there was a way to convert the lead of an unfavorable environment into gold: hedge funds.  The equity bear market of 2000-2002 and a dearth of obvious investment ideas suddenly bestowed hedge funds with the aura not merely of respectability, but also of sophistication.  They were no longer speculative, unregulated cowboys, too racy for clean-living fiduciaries.  Hedge funds were the place to be.  The success of pioneering institutional investors such as Yale’s endowment enticed others to follow.  Fund consultants, gatekeepers to many pension funds and endowments, started treating them as a separate asset class.  In their alchemical system, the magic designation “asset class” means that the investors who pay the consultants’ fees must put some money in every asset class, otherwise, horrors, they might miss being on the efficient investment frontier.

Hedge funds, now bearing the Good Housekeeping seal of approval from the fund consultants, saw a large influx of new money.  Estimates of hedge fund industry size vary, since its members are not required to report to anyone other than their investors and many are secretive.  But experts agree the funds showed enviable growth in the wake of the dot-com bust.  For instance, Morningstar, which includes mainly large hedge funds in its database, shows a compound annual growth rate of nearly 20% in assets managed from 2002 to 2007.

Why such robust growth?  Investors expect to see at least low double digit returns on a net basis to justify the fat fees and confirm the supposed superior skill of the hedgie.  To deliver that minus the funds’s fees (typically 2% annually, plus 20% of the profits) and recoup transaction costs, and sometimes an additional layer of fees from a fund of funds manager, hedge funds need to make a gross return of over 20%.

To meet that level, a fund manager would need to be unusually skilled and/or take a great deal of risk, often in the form of leverage.  Or like Bernie Madoff, he could simply lie about his results.

Hedge funds are expected to adhere to a particular style, such as “event driven” (speculating on the outcome of takeovers), “market neutral” (meaning they offset long and short positions so as not to be exposed to the direction of equity markets), or “global macro” (making bets in favor of or against international markets, such as German bonds or Brazilian equities; George Soros’s raid on the pound was a global macro play).

Strategies that focused on debt instruments became the hot new area.  It sounded fresh and sophisticated, always a siren song to investors.  The newly fashionable style of structured credit strategies accounted (by some estimations) for roughly 28% of the total funds deployed in this period–over $400 billion after allowing for the use of borrowings.  And these hedge funds were far from the only participants.  Investment banks and European banks were significant, probably larger in aggregate, and some hedge funds with broad mandates, such as global macro, were also active players.

Most engaged in a levered spread play in illiquid assets.  That is a fancy way of saying:

  • The hedge funds and investment banks bought assets that produced income, in this case, tranches of various structured credit transactions.
  • They hedged some of the risks of those investments, and still had income left over.
  • They borrowed a ton to improve returns or invested in instruments that behaved as if the hedge fund had borrowed a great deal (small changes in the performance of the underlying assets would produce very large swings in the value of the chosen instrument).
  • Because the instruments used for these strategies didn’t trade much, their prices were not volatile, which made them look less risky to investors than they were.

The traders were therefore making extremely leveraged bets using credit-based assets.  As we will see, this was tantamount to the riskiest sort of banking.

In fact, the net effect of the resecuritization using these bottom layers was leverage on leverage.   It has the effect of adding another layer of borrowing to an investment that was already geared.  Let us say you are an investor in a fund, and for every dollar you invest, the fund borrows four.  That means your one dollar of investment backs five dollars of assets.  But if you borrowed half of the money you put in, the effective leverage is even higher thanks to the fact that the supposed equity was not real equity, but itself was partly borrowed.   In reality, only one dollar of risk capital supports ten dollars of investment.  The use of these bottom tranches, the ones that were equity-like even if they were not called “equity,” to create new deals that had their own equity and near equity slice, produced a similar result, but with much greater ultimate leverage.

The willingness in capital markets to hold large volumes of AAA-rated structured credit instruments, no matter how complex, was not the sole reason for the so-called “infinite bid” for this product in the later stages of the lending boom.

In June 2005, the International Swaps and Derivatives Association (ISDA), an industry association for over-the-counter derivatives dealers, created the protocol that allowed credit default swaps to be written on asset-backed instruments, such as the subprime mortgage bond tranches that went into CDOs.  In 2006, a company called Markit launched a credit default swaps index that referenced a basket of twenty subprime mortgage issues, with different prices for each tranche.  That provided another way to hedge, since dealers and investors could buy and sell protection on particular tranches of the index.

Credit default swaps on asset backed securities suddenly created a whole new range of possibilities.  Yes, CDOs had often used insurance even before the ISDA change, but it was provided by insurers with AAA ratings, like AIG and the so-called monolines such as MBIA and Ambac.  They stuck to providing credit enhancement for the top tranches, often to provide a guarantee that reduced capital requirements for large financial firms, as we discussed in chapter 7.

Now new players could also provide protection, enlarging the universe of possible suppliers of credit and lowering the price of borrowing.  Moreover, it was now possible to buy guarantees on the risky tranches. The new credit default swaps on lower-rated securities opened up exciting possibilities for hedge funds and the proprietary trading desks of investment banks, hedge fund-like units that speculated with the house’s money.  Now they could go short mortgage bond tranches, meaning they would profit if their prices fell.  They could also use CDS to construct trades that mimicked being short the rated tranches of an ABS CDO, such as the super senior or the BBB layer.

Meanwhile, the appetite for CDOs was insatiable in 2005 and 2006.  In those years, demand was so overheated that Financial Times editor Gillian Tett noted,

“The big, dirty secret of the securitization world was that there was such a frenetic appetite for more and more subprime loans to package into CDOs that the supply of mortgage loans had started lagging behind demand.”

Using the new markets in CDS on lower tranches, packages (usually major capital markets firms) found a way to cope with the dearth of supply of raw material of CDOs.  They created and sold so-called synthetic collateralized debt obligations in impressive volumes.

Synthetic CDOs used the premiums from guarantees on (technically, “referencing”) subprime mortgage bonds to provide cash flow to investors.  Since a lot of players wanted to hedge the risk of holding these bonds, there was no constraint on creating these deals.  Synthetic asset-backed CDO issuance was in close to a one-to-one ratio with cash CDOs, with CDOs backed by loans at $490 billion and those consisting solely of credit default swaps at $450 billion.  Those levels were both double the 2005 volumes.  Many of the CDOs issued were also hybrids, containing both ordinary cash bonds (subprime bonds) and synthetic bonds (from guarantees on subprime bonds).

But why were investors so keen, one might even say desperate, to buy such complicated, opaque assets?  We come back to our trading sardines.  Market participants convinced themselves that that had largely eliminated default risk and could focus on mere pricing differentials between different types of instruments.  It didn’t matter what was in that $5 can, if you had a cheap hedge against the risk that it was rotten.

And some hedge funds played a very direct role in teeing up new deals, and as a result, greatly increased demand for loans.  Put simply, in the later stages, hedge funds and investment banks were not only big buyers, but also big creators of trading sardines.  And trading sardines is exactly what they were.  Indeed, some of the strategies made no sense unless the tins’ contents were certain to be bad.

In the early years of the explosive growth of collateralized debt obligations which were manufactured heavily from residential mortgages, the end buyers of the AAA tranches of CDOs were typically pension funds and insurance companies, hungry for AAA paper that offered higher-than-normal yields.  Even with strong demand for the AAA tranches, the growth of the product had historically been constrained by the need to find someone to take the nasty lower layers.  While the “mezz” or BBB slice was often finessed by rolling it into a new deal, investors in the top tranches did want to see that someone was on the hook for the losses.  The CDO manager, who identified and vetted the instruments that went into the deal, was expected to take at least some of the equity tranche; hedge funds were the usual suspects for the balance.

But in late 2005, those patterns all started to change.  Demand from historical cash (i.e., “real money”) AAA buyers started to soften.  CDOs looked to become victims of their own success.  As the product became more popular, high demand led to higher prices, which meant lower yield, when higher income than other AAA instruments had been their raison d’etre.  And as the structures became riskier and riskier, some traditional buyers started to cool on the product.

But in its place, even stronger demand rose as the trading sardines market took over.  The major investment banks and European banks showed an uncharacteristic willingness to eat their own cooking, at least as far ar the AAA tranches were concerned, thanks to bogus accounting that allowed traders to be paid bonuses on profits not yet earned.

The “negative basis trade” that we saw in chapter 7 was the grist for this strategy.  The simplest version of the negative basis trade occurred when the packager of a deal (meaning the investment bank that would in the normal course of events merely underwrite the deal) kept some of one of the AAA tranches of a collateralized debt obligation and hedged it with a credit default swap.  The treatment, for internal reporting and bonus purposes, was the equivalent to accelerating the future earnings from the bond, less the cost of the AA insurance and funding costs.

We know how this movie ended.  Many of those AAA-rated CDO tranches are now toxic waste, and the AAA guarantors of this paper, like AIG and the so-called monoline insurers, MBIA and Ambac, are no longer rated AAA.  The whole procedure was a sham.  As the Bank for International Settlements blandly noted, “Substantial losses were subsequently incurred.”

But it gets better.  So far the story is that there was insatiable demand for manufactured high yield AAA instruments because a bunch of people got high on their ability to game their firms’ bonus system.  This behavior was increasingly aided and abetted by hedge funds and proprietary trading desks at investment banks that pursued credit-based strategies that, due to less frequent price fluctuations, looked less risky than they really were.  This sort of reckless abandon is a sure sign the end of a cycle is nigh.

All of this additional trading had the rather nasty side effect of creating considerable demand for the worst subprime paper, the higher yielding, meaning the dreckier, the better.

Hedge funds and banks following similar strategies would engage in what they called “credit arbitrage” or a “correlation trade.”  The name “correlations trade” comes from the fact that the traders were looking for misvaluations of the correlation risk implicit in the pricing of the various tranches.  Whatever the merits of this rather arcane idea, the strategy often wound up looking like a simple interest rate spread play.

As you went up the tranches of a CDO, the yield dropped.  The equity tranche would pay higher coupon, at least until defaults started to hit, than the next higher tranche, BBB, and so on.  And the cost of buying protection was even lower than the coupon on any tranche.  That meant for any layer in the CDO parfait, you could buy it (“go long”), and use the income to buy CDS protections against a higher-rated slice (“go short”).  That way, you would be betting that the higher-rated tranche would fall in price while still showing a profit on a current basis–known in the industry as a “long-short trade.”

For instance, an investment bank could buy the BBB tranche, and buy CDS protection in order to go short against the next higher slice in the same deal, the single A layer.

Let’s see how this strategy plays out under different scenarios.  Suppose the economy hums along, housing prices keep rising and subprime borrowers keep paying or refinancing their loans.  As long as enough pay so that the BBB slice of the CDO is undamaged, then you receive the full coupon on it, while paying a bit less for your CDS on the next higher layer.  So you make money.

Suppose, on the other hand, that the housing market crashes and all of the underlying mezzanine subprime bonds become worthless.  Then you lose your coupon on the BBB, but your CDS protection against the A tranche pays off.  You again make money.

The way you lose money with this strategy is if only the equity and BBB tranches become damaged but the A and all higher tranches remain intact.  Since as we have discussed, all of the tranches in a mezz CDO referenced some of the worst risk exposures from subprime mortgages, it seemed entirely reasonable that the BBB and A tranches in the resulting CDO would be very unlikely to behave differently from each other.

This credit arbitrage strategy was therefore a good one for traders who thought that subprime was going to end badly, but didn’t know when, and so didn’t want to go broke shorting subprime in the meantime.  The strategy also produced increased appetite for the lower layers of CDOs, which naturally made it considerably easier to create new CDOs.

Let’s consider what that means:

  • This type of investing created demand for subprime and other dodgy mortgages, like option ARMs (adjustable-rate mortgages). They were now prized not because investors wanted to own them but simply because their high yields made them great vehicles for trading strategies or bonus boosting.
  • The demand for these risky mortgages was so great that not enough could be created, hence the extensive use of synthetics. But all that demand for the income from credit default swaps (which was equivalent to providing insurance on the risk of default) lowered what it cost to buy this protection.  That via arbitrage lowered the interest required of subprime borrowers even more.  The derivatives and the related trading strategies were making the product even cheaper.  The tail was wagging the dog.

Like other transactions involving illiquid assets, these transactions were “marked to model.”  The CDO tranches involved in these strategies were not subject to the noise of daily market price moves.  As mentioned earlier, that made them more attractive to the fund of funds and fund consultant gatekeepers.  Remember, lower variability of the monthly prices makes a fund look better to investors, since modern finance defines volatility as a type of risk.  Illiquidity, which should have been seen as a risk, was instead viewed favorably.

Let’s consider an even more exciting variant.  The really smart guys were the ones who realized how deranged this all was, and used the bottom tranches to fund a short suprime bet.  They weren’t simply trying to match exposures in a crude fashion, but were using the high payout of the lower tranches as a cheap way to finance and considerably lower the cost of a wager against the subprime market.

Recall that the ability to issue CDOs depended on being able to place the slices that took the first losses: the pesky mezz and equity tranches, often referred to as nuclear waste.  Since there was so much demand for the AAA tranches that they were overpriced, it should follow that the lower tranches, particularly the equity piece, were cheap and therefore attractive.  But even so, the equity tranche was exotic and normally only a limited number of buyers were receptive.

Since the equity tranche was the scarce part of the CDO equation, anyone who funded it became the sponsor of a deal.  An investment bank might round up a CDO manager, which was often just a guy or two with a Bloomberg terminal, to handle the assmeblage of assets for the CDO and assist in marketing it.  The investment bank would provide the warehouse funding until the CDO was launched (for free, a sign of how lucrative they thought the business was) and would structure and sell it.  The hedgie at a minimum had veto rights over the assets put in the CDO and could even say what bonds and loans it wanted in the deal.  We set forth how this process worked, plus the ultimate consequences to the participants, in appendix II.

One hedge fund, Magnetar, went into the business of creating subprime CDOs on an unheard-of scale.  The fund is named for a neutron star with a powerful magnetic field that emits gamma rays and other forms of toxic radiation.  Magnetar named the deals they sponsored after constellations (for instance, Orion, Cetus, Sagittarius).

What exactly did Magetar do?  They created a ton of product through their Constellation program, although you would have to know the industry to get the joke.  Magntar’s name appears howhere on the offering documents, nor do they have an official legal relationship to the deals.

Magnetar supplied the funds for the equity tranche of each deal they sponsored.  They also went short many of the rated tranches in the same deals.

Understand how this arrangement works.  Magnetar owns the equity layer, which throws out a lot of cash for perhaps a year or two and then starts to decay quickly.  They bet against the better slices, short the very same deals they created, via the credit default swaps that were the dominant constituent of these CDOs.  The difference between his strategy and the ones described above is that the correlation trade-type investors were roughly matching their exposures.  Magnetar used the rich cash distributions of the equity layer to fund a much bigger short bet against BBB rated subprime bond tranches than their long equity position.

Remember, the equity layer suffers defaults first, and only when it is exhausted do the mezz and higher layers start seeing cash flow shortfalls.  That means Magnetar’s strategy makes no sense if the equity layer performs well: in that case Magnetar and other funds that went this route would have bought a lot of insurance (via credit default swaps) for no good reason, and only earned a meager positive spread or even have shown modest losses.  It looks even worse if the equity layer defaults while the mezz and better rated tranches continue to pay out.  It only works if the deal is so bad that the equity, plus the higher layers, are all toast.

Magnetar would not make its target returns on the equity tranche alone.  The deals had to fail for them to succeed.  It was common for funds like magnestar to let a trading desk know what parameters it wanted, and the traders would in turn line up suitable investments with the CDO manager.  Magnetar influenced the transaction by mandating a certain equity return, which meant the CDO would have to hold the “spreadiest” (i.e., riskiest) crap.  As the Wall Street Journal put it, “Magnetar swooped in on securities that it believed could become troubled but were paying big returns.”  And Magentar appears to have succeeded in achieving the highest profit result, namely, teeing up deals that went bust.  As an employee of a firm that packaged some of Magnetar’s deals explains:

“At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance.  The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .

Magnetar’s idea was that CDOs were destined for long term failure–that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros.  And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade.  The community is right. . . without someone willing to fund the equity of a CDO there was no way to get one done.  So, Magnetar made the logical leap. . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.

The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions–i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen.  So, their carry cost of the shorts was offset by the one or two equity payments.  After that, their upfront costs were covered and they would own the 100 point options for free.

Magnetar made A TON of money. . . I’d expect every bit as much as Paulson [a hedge fund manager who earned $15 billion shorting subprime mortgages in 2007].”

If credit default swaps were regulated, this would be insurance fraud on a massive scale.  But since the industry has bought tooth and nail to keep CDS free of any pesky restrictions, what Magnetar did was completely legal.  Magnetar was in fact doing what they were supposed to do, namely looking out for their investors.”


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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