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Econned and Magnetar

January 31, 2012

Gaming the risk model

When I worked in finance, there was a pretty well-known (and well-used) method of working around the pesky requirements of having a risk model and paying attention to risk limits in your group.

Namely, you’d let a risk guy in the group for a while, long enough to write a half-decent risk model, and then you’d say thanks, and we don’t need you anymore we’ll run with this, and then you’d kick him out of the group. You’d then spend the next few years learning how to game the risk model.

In particular you’d know exactly what kind of trades you could put in that the risk model can’t “see”: things like interest rate risk or counterparty risk, that the poor risk guy didn’t think of at the time, or even better the market you trade in would have developed and changed in the last few years so you were applying the risk model to instruments it wasn’t even meant to measure.

That way you could always stay within your risk limits, as a group, even while you took larger and larger bets on things that were invisible to the risk model. As long as the world didn’t blow up, this method returned higher-than-expected profits, so your “Sharpe ratio” looked great. You got rewarded for this, and in the meantime the company you worked for took on the risk (and they typically didn’t see it as coming from your trading group but rather as some amorphous systemic risk). It’s not clear how many people how high up were in on this method, but it seemed pretty clear that they also enjoyed the ride as long as it lasted.

The CDO market

One really enormous and tragic example of this behavior is described in Yves Smith‘s brilliant book Econned, in the chapter describing the CDO market and Magnetar Capital‘s involvement.

CDOs were  the reason we had a global economic crisis and not just a housing bubble. The CDO market is complicated, and you can learn a lot about it by reading the book. Suffice it to say I’m not going to be able to explain the whole thing, but let me simplify the story thus.

At the beginning (late 1980s through mid-late 1990s) there were not that many securitizations outside of the federal arena (Freddie Mac, Fannie Mae, and FHA), and they were pretty useful because they made piles of riskier but still viable-looking mortgages more predictable than individual mortgages. The top of the pile (they were separated in to groups called “tranches” depending on possible defaulting actions) were rated AAA by the big three ratings agencies (Moody’s, Fitch, and S&P) and probably deserved it, because they had a big cushion of loss protection beneath them. The lower tranches were lower rated and harder to sell, which limited the size of the overall market.

Starting around 2003 the lower-rated, harder-to-sell tranches from the BBB to the junior AAA tranche started getting resecuritized into instruments called CDOs. In fact there were riskier CDOs, called mezzanine CDOs, which consisted mainly of the BBB tranches, and “high grade” CDOs consisting mostly of old A and AA tranches. These CDOs were again tranched, with around 75% of the par value getting an AAA rating.

Yes, you heard that right: if you took a bunch of easy-to-imagine-they’d-fail low rated mortgage bond tranches  (especially if you knew anything about the terms of those mortgages and how much they were counting on the housing market to continue its climb), and bundle them together, then the resulting package would, at its highest tranche, be deemed AAA. It made no sense then and it makes no sense now.

The CDS and synthetic CDO markets

Enter the credit default swaps market. The ability to buy CDS protection (insurance on the underlying bonds) on a higher tranche  of the mortgage bonds (the first generation securitization) while purchasing a lower tranche made it possible for lots of people to bet that “if things go bad, they will go really bad”, while limiting their overall exposure. Moreover, the income on the lower rated tranche would fund an even bigger short position on the higher rated tranche, so this was a self-financing bet.

The demand for more cheap credit default swaps led some clever traders to realize they could create CDOs largely or entirely from credit default swaps rather than actual bonds. No need to be constrained by finding real borrowers! And you could bet against the same crap BBB bonds again and again, and have them packaged up and have most of the value of the “synthetic” or “hybrid” CDO rated AAA (again with the collusive help of the ratings agencies).

At first, the big protection sellers in the CDS market was AIG and the monoline insurers. But they only wrote CDSs on the least risky AAA CDO  tranches. Later, after AIG stopped being involved, that side of the CDS market was entered into by all sorts of really dumb people, with the help from the complicit ratings agencies who kept awarding AAA ratings.

Even so, there was still a bottleneck for this re-rebundled synthetic/heavily synthetic CDO market. Namely, it was hard to find people to buy the so-called “equity tranche”, which was the tranche that would disappear first, as the first crop of the underlying loans defaulted.

Magnetar

That’s when Magnetar Capital came in. They set up deals to fail. They did this through explicitly designing the synthetic CDOs (banks gave this privelege to whomever was willing to buy the equity tranche) and by, in addition to buying the equity tranche, they bought up all of the CDS’s in the synthetic CDO.

The overall bet Magnetar Capital was taking was similar to the one above: when the market goes bad, it will go really bad. The difference is that Magnetar’s exposure was altogether very short: they set up the equity tranche to pay lots of cash in the short term (a couple of years), which would finance the cost of all of the CDSs in the hybrid CDO, which meant they didn’t just cover the exposure but magnified it multiple times. And it was again a self-financing bet, as long as they were right about the market exploding rather than slowly degrading.

How big was this? Magnetar Capital made the majority of the market in 2006, which was one of the biggest years in this market. And everything they did was legal. They also drove demand in the subprime mortgage market, during its most toxic phase, by dint of a combination of leverage and the clever manipulation of investors, specifically convincing them to post cash bonds.

WTF?

Let’s go back to the groups gaming their risk models from the beginning of this post. Same thing happened here, except the group was this entire market, and the risk guy was the combination of the ratings agencies and AIG, as well as the greedy fools who wrote CDS on mortgages in 2006. And instead of the hedge fund being on the hook for their trading group’s games, in this case it was the United States and various European governments who were on the hook.

How predictable was this whole scheme? My guess is that Goldman Sachs knew exactly what was happening and what was going to happen. They made a very intelligent bet that if and when the housing market went under, AIG would be backed by the government. In essence this entire market was an enormous bet on government bailout. Not everyone knew, of course, especially the guys who were long the market when it collapsed, but lots of people knew. The same people who right now know where the dead bodies are on the books and who aren’t coming forward with a plan to resuscitate the financial system, in fact.

At the very least I think this story argues for the treatment of CDS as insurance, with the requisite regulation. In different terms, Magnetar chose buildings where they saw arsonists enter with gallons of gasoline and matches, and bet everything on a fire in that building. The question then is, how many fire insurance claims should one entity be allowed to buy for one building?

Categories: finance
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