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Home > Blog > Category Archives: Credit default swaps

Category Archives: Credit default swaps

Magnetar Hedge Fund Sheds New Insight Into Wall Street’s Dark Side

An obscure hedge fund called Magnetar offers new details into the world of collateralized debt obligations (CDOs) and how the instruments cost investors billions while yielding a payday bonanza for Magnetar. And that’s the irony. What Magnetar did appears to be legal.

Magnetar and the toxic deals it created and then bet against are the subject of an investigative story by ProPublica and co-produced with Chicago Public Radio’s This American Life and NPR’s Planet Money.

The short version of Magnetar – which was started up by former Citadel trader Alec Litowitz – begins with the Chicago hedge fund buying up the riskiest portion of CDOs. At the same time, Magnetar placed bets that portions of its own deals would fail. Meanwhile, Magnetar ended up reaping a massive fortune.

Magnetar worked with most of Wall Street’s top banks in its deals – deals that ultimately produced $40 billion worth of extremely toxic, high-risk CDOs. Among the banks that helped sell those toxic assets to investors: Merrill Lynch, Lehman Brothers, Citigroup, UBS and JPMorgan Chase.

“Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.”

ProPublica offers an excellent slideshow of how Magnetar orchestrated its CDO deals. Entitled The Anatomy of the Magnetar Trade, the slides provide a straightforward and simple account of the players involved in the CDO market and how when the instruments ultimately collapsed, Magnetar profited.

The complete (5,900 words) story on Magnetar is well worth the read. You can view the story in its entirety here.

Credit Default Swaps: Dangerous And Thriving

Credit default swaps are blamed for instigating the nation’s financial crisis, helping to bring companies like American International Group (AIG) to its knees after it could no longer pay the many claims it owed on the swaps contracts. Nearly three years after the fact, credit default swaps and other complex derivative instruments are still a booming fixture on Wall Street and, unexplainably, largely untouched by financial reform efforts.

This irony is the subject of Gretchen Morgenson’s Feb. 28 column in the New York Times. In the article, she writes that Congressional reform plans for credit default swaps are “full of loopholes,” a fact that almost guarantees “that another derivatives-fueled financial crisis” is right around the corner.

According to the Bank for International Settlements, credit default swaps with a face value of $36 trillion were outstanding in the second quarter of 2009.

Morgenson’s article includes comments from Martin Mayer, a guest scholar at the Brookings Institution and a noted author on banking and finance-related issues. On the subject of credit default swaps, Martin says the following:

“Credit default swaps are a way to increase the leverage in the system, and the people who were doing it knew that they were doing something on the edge of fraudulent… They were not well-motivated.

Mayer’s criticism of credit default swaps dates back several years. On May 20, 1999, he penned an Op-Ed piece in the Wall Street Journal, titled The Dangers of Derivatives. Some of his selected comments include the following:

These over-the-counter derivatives – created, sold and serviced behind closed doors by consenting adults who don’t tell anybody what they’re doing – are also a major source of the almost unlimited leverage that brought the world financial system to the brink of disaster last fall. These instruments are creations of mathematics, and within its premises mathematics yields certainty. But in real life, as Justice Oliver Wendell Holmes wrote, “certainty generally is an illusion.” The derivatives dealers’ demands for liquidity far exceed what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.

“Meanwhile the rules of this game – adopted and enforced by the world’s banking supervisors – further shrink what are already low time horizons in the financial markets. Measuring their positions every day through the algorithms of “value at risk” analysis, players must make constant adjustments of hedges and options to control the losses they may suffer from unanticipated volatility of market prices. In real markets, often enough, you can’t do that.

“The current [plat du jour] – the credit derivative – is the most dangerous instrument yet, and neither the risk controllers at the big banks nor the bank examiners seem to have any good ideas about how to handle it. A vehicle by which banks can swap loans with each other apparently gives everybody a win – banks can diversify their portfolios geographically and by category with the click of a mouse.

“But the system is easily gamed, and it sacrifices the great strength of banks as financial intermediaries – their knowledge of their borrowers, and their incentive to police the status of the loan.

“When a loan is securitized, nobody has the credit watch. Researchers at the Federal Reserve Bank of New York concluded that in the presence of moral hazard – the likelihood that sloughing the bad loans into a swap will be profitable – the growth of a market for default risks could lead to bank insolvencies.”

Fast forward to 2008 and 2009 and Mayer’s predictions became reality. Morgenson contacted Mayer for her Feb. 28 column, asking for his thoughts on solutions to the problems that credit default swaps have produced. Among his recommendations:

  • Companies that trade in credit default swaps should be required to put up more capital to back them, Mayer says. That way, if a client asks for payment, the issuer actually has the funds available to make good on the payment.
  • Increased regulatory oversight of credit default swaps needs to become the rule, according to Mayer. In addition, he suggests that credit default swaps must be exchange-traded so that their risks are more transparent.

“The insistence that you mustn’t slow the pace of innovation is just childish,” Mayer said in the NYT’s article. “Innovation has now cost us $7 trillion,” a price tag that refers to the loss in household wealth resulting from the financial crisis. “That’s a pretty high price to pay for innovation.”

More Investors Prevail In Cases Over Toxic RMK Funds

The arbitration scorecard keeps getting bigger for investors and their arbitration cases against Memphis-based Morgan Keegan & Co. At the heart of the legal disputes: Seven mutual bond funds that aggrieved investors say Morgan Keegan and fund managers led them to believe were invested in conservative preferred stocks and corporate bonds. Instead, the funds, collectively known as the RMK Funds, took high-risk bets on speculative and toxic financial products such as collateralized debt obligations and derivatives.

Other troubled RMK funds at the center of the ongoing litigation were tied to the credit default swaps business, an investing strategy that essentially entails a “bet” between two parties on the likelihood a bond or similar type of investment will default. When the housing market crashed and burned in the summer of 2007, that’s exactly what happened, and certain RMK funds subsequently were forced to pay off huge losses.

Ultimately, Morgan Keegan’s investing gambles, along with the company’s alleged deception to keep the credit risks of the funds’ investments a secret, would cost investors dearly. Some of the RMK funds lost more than 90% of their value following the collapse of the housing market. In turn, investors suffered more than $2 billion in losses in just 2007 alone.

Since then, hundreds of arbitration cases have been filed by investors against Morgan Keegan for losses in the funds. Now, after months of waiting to tell their story, it appears momentum is building on the side of investors.  As reported June 7, 2009, by The Birmingham News, 16 of investors’ 20 wins came in the last 25 hearings with the Financial Industry Regulatory Authority (FINRA). In just the month of May 2009, FINRA announced eight arbitration decisions in favor of investors.

As for Morgan Keegan, the legal battle over its collapsed bond funds has played havoc with its stock price. The company’s shares plummeted more than 70% in the past year.

In 2008, management responsibilities for the seven RMK funds were handed off to Hyperion Brookfield Asset Management. Meanwhile, the former Morgan Keegan manager of the funds, Jim Kelsoe, no longer manages any Morgan Keegan funds, according to The Birmingham News article, and has been “reassigned” to an unspecified role within the company.

Credit Default Swaps Create Worldwide Tsunami Of Trouble

Credit default swaps (CDS) may be described as insurance-like contracts designed to hedge against default on loans or bonds, but they are far from ordinary insurance. Created in the early 1990s by JPMorgan Chase & Co., credit default swaps belong in a derivatives class all by themselves. Some call them ticking bombs; others – most notably billionaire investor Warren Buffett – refer to credit default swaps as financial weapons of mass destruction, carrying dangers that are potentially lethal and deadly.

Now matter how you characterize them, most financial experts now agree that credit default swaps are, in large, responsible for the upheaval in the stock and credit markets and the resulting financial crisis happening around the world.

A credit default swap essentially is an obscure and complex derivative instrument that takes the form of a private contract between a buyer and a seller. The buyer (investor) of a credit default swap pays an upfront fee plus annual premiums to a seller, which typically is a bank or hedge fund, to cover potential loss on the investment outlined in the contract.

The underlying caveat to a credit default swap is the counterparty risk involved in the contract. The credit default swaps market – estimated at $62 trillion in 2007 – is unregulated, with swaps sold over the counter. With no regulation, there’s no entity overseeing the trades to ensure a purchaser of a credit default swap has the financial resources to make good on a swaps contract if it is called in.

Think Bear Stearns. American International Group (AIG). Lehman Brothers Holdings. Lehman Brothers was deeply entrenched in the credit default swaps market. When the company filed for bankruptcy on Sept. 15, 2008, sellers of its credit default swaps contracts found themselves on the hook for billions and billions of dollars.

As for AIG, its involvement in credit-default swaps reportedly pushed the financially troubled firm to the brink of bankruptcy in September before the federal government stepped in with a bailout that now totals more than $182 billion.

And then there’s Bear Stearns. It, too, became crushed under the weight credit default swaps. Its fate was finally sealed when JP Morgan – ironically the inventor of the derivative instruments – purchased the 85-year-old investment firm in March 2008 for the fire-sale price of $2 a share. Under pressure from shareholders, the deal was later revised to $10 a share.


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