Come On Man...Everyone's Doing It

This American Life has some of the best long-form reporting on the financial crisis. In particular, normal people like us have a prayer of understanding what happened.

Their latest story coveres the Magnetar Trade. Depending on who you believe, Magnetar either bet both for and against the housing market (that would be Magnetar's view - they were just doing their jobs and "hedging") or they created particularly crappy CDOs just so they could bet against them (that would be ProPublica's view).

You can understand the Magnetar trade like this:

• You put 5% down on a house.
• You come to me and ask me to put in 95%. This is an equity sharing arrangement, not a loan; that is, I will own 95% of the house, and you will own 5% of the house. I am nervous; to entice me, you say that you'll eat the first losses if the house value goes down. (In other words, you are enticing me by offering up your 5% investment as some kind of "price protection".)
  
• You take out fire insurance on the entire house.
• The house burns down. You lose your 5% up front but collect the entire insurance payment. I'm out my 95%.

The claim against Magnetar is that they requested the house be built out of matchsticks - they requested that the CDOs be built as badly as possible. This implies that they expected return on their insurance payment, not their initial small investment.

To look at this another way: in order to take insurance out on the house, Magnetar needs the house to be built. They put up their 5% money to lure others in. (Come on man, come invest, everyone's doing it, we have our money in.)

There are two separate sets of losers from the Magnetar trade:

• Whomever bought the end CDOs that lost value (burned down) lost their investment.
• Whomever sold the insurance to Magnetar lost money when they had to pay out.

For the end CDO buyers, ProPublica lists some of them, and I can't imagine they won't sue. In particular, I would expect them to sue the investment banks that built the CDO with Magnetar's money. The problem is that the banks building the CDOs may simply have been stupid.

(It is a certain special kind of stupidity of course, one that earns the banks lots of up-front fees. The problem that the bank can take your money, lose it all, earn a fee in the process, and not be considered criminals is a topic that will have to wait for another blog post.)

I don't know who sold insurance to Magnetar, but it may have been a similar group. Wall street banks can turn insurance into synthetic bonds. (This post by Felix Salmon may help explain how this works.)

The real problem here is: I don't see how we'll ever really know what happened; since Magnetar is a hedge fund, they're not required to disclose who they traded with, and they're not offering up a list of trades to prove their claim that they were not hoping to burn the house down. Since Magnetar is quite successful, there won't be an autopsy. (Compare to LTCM, which failed in 1998 and is now described in detail in dozens of financial history books.)