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Sunday, April 1, 2012

The Wall Street Money Machine (70% off)

"The Wall Street Money Machine" is an investigative report prepared by ProPublica and NPR's Planet Money. It examines two aspects of the financial crisis:

* the role of hedge fund Magnetar, which worked in concert with the banks to create high-risk CDOs which it then bet against

* how the banks artificially increased demand for CDO's by co-opting CDO manager and forcing them to buy these derivatives under threat of losing future business

Toward the nadir of US housing prices, Chicago-based hedge fund Magnetar came up with a novel concept: work directly with the big banks to create mortgage-backed securities comprised of mortgages most likely to default. The banks (Merrill, Citi, Goldman, etc.) then promoted these CDOs to their clients, while Magnetar took out short positions on them. This recalls to mind Goldman's now-infamous ABACUS fund, which the bank internally bet against while simultaneously promoting to its clients. Before long, Magnetar alone accounted for a large percentage of the CDO market.

At the same time, banks were beginning to realize that investor demand for its mortgage-based securities was beginning to flag. Rather than wind-down its reliance upon these toxic assets, they opted for a different approach: co-opt the supposedly independent fund managers and force them to purchase newly-issued CDO under threat. Rather than assert their independence, most fund managers complied with the banks' demands rather than put their lucrative fee streams in jeopardy. Indeed, the banks often made life easier by approaching potential future managers with propositions to set them up for the sole purpose of buying their toxic assets, thereby artificially stimulating demand. In several cases, the banks even went as far as creating new departments within their organizations charged with buying each new mortgage-backed security in return for a split on fee revenue.

The banks also relied heavily upon so-called CDO squared: creating a new CDO for the sole purpose of buying-up the most toxic elements of already-existing CDO's. In a moment of pure financial alchemy, the ratings agencies which had previously given these high-risk mortgage bonds lower ratings re-rated them at triple-A levels when they re-appeared in a new CDO. This cross-purchasing between CDO's also helped create the illusion of demand, and drove correlations within mortgage-backed securities to 1. The time-bomb had been set.

The net effect of this was to artificially prop-up prices due to the apparent continued demand for CDO's. This allowed the banks to extend their revenue streams for much longer than would have been the case had normal supply-demand curves dictated pricing. As a result, the worst offenders (Merrill) imploded the moment housing prices began to grow less quickly-- to say nothing of housing prices actually falling.

The piece makes for a quick read, but is necessarily limited in scope to the two areas above. For a reader already familiar with the causes of the 2008 crash, it makes for an enjoyable examination of two less-covered aspects of the disaster.

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