Quantive Easing Explained

[Moot]

The folks making the most money of this strategy were a handful of hedge funds. The strategy is often referred to as the "Magnetar" strategy, named for one of the first hedge funds known to employ it. Basically, it worked like this: the hedge fund bought certain the riskiest portions of CDOs and then bought credit default swaps against them. The strategy at this point, is simple: if the market keeps going, the riskiest tranches provide a handsome rate of return, well in excess of that necessary to pay for the CDS insurance. If the market bombs, the CDS kicks in and the owner makes a handsome rate of return that way. Critics of Magnetar accuse them of helping the trade along by insisting that the underwriters include ever more risky deals in the CDO, thereby shifting the odds for default in Magnetar's favor. You can read an interesting description of the trade here.

Magnetar was not the only hedge fund to do this trade, Paulson being perhaps the other best-known one. Once they figured it out, mainly by observing what their hedge fund clients were up to, several dealers did it as well. The dealers though, had left themselves open to considerable market risk in the totality of their CDO dealings, and this trade mostly just kept them from losing as much when the market did go south.

On balance, the biggest money on these trades was made by a relatively small group of hedge funds, not the banks.

LOL "The folks...?" Only "a small group of hedge funds?" How folksy and quaint you make it sound. Those hedge funds literally brought this country to it's knees and a quite few others as well. Yes both Paulson and Magnetar were the most famous cases, but hardly the first or the only ones to use the strategy. To suggest that it was a merely "a small handful of hedgefunds" is disingenious considering nearly all the big banks were involved in the CDS scam in one way or another. Paulson, one of the largest hedgefunds in the world is implicated with Goldman Sachs and Deustch Bank in defrauding investors. Magnetar is implicated with Leman Brothers and JPMorgan and "Norma" is implicated with Merrill Lynch. The fact that some of the banks were caught holding the bag is irrelevant to the fact that they were defrauding investors and gambling with other people's money and lives. But not just people, entire countries, cities, retirement funds, and businesses world wide. Did you read the reply to WSJ article you linked to? You should have....

"My 2003 book, “Collateralized Debt Obligations & Structured Finance,” includes the “Magnetar” structure as applied to corporate CDOs. I don’t know the first person to use that structure, but contrary to many finance articles and recent books, the “Magnetar” structure itself wasn’t new when it was applied to mortgage loans and other asset backed securities. For example, it wasn’t developed by any of the people in Greg Zuckerman’s book, The Greatest Trade Ever. Furthermore, there are a large variety of structured products and a huge network of players. Magnetar was a cog in the wheel, but the story is much bigger then just this one hedge fund..."read
The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going - ProPublica

A Fund Behind Astronomical Losses - WSJ.com

Janet Tavakoli: ProPublica's (and NY Times') "Untold" Magnetar Story Creates Excuses for Wall Street and Washington

Charges of fraud against the banks:

WASHINGTON (AP) — The government has accused Goldman Sachs of defrauding investors by failing to disclose conflicts of interest in mortgage investments it sold as the housing market was collapsing.
The Securities and Exchange Commission said in a civil complaint Friday that Goldman failed to disclose that one of its clients helped create — and then bet against — subprime mortgage securities that Goldman (GS) sold to other investors...."
SEC charges Goldman Sachs with fraud in subprime case - USATODAY.com

SEC Charges Goldman Sachs With Fraud in Structuring and Marketing of CDO Tied to Subprime Mortgages; 2010-59; April 16, 2010

WASHINGTON (AP) — Wall Street bank JPMorgan Chase (JPM) has confirmed that federal regulators are investigating whether it allowed a hedge fund to improperly choose assets for a $1.1 billion mortgage securities deal....
SEC investigating role hedge funds played in JPMorgan securities deal - USATODAY.com

Bank: Merrill Committed Same Fraud as SEC Claims Goldman Did - WSJ.com

Ha, just wait, the blood sucking crooks will get a slap on the wrist and time doing "community service." Nothing has changed.

 

[Moot]

Your not looking at the whole trade. The hedge fund purchased only one tranche of an issue, then purchased CDS on the entire issue. I have a similar-in-spirit trade on just now. I own some preferred stocks of a couple of banks. Because those banks were still under a cloud when I bought them, those preferred stocks were yielding 8% - 12% at the time. Simultaneously, I purchased puts on the common stocks of the underlying banks. So, what are the possible outcomes? First, my yield on the preferred stocks is quite high, almost enough to pay for the puts that I purchased, so I'm able to carry the trade at much lesser cost. Second, if the banks financial condition improves sufficiently, my preferred stocks will go up in value, possibly quite a lot. Third, if the banks financial condition deteriorates further, the preferred stocks will hold their value much better than the common due to the preference features of preferred stocks, while simultaneously, my puts will increase dramatically. The trade loses by the underlying stocks remaining essentially unchanged for a long-enough period of time that my puts continue to expire worthless over that period, thereby increasing my cost of maintaining the trade.

This trade is not unique to me; it is well-known and is done all of the time by many, many market participants. It is perhaps best viewed as a kind of straddle: you are positioned to make money if the underlying common goes up a lot, or goes down a lot. You lose money if the underlying continues to trade in a relatively narrow range. The advantage gained by using the preferred instead of put and call options is the lesser carrying cost.

The CDO/CDS trade is merely a variation on this same trade idea.

The difference is you bought and own the preferred stocks in the bank, which means you have some skin aka collateral in the game. The banks were/are shorting sythentic CDO's and betting against their own clients who were buying long. That's akin to "buying fire insurance on your neighbor's house and then commiting arson".

For example, during April 2010 certain Wall Street investment banks and hedge funds were criticized for allegedly creating CDO or synthetic CDO securities designed to favor the short position, without adequately disclosing this to the long investors.[7] The New York Times quoted one expert as saying: “The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen...When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.” One bank spokesman said that synthetic CDO created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market.[2]

Former Federal Reserve Chairman Paul Volcker has argued that banks should not be allowed to trade on their own accounts, essentially separating proprietary trading and financial intermediation entirely in separate firms, as opposed to separate divisions within firms. His recommendation has been called the Volcker Rule. Proprietary trading can be speculative in nature, while pure financial intermediation would typically involve hedging, with the profit to the intermediary based on fees for arranging transactions only.

Economist Paul Krugman wrote in April 2010 that the creation of synthetic CDO should not be allowed: "What we can say is that the final draft of financial reform...should block the creation of 'synthetic CDO’s,' cocktails of credit default swaps that let investors take big bets on assets without actually owning them."[8] Financier George Soros said in June 2009: "CDS are instruments of destruction which ought to be outlawed."[9]

Author Roger Lowenstein wrote in April 2010: "...the collateralized debt obligations...sponsored by most every Wall Street firm...were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house...even when these instruments are used by banks to hedge against potential defaults, they raise a moral hazard. Banks are less likely to scrutinize mortgages and other loans they make if they know they can reduce risk using swaps. The very ease with which derivatives allow each party to 'transfer' risk means that no one party worries as much about its own risk. But, irrespective of who is holding the hot potato when the music stops, the net result is a society with more risk overall." He argued that speculative CDS should be banned and that more capital should be set aside by institutions to support their derivative activity.[10]

Columnist Robert Samuelson wrote in April 2010 that the culture of investment banks has shifted from a focus on the most productive allocation of savings, to a focus on maximizing profit through proprietary trading and arranging casino-like wagers for market participants: "If buyers and sellers can be found, we'll create and trade almost anything, no matter how dubious. Precisely this mind-set justified the packaging of reckless and fraudulent "subprime" mortgages into securities. Hardly anyone examined the worth of the underlying loans."[11

Synthetic CDO - Wikipedia, the free encyclopedia

There's your free market, folks.

 

[oldreliable67]

The difference is you bought and own the preferred stocks in the bank, which means you have some skin aka collateral in the game. The banks were/are shorting sythentic CDO's and betting against their own clients who were buying long. That's akin to "buying fire insurance on your neighbor's house and then commiting arson".

Well, no, it is not. Clients, in their never-ending search for more yield, demanded this stuff. So the street created it for them. Purchasers cannot, ever, abdicate their responsibility for due diligence. The data was, and is out there for all to see and evaluate. As I said previously, if there instances when the dealers deliberately obfuscated any information about a deal, they should be held accountable.

As for a dealer-or any market participant-buying CDS protection on an issue a client holds being wrong, that is patently ridiculous. Every day, around the globe, clients buy stocks while dealers and other market participants initiate and/or hold short positions in those very same stocks. Every day, around the globe, clients purchase bonds of many types of issuers (gov'ts, corp's, etc.), while dealers and other market participants initiate and/or hold short positions in those very same issues. These short positions can be in the form of CDSs, puts, call options sold short, or actual short sales.

As for my personal positions, I didn't have to purchase the preferred stocks. I could have simply purchased the puts alone. Then what happens to your 'skin in the game' argument? In this particular instance, I wanted to purchase them in order to earn the relatively high rate of return in order to mostly fund the purchasing the puts. Moreover, it reduces the overall riskiness of the trade. But the point is, the purchase of the preferreds was not necessary; it was and is not necessary for one to have 'skin in the game' in order to have a viewpoint on the appropriateness of the price level of any asset.

This is not, repeat, not insurance in the traditional sense. 'Insurable interest' is not a concept that transfers to the securities markets. Due diligence and caveat emptor do transfer.

As for your quotes and cites where everybody has an opinion on the Magnetar and other trades, they are mostly self-serving and some are just plain baloney. Of the others, Samuelson has a valid point about the change of culture; Krugman is, IMO, a highly-educated idiot; Volker has it mostly right about proprietary trading but takes it a bit of an extreme "kill-em all and let God sort out the good guys from the bad guys" position.

There's your free market, folks.

Absolutely right. Customers demanded the stuff. The street fulfilled their need. Even 'free markets' need regulation, though. The market for stocks has been regulated since it outgrew the Buttonwood tree. In the mid-1980's until the mid-1990's, I continually espoused the need for derivatives to be more regulated and eventually to come under the auspices of some regulatory agency (at the time, I thought the CFTC was probably the most appropriate) and more important, to have a clearing agency analogous to the commodities clearing corporations. My predictions of ultimate disaster were roundly pooh-poohed and ignored.

Notice that I'm not advocating doing away with the CDS market, a la Paul Krugman, but installing a framework within which market and credit exposures are monitored and easily identified. The single factor most influencing the crisis, IMO, was the lack of timely information re: exposures.