Saturday, October 9, 2010

OF COURSE, They Knew All Along: Banks’ Self-Dealing Super-Charged Financial Crisis - Will We Ever "Break the Banks?" Truth About Magnetar

Will We Ever "Break the Banks?" Ha! Doubtful. We can't even prosecute lawbreakers. They only get asked for minimal fines as penance for breaking YOU (US)! The oddest national occurrence is that now that we know the extent of the fraudulent behavior at the top and how they changed the laws specifically to benefit themselves, that no criminal proceedings occur still. Anywhere. From (of all sources now . . .) Newsweek (trying to rehabilitate its past image?). (Emphasis marks added - Ed).

As an adult, however, my love of the legal system - a child’s dream of truth and fairness - grew more complicated, gnarled by the understanding that justice isn’t meted out equally after all, especially if you’re an investment banker. My first inkling of this came as a doctoral student at MIT in the 1980s. I learned that large corporations outspend the government by as much as 100 to 1 in their efforts to shake charges, and many of my professors made millions as expert witnesses for the defense. Later, as a software entrepreneur, I watched as dozens of dotcoms went public, their stock prices inflated by the investment banks that helped them get there. Investors lost everything in the ensuing crash. But the big Wall Street firms escaped criminal prosecution, and the fines they paid were a tiny fraction of their profits. This pattern - fines, but not prosecutions - has become the norm for offenses that would land ordinary people in jail. For example, earlier this year an Iranian-born U.S. citizen was convicted of operating an illegal money-transfer process, violating trade sanctions by sending $3 million to people and firms in his home country without proper documentation. He got a two-and-a-half-year sentence. Also this year, however, Barclays settled charges that it had processed transactions between banks in Iran, among other sanctioned countries, and U.S. entities. The bank signed a “deferred prosecution agreement,” meaning it “acknowledges responsibility for its conduct,” but the charges will be dismissed after a period of good behavior. It merely paid fines. Since January 2009, two other banks have settled similar criminal charges through fines. Nobody has been arrested. CEOs Behaving Badly During the last two decades, major U.S. and European banks have paid fines to settle charges of, among other things, accounting fraud (Fannie Mae, Freddie Mac), assisting Enron’s fraud (Citigroup, J.P. Morgan), assisting people in tax evasion (UBS), using bribery to sell financial products (J.P. Morgan), money laundering (Citicorp), and fraudulently recommending stocks in exchange for business (10 investment banks in the dotcom era). In paying the fines, none of these banks acknowledged wrongdoing.

Now we’re witnessing another round of this shameful routine. President Obama and Attorney General Eric Holder Jr. have said they would hold Wall Street accountable for the crash, warning “unscrupulous executives,” in Holder’s words, that “we will investigate you, we will prosecute you, and we will incarcerate you.”

But despite fraud on a scale possibly unmatched in history, the Justice Department has not charged a single executive or firm. The Securities and Exchange Commission, meanwhile, has extracted only fines from a handful of big banks. Three of the federal judges who oversaw these cases - none of which included an acknowledgment of guilt - protested from the bench, saying the fines are “not enough to deter anyone from doing anything,” the justice is “half baked at best,” and the banks are getting “a free ride.” (Holder has defended his financial-fraud task force, stressing “the totality” of its efforts, including cases against mortgage fraud and insider trading; SEC chairwoman Mary Schapiro has noted that the bulk of its investigations are “not necessarily” done.)

Banks’ Self-Dealing Super-Charged Financial Crisis "They Created False Demand" Over the last two years of the housing bubble, Wall Street bankers perpetrated one of the greatest episodes of self-dealing in financial history.

Faced with increasing difficulty in selling the mortgage-backed securities that had been among their most lucrative products, the banks hit on a solution that preserved their quarterly earnings and huge bonuses:

They created fake demand.

A ProPublica analysis shows for the first time the extent to which banks - primarily Merrill Lynch, but also Citigroup, UBS and others - bought their own products and cranked up an assembly line that otherwise should have flagged. The products they were buying and selling were at the heart of the 2008 meltdown - collections of mortgage bonds known as collateralized debt obligations, or CDOs.

As the housing boom began to slow in mid-2006, investors became skittish about the riskier parts of those investments. So the banks created - and ultimately provided most of the money for - new CDOs. Those new CDOs bought the hard-to-sell pieces of the original CDOs. The result was a daisy chain that solved one problem but created another: Each new CDO had its own risky pieces. Banks created yet other CDOs to buy those.

Individual instances of these questionable trades have been reported before, but ProPublica's investigation, done in partnership with NPR's Planet Money, shows that by late 2006 they became a common industry practice.

An analysis by research firm Thetica Systems, commissioned by ProPublica, shows that in the last years of the boom, CDOs had become the dominant purchaser of key, risky parts of other CDOs, largely replacing real investors like pension funds.

By 2007, 67 percent of those slices were bought by other CDOs, up from 36 percent just three years earlier. The banks often orchestrated these purchases. In the last two years of the boom, nearly half of all CDOs sponsored by market leader Merrill Lynch bought significant portions of other Merrill CDOs.

ProPublica also found 85 instances during 2006 and 2007 in which two CDOs bought pieces of each other's unsold inventory. These trades, which involved $107 billion worth of CDOs, underscore the extent to which the market lacked real buyers. Often the CDOs that swapped purchases closed within days of each other, the analysis shows.

There were supposed to be protections against this sort of abuse. While banks provided the blueprint for the CDOs and marketed them, they typically selected independent managers who chose the specific bonds to go inside them. The managers had a legal obligation to do what was best for the CDO. They were paid by the CDO, not the bank, and were supposed to serve as a bulwark against self-dealing by the banks, which had the fullest understanding of the complex and lightly regulated mortgage bonds.

It rarely worked out that way. The managers were beholden to the banks that sent them the business. On a billion-dollar deal, managers could earn a million dollars in fees, with little risk. Some small firms did several billion dollars of CDOs in a matter of months.

"All these banks for years were spawning trading partners," says a former executive from Financial Guaranty Insurance Company, a major insurer of the CDO market. "You don't have a trading partner? Create one."

From Foreclosure:

The core issue for the economy is the continued cost of a housing bubble made possible only after what Clinton Treasury Secretary Lawrence Summers back then trumpeted as necessary “legal certainty” was provided to derivative packages made up of suspect Alt-A and subprime mortgages. It was the Commodity Futures Modernization Act, which Senate Republican Phil Gramm drafted and which Clinton signed into law, that made legal the trafficking in packages of dubious home mortgages. In any decent society the creation of such untenable mortgages and the securitization of risk irrationally associated with it would have been judged a criminal scam. But no such judgment was possible because thanks to Wall Street’s sway under Clinton and Bush the bankers got to rewrite the laws to sanction their treachery.

It is Obama’s continued deference to the sensibilities of the financiers and his relative indifference to the suffering of ordinary people that threaten his legacy, not to mention the nation’s economic well-being. There have been more than 300,000 foreclosure filings every single month that Obama has been president, and as The New York Times editorialized, "Unfortunately, there is no evidence that the Obama administration’s efforts to address the foreclosure problem will make an appreciable dent."

The ugly reality that only 398,198 mortgages have been modified to make the payments more reasonable can be traced to the program being based on the hope that the banks would do the right thing. While Obama continued the Bush practice of showering the banks with bailout money, he did not demand a moratorium on foreclosures or call for increasing the power of bankruptcy courts to force the banks, which created the problem, to now help distressed homeowners. ...foreclosures are behind Tuesday’s news that U.S. home sales reached their lowest point in 15 years and that there is unlikely to be an economic recovery without a dramatic turnabout in the housing market. The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going Inside Job: Bet Against The American Dream! In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.

At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund [1] helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages. When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers.

Yet the hedge fund, named Magnetar for the super-magnetic field created by the last moments of a dying star, earned outsized returns in the year the financial crisis began.

How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade [3]. Nearly all of those approached by ProPublica declined to talk on the record, fearing their careers would be hurt if they spoke publicly. But interviews with participants, e-mails [4], thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street.

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations - CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

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 [5] it never selected the assets that went into its CDOs.

Magnetar says [6] it was "market neutral," meaning it would make money whether housing rose or fell. (Read their full statement. [7]) Dozens of Wall Street professionals, including many who had direct dealings with Magnetar, are skeptical of that assertion. They understood the Magnetar Trade as a bet against the subprime mortgage securities market. Why else, they ask, would a hedge fund sponsor tens of billions of dollars of new CDOs at a time of rising uncertainty about housing?

Key details of the Magnetar Trade remain shrouded in secrecy and the fund declined to respond to most of our questions. Magnetar invested in 30 CDOs from the spring of 2006 to the summer of 2007, though it declined [8] to name them. ProPublica has identified 26 [9].

An independent analysis [10] commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs. The study [10] was conducted by PF2 Securities Evaluations, a CDO valuation firm. (Magnetar says defaults don't necessarily indicate the quality of the underlying CDO assets.)

From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn't cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom. At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses [9], the banks didn't disclose to CDO investors the role Magnetar played.

Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.

Some bankers involved in the Magnetar Trade now regret what they did. We showed one of the many people fired as a result of the CDO collapse a list of unusually risky mortgage bonds included in a Magnetar deal he had worked on. The deal was a disaster. He shook his head at being reminded of the details and said: "After looking at this, I deserved to lose my job."

Magnetar wasn't the only market player to come up with clever ways to bet against housing. Many articles and books, including a bestseller by Michael Lewis [11], have recounted how a few investors saw trouble coming and bet big. Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.

Magnetar's approach had the opposite effect - by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn't alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, "Econned," [12] that "Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder."

Please read the whole essay. If you have the time and fortitude. Suzan ________________

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