Tuesday, April 13, 2010

Must Read
Here is a link to an incredible article about the financial crisis.  It details how one hedge fund helped prolong the credit boom.  Cracks in the system began to show in 2005 when spreads on securitized loans (CDOs) began to expand, as Wall Street became nervous about the quality of the securitized offerings.  In stepped a new hedge fund, Magnetar, which aggressively sought the riskiest pieces of new CDOs called the "equity" tranche.  Magnetar's willingness to acquire the small portion of equity, in the range of $10 million, and typically the hardest part of a CDO to sell, allowed investment banks to create CDOs in the range of $1.5 billion or more.  Magnetar even had a hand in developing the CDOs, picking actual securities that would comprise a CDO's holdings.  Magnetar wanted the riskiest loans available in the CDOs where it bought the equity.  While Magnetar was buying the equity and loading up the CDOs with as much risk as possible,  it was also buying credit default swaps, betting that its CDOs would default.  Defaults was where it made huge profits, more than offsetting the loss of the equity portion.  At one point, Magnetar was even able to package and sell some of its CDO equity portions.

Magnetar's willingness to buy high risk CDO equity sparked a resurgence in the CDO market, and therefore mortgage lending, leading to record underwriting of CDOs in 2006 and into 2007, until the whole market collapsed in the summer of 2007.  Magnetar posted huge profits in 2007 as its bets against its CDOs paid off.  This article debunks the thought that no one saw the credit crisis coming.  As early as 2005 the warning signs were apparent, but the availability of money, especially equity, caused investment banks to overlook the obvious.

No comments: