How to Short The US Housing Market and Throw an Economy Into a Recession

I’ve been writing a bit over at Housingwatch about the recent news surrounding reasons behind housing market crash, viewed through the 20/20 lenses we all posses. The good folks at AOL like to keep posts around 500 words to keep things tight and to the point. So, I’ll bring some of the words I couldn’t say over there, over here.

You can’t make this stuff up:

Magnetar Capital, a Chicago based hedge fund, went into business in 2005 at about the time that Sub-Prime mortgages were recognized as being ‘toxic’ in the sense that they don’t perform, as in- Homeowners don’t make their payments and investors don’t get paid. Nonetheless, they started buying up these toxic loans (through various conduits) and bundling them up in Collateralized Debt Obligations (CDO’s), creating huge demand and liquidity for dogshit mortgages to put people in.

All Magnetar CDO’s contained the worst kind of mortgages…the No Income No Asset, No Job, Low FICO, short term ARM variety located in states with the highest appreciation mortgages…the mortgages that default like the consumers they gave them to had no income or jobs with a poor track record of paying debts back.

Magnetar subsequently bought Credit Default Swaps (CDS’s) or insurance policies against the dogshit CDO’s (they created) just in case they defaulted. CDS’s cost money in the form of premiums, just like you pay on your car insurance. Magnetar used the higher yields from the CDO’s they created to pay the CDS insurance premiums…until the CDO’s defaulted that is…then they collected the insurance policies payout. These insurance policies paid out far more to the hedge fund than any loss they would incur if, err, when the CDO defaulted.

This became known as ‘The Magnetar Trade’ as is being pegged as the primary reason the US Housing market crashed so hard and pulled the world economy down with it.

For review: The Magnetar Trade strategy was to fuel the marketplace by purchasing dogshit mortgage securities (creating liquidity and loans) bundle them up into CDO’s, sell them to investors as AAA rated then bet Big Money on the fact the CDO would default, and collect said Big Money when they did. It was simple, elegant even, and legal.

Almost every major institution on Wall Street played this game, executing ‘Magnetar Trades’…Merrill Lynch, JP Morgan, Lehman Brothers even the Streets most prestigious firm: Goldman Sachs. John Paulson of Paulson and Co. (near future scapegoat/pariah) created the Abacus Fund for Goldman. Abacus was architected after the Magnetar blueprint.

Recently the SEC decided to bring a lawsuit against Goldman Sachs alleging fraud around the Paulson created Abacus hoo-ha. The core of the suit alleges Goldman deceived and sold investors on a security that Paulson helped design to fail, and made a bunch of money because of it.

Regardless of lawsuits and agendas, there is no getting around the fact that these sort of ‘investment strategies’ by ‘Wall Street’ negatively effected millions of homeowners…fuck the investors and investment banks. It’s not hard to draw a pretty straight line between Wall Street greed and the implosion of the US Housing market.

I don’t think the lawsuit sticks but it raises an incredible amount of awareness in the public arena around a sophisticated and sinister Wall Street play that negatively effected millions of homeowners. That’s great for pushing an agenda, especially a political one as the timing of all this is obviously politically motivated…but this isn’t a political post- I pro-actively filibuster myself from political arguments so this doesn’t turn into a 3000 word circular argument.

Consumers were unwitting pawns subsidizing this game of sophisticated capitalism…that’s whats going to be played out in the press on on TV. So, will a public growing more weary by the day of Big Government side favorably with Big Government having its way with Wall Street?

Thomas A B Johnson

Government is calling Wall Street a whore while paying for her apartment, and coming by for a little sample just for stress relief.

jeff corbett

Nice!

Notorious R.O.B.

The strength of 7DS, I think, is in our diversity of opinion among other things. In this case, Jeff, I think you're missing some important critical pieces of data. As such, your last paragraph couldn't be more wrong.

To start, the primary "victim" in the Goldman situation was a yield junkie German investment fund. In fact, it was so bad that the fund fired the guy responsible for most of the buying, and yet kept on doing it. From the article:

IKB would approach banks with a request for a specially tailored CDO that matched their investment strategy of seeking out exposure to the riskiest bonds, because these came with the highest yields. And according to bank staffers involved in these transactions, which included not only Goldman but its German rival Deutsche Bank, they paid tens of millions of dollars in fees to get into these deals.

Now, the investors in IKB probably got screwed, but it seems a real stretch to say that these guys were somehow duped into buying subprime paper. They were actively looking for the worst pieces of crap you could get in hopes of generating yield.

The article makes clear that IKB was a very sophisticated investor: "They had a big research team of 20 guys and would inspect the asset quality outside of what any rater was saying about the bond." These guys knew the risks and took them, in search of returns.

I hardly call IKB or its investors "unwitting pawns". Nor do I call what Goldman did "sinister and sophisticated" manipulation.

Now, if the argument is that IKB's investors were comprised of pension funds and mutual funds and so on whose beneficiaries are unwitting consumers... okay... but that's why IKB and mutual funds and pension funds and professional managers, right? If those guys didn't do their job of protecting the investor... why are we blaming Goldman Sachs or "Wall Street" for delivering to clients (like IKB) precisely what they want: crappy subprime paper?

Having delivered such crappy subprime paper to yield junkies, are we blaming Goldman or others for having bought CDS on such crappy paper?

-rsh

jeff corbett

In the Goldman situation you are correct, IKB was the 'Primary victim', albeit a sophisticated outfit that 'shoulda know better' who was buying into these CDO's for different reasons:

"They would borrow short term debt on the commercial paper market in order to fund their purchases of mortgage bonds and CDOs. The difference between the costs of borrowing and the yield on the investment assets was the source of their profits. The assets of the conduits served as collateral for the short-term loans, which meant lenders to Rhineland and Rhinebridge would be entitled to their assets if they couldn't make good on their debt."

IKB knew what they were getting into, so I wouldn't classify them as a victim...

Goldmans Abacus fund (based on the Magnetar blueprint) was but one of many and the trickle down effect, affected many more down stream, all the way to main street.

So, on the black and white issue of 'Did Goldman do anything illegal'? No, likely not- For the reasons you outline. They were just putting together securities, and engaging in tried and true practices of high risk, high yield, hedge your bet strategies...use the high yields to pay the high insurance premiums until the security defaulted, then really cash in.

Where the sinister (unethical?) part comes in, is that these funds enabled, created if you will, a market for dogshit mortgages that inflated the bubble...When it finally did pop, it was magnitudes larger than it could have been.

Should consumers been more careful about getting into mortgages that they couldn't afford? Yes. But it was a 'Great time to buy'!?!

These funds shorted the housing market. Absolutely brilliant Wall Street strategy...that isn't likely to be seen that way on main street.

Notorious R.O.B.

I don't disagree that main street won't see things the same way. After all, there were periods when Congress (and Main Street) agitated to prevent short sales of equities, period.

That doesn't mean they're right.

The part I don't quite get is why you think these funds enabled a market for dogshit mortgages. If the demand isn't there, the product would fail. The trouble, it seems to me, was with yield-chasing institutions who needed to take greater risks in order to generate the kinds of returns they were promising investors.

The real problem for me is that these funds, once they failed because risk caught up with them, go around asking for government handouts and bailouts. And our masters in Washington, at the Fed, at the SEC, at the Treasury bail them out and make arguments about "collapse of the financial system". That's had a greater impact on Main Street than any Wall St. machination.

Your point is well-taken, that these geniuses on Wall St. created some products that are the finance equivalent of porn. Sure, they're legal, and even "ethical" in some cases, but I wouldn't want my Mom to know that's how I make a living.

-rsh

jeff corbett

Looks like its you and me at the water cooler :)

Funny you should mention the prevention of short sales. The uptick rule was removed in 2007 and reinstated in 2009...but thats another topic for another time.

"The part I don't quite get is why you think these funds enabled a market for dogshit mortgages. If the demand isn't there, the product would fail. The trouble, it seems to me, was with yield-chasing institutions who needed to take greater risks in order to generate the kinds of returns they were promising investors."

1. Timing. By 2005 the first round of Sub-Prime mortgages had completed their fixed periods and were coming out dirty. Magnetar Capital and their elegant fund strategy began in 2005. This was about the time when mortgage conduits began rolling out very niche-y Sub-Prime mortgages with huge incentives...like no verification of mortgage/rent required, rolling 30-60-90 day lates = still qualified, 1 day out of Bankruptcy, 'stated wage earner' type of dogshit...effective rewriting the initial Sub-Prime crowd (and ushering in a new heard) into a new, extra toxic tranche of mortgages. 2 year ARMS with 3 year pre-payment penalties were sooo 2003.

2. The product did fail- Again. Only this time some well adjusted hedge funds did it right and banked on the losses they knew were coming. They needed even higher risk securities with the accompanying yields to pay investors (for a little while) and the premiums for the short. Instead of allowing the market to self-correct, these funds inflated the bubble further by fueling the market with this type of credit...demand from consumers, mortgage and real estate professionals never waned one bit. This was finance porn, an orgy of sorts, and more people paid to play and/or watch than will ever admit.

Demand on Wall Street is no longer there because 'all markets are cyclical' or something like that...the lights got turned on, the party's over to the point of qualifying for a mortgage today is the antithesis of 2005. People and property who are well qualified are being turned down because there is no appetite for a simple low yield annuity in an emotionally unstable market where the underlying assets are still probably overvalued. There are bigger dollars to be made elsewhere...On to the next one.

In the words of Def Leppard- It was better to burn out than fade away...

Trace

The solution is clear: when investing, if you see use of "dogshit" in the instrument description or prospectus, steer clear!