How Some Made Millions Betting Against The Market
In 2006 and 2007, several banks and hedge funds realized what was happening to the U.S. economy while it was happening — and then made vast fortunes by betting against the markets.
"Lots of bankers knew that things were in trouble, and they went on — they did it anyway," says ProPublica reporter Jesse Eisenger. "Some of them did it because they could bet against it. Some of them did it because they could make fees by helping clients who were betting against it. And some of them did it just to keep the machine do it and make huge bonuses."
Eisinger and his colleague Jake Bernstein recently received the 2011 Pulitzer Prize for National Reporting for a series of stories about the banks and hedge funds engaged in questionable financial practices that contributed to the near-collapse of the nation's financial system.
On Monday's Fresh Air, Bernstein and Eisinger talk to Dave Davies about their Pulitzer Prize-winning series of stories on Wall Street's short-sighted greed — which counteracted the popular notion that no one foresaw the financial crisis coming.
In 2007, a suburban Chicago hedge fund named Magnetar seemed to outsmart the rest of the financial industry. As the U.S. economy tanked, Bernstein and Eisinger discovered that the hedge fund made a vast fortune by betting against the market.
In 2006 and 2007, Magnetar created and repackaged a series of complicated and risky financial securities — called collateralized debt obligations (CDOs). The securities were made up of subprime mortgage-based bonds bundled with mortgage securities — and banks were more than happy to get rid of them.
At the same time, Magnetar pushed for risky investments to go inside those CDOs. They also secretly placed even larger bets against the CDOs using an instrument called a "credit default swap" — essentially insurance on a corporate loan.
"If it failed, they would make many times what they had put into it," explains Bernstein.
After the housing bubble burst, the pools of loans underneath the CDOs started to default and Magnetar began to profit. Bernstein and Eisinger reported that many of the bankers who worked on the securities deals at Magnetar pocked millions of dollars in bonuses. And the firm did "spectacularly well."
"[Their main fund was] up 76 percent in 2006," says Bernstein. "Their main fund made hundreds of thousands of dollars on this. But quantifying exactly how much they made is very hard to do because hedge funds are fairly opaque and they don't have to report great detail about their performance."
At least nine banks helped Magnetar with their deals, including Merrill Lynch, Citibank, UBS and JPMorgan Chase. By propping up the CDOs, says Bernstein, the banks and Magnetar helped prolong the financial crisis by masking a problem with the risky investments.
"The incredible damage to the economy, in large degree, was because it went on for several more years than it should have and Wall Street really just inflated the heck out of it," he says. "So Magentar had a big role in that."
Bernstein and Eisinger had extensive conversations with Magnetar and have published all of their written correspondence on the ProPublica website.
"From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at that time," they wrote last April. " 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."
Creating Fake Demand
Bernstein and Eisinger also discovered that Wall Street banks created fake demand for CDOs in order to preserve their quarterly earnings and executive bonuses.
"What we found was that the banks were orchestrating sales [and] swapping sales [with other banks,] says Bernstein. "They were doing 'You buy mine and I buy yours' type of deals. They were essentially having this kind of daisy chain of demand."
Though there weren't real buyers, the banks could profit by keeping the artificial demand for CDOs up — because each bank received fees for orchestrating purchases of the CDOs.
"A typical CDO could net the bank that created it between $5 and $10 million — about half of which usually ended up as employee bonuses," wrote Bernstein and Edelstein. "But the strategy of speeding up the assembly line had devastating consequences for homeowners, the banks themselves and, ultimately, the global economy."
Eisinger explains that the entire business model was "extraordinarily fake."
"It was based on demand that wasn't there and promises that couldn't be kept," he says. "So when we came out of meetings [and we were] starting to get glimmers of understanding about this — that this business that had been worth supposedly hundreds of billions of dollars was really on a edifice of tissue — we were astonished. It was scary. But there were all deals that largely had no substance behind them."
Jesse Eisinger is a veteran business reporter who wrote for The Wall Street Journal. He is also the former Wall Street editor of the Conde Nast Portfolio. Jake Bernstein is a former writer and executive editor for the investigative bi-weekly, The Texas Observer.
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