Journalism in the Public Interest

SEC Investigating Yet Another Magnetar CDO

The Securities and Exchange Commission is investigating yet another mortgage securities deal involving the hedge fund Magnetar—this time over a deal with Japanese bank Mizuho, a latecomer to the CDO market and one of its biggest losers, reported the Wall Street Journal.

The Journal notes that the investigation into this collateralized debt obligation, Tigris, may not ultimately result in charges. It’s part of regulators’ wide-ranging probe into the CDO business, which fueled the housing bubble and worsened its eventual collapse. 

Tigris was one of more than two dozen collateralized debt obligations linked to Magnetar. As we detailed last year, Magnetar often pushed for riskier assets to be included in deals and placed bets against many of the same investments. It ultimately helped create more than $40 billion in CDOs. (Magnetar has always maintained that it did not have a strategy to bet against the housing market. The hedge fund has also not been accused of wrongdoing as part of the SEC’s probe.)

Tigris was a bit different. As we reported last year, Tigris was created to tie up some loose ends from Magnetar’s past deals and get troubled assets off its balance sheet: 

In the spring of 2007, Magnetar began to have a problem: The hedge fund was sitting on hundreds of millions of dollars' worth of CDO equity and other low-rated portions of its deals. With the decline of housing prices accelerating, off-loading these pieces would be very hard. 

[Mizuho’s Alex] Rekeda and Magnetar came up with a remarkable CDO. They took their risky portions of 18 CDOs they had helped created -- and repackaged them to sell them to others. Bundling up the dregs of a CDO was rare, if not unprecedented.

This deal, Tigris, which closed in March 2007, tied together $902 million of Magnetar's risky assets. 

The deal was so bad that one rating agency—Moody’s—refused to rate it. Soon after it closed, Tigris was downgraded and went into default. Mizuho wrote it off. Magnetar essentially got rid of its low-rated assets by pledging them to Mizuho in exchange for $450 million, which it got to keep even after the CDO went bust.

We’ve asked Mizuho for comment on the investigation but have not yet heard back.

The SEC has also been investigating a Citigroup CDO deal called Class V Funding III, as we reported last fall. The Journal reports that SEC officials are now in “advanced talks” with Citigroup and are pressing for a settlement of more than $200 million. The $1 billion deal was featured in our story on banks’ self-dealing, or the practice of packaging of hard-to-sell pieces of CDOs in new CDOs in order to keep the lucrative market going.

As we reported, regulators had been scrutinizing the deal, struck in 2007, to determine whether Citi improperly influenced an independent manager to include specific assets in the CDO that were detrimental to the interests of investors.

One notable thing about Class V Funding III was that nearly a quarter of the CDO’s assets were slices of other Citigroup CDOs. In addition to marketing and selling the deal to investors, Citigroup also bet against the deal.

Asked for comment, a bank spokeswoman declined.

Why isn’t the investigation starting at the blocking oversight of Fannie Mae and Freddy Mac or the push in Congress for subsidized housing?

Seriously, it’s Economics 101:  Supply, demand, and price are related.  With a fixed supply and decreased price, demand will shoot up.  If the decreased price isn’t real (because it’s based on unstable credit), you’ll get a bubble and collapse.

Yes, the banks should bear some responsibility.  Yes, the people who borrowed the money should be trying to pay it back.  Yes, the CDO industry is dangerous.  However, if one is trying to investigate the causes of the housing crisis, it’s kind of stupid to not start at the beginning.

This rebundling of some of the most toxic debt and marketing to entities soon to default is clearly a purposeful version of “hot potato”.  You have to consider that the whole thing was a setup with the buyers of the rebundled CDO’s knowing full well that they were bad but making the deal anyway as a favor, or in lieu of future consideration.  This was the entire business model of the financial sector regarding CDO’s.  Sell them back and forth, rebundle, sell again, making money with each transaction and hedge against the inevitable collapse.  It was akin to making money out of thin air.  That was what drove the housing bubble and led to liar loans, variable rate loans and 0 down loans.  It didn’t matter if people could afford to pay back the loan at all.

Since Will brings up the model, it’s worth pointing out that the model was pioneered by Ken Lay at Enron and resulted in California’s energy crisis a few years back.  Enron basically created out-of-state subsidiaries whose sole purpose was to buy fuel from the parent and resell it back at a higher price.

I imagine the discussion was something like, “it’s really hard to run a Ponzi scheme because there’s a limited supply of suckers.  Is there some way of doing it without having investors…?”

And it’s probably not a coincidence that the other big economic story of 2008—Al Gore’s carbon credit exchange—had a certain late, not-so-lamented Mr. Lay as chief architect.

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