Felix Salmon

Well done to CalPERS for responding forcefully to a rather silly Stanford policy brief which gets very alarmist about California’s pension liabilities. There are so many enormous and immediate fiscal problems facing California right now that it seems utterly pointless to put out a paper saying that the state should inject $200 billion into its pension funds — especially when the logic of the paper is as confused as this:

The CalPERS portfolio has had returns averaging 7.91 percent over the last 25 years, with a standard deviation of 11.91 percent. As expected, the high standard deviation means that 68 percent of the time, returns range from –4.0 percent to 19.82 per­ cent. Historically, if CalPERS had simply invested in investment­ grade corporate bonds, the fund could have earned 7.25 percent, only .66 percent less than it has earned with its highly volatile portfolio. This small reduction in earnings would have allowed CalPERS to reduce volatility by a full 7.68 percentage points.

Therefore, in order to avoid future severe underfunded scenarios, we recommend that CalPERS, CalSTRS, and UCRS allocate more of their investment portfolios to fixed income asset classes, thereby reducing risk with a minimal loss of long term investment performance.

I’m not entirely sure where to start on this, but are the Stanford wonks really unaware that the rate of return on fixed-income investments over the past 25 years is largely a function of the fact that interest rates have been declining steadily over that time? And that now they’ve reached zero, they can’t really continue to do so for the next 25 years?

On top of that, the Stanford types seem to think that it makes sense to use a risk-free discount rate to calculate pension-plan liabilities, while even they admit that the assets shouldn’t be invested in a risk-free manner.

I do like the way that the Stanford paper tries to look at the probability of a shortfall of various magnitudes, rather than simply boiling things down to one number. But I’m not convinced by the methodology it uses to arrive at those probabilities, or by the way that the paper ignores all the political realities surrounding pension contributions and payouts.

The fact is that a defined-benefit pension scheme is always going to run the risk that it won’t be able to meet its liabilities as they come due. The California pension plans constitute an attempt to save hundreds of billions of dollars to pay for the pensions of the state’s workers; the attempt might succeed, or it might not.

But right now there are clearly more important and urgent things to do with California’s tax revenues than throw them into a pension pot to support the retirees of the 2040s and beyond. CalPERS might not be perfect, but it’s a lot less dysfunctional than most of the rest of the state government. Let’s get our priorities straight here.

Nina Munk on Peter Gelb. Didja know that Met chorus members make $175k + hugely generous benefits? — VF

UK vulture-fund act becomes law — Reuters

Why Businesses Don’t Experiment — Ariely

Statement on the support to Greece by Euro area Members States — Europa

“People with mortgages are still renters, it’s just they rent the money to buy the house instead of the house itself.” — Comment from davejones

Steven Johnson in Ben Stein’s old Everybody’s Business spot. A vaster improvement cannot be imagined — NYT

Why Was the Polish President In a Soviet Plane? — Economist

10 Ways To Earn More Than You Can Working At The Columbia Journalism Review — Hunter Walker

Andrew Ross picks up on this anecdote from Roger Lowenstein’s new book:

The problem of executive pay did not admit to an easy fix. Well into the crisis period, when banks such as Citigroup were operating on federal investment and when Citi’s stock was in single digits, Vikram Pandit, the CEO, was observed with a lunch guest at Le Bernardin, one of the top-rated restaurants in New York. Pandit looked discerningly at the wine list, saw nothing by the glass that appealed, and ordered a $350 bottle so that, as he explained, he could savor “a glass of wine worth drinking.” Pandit drank just one glass; his friend had none.

I have to say I have a grudging admiration for Pandit here. For one thing, this story doesn’t really speak to the issue of executive pay: Pandit made his real money not as an executive but as a part-owner of Old Lane, which got bought by Citigroup for a vastly overinflated sum. Yes, Old Lane was bought largely for the purpose of bringing Pandit into the Citi fold, but that kind of thing is very hard to consider “executive pay”.

What’s more, I’m sure the rest of the bottle hardly went to waste: most likely it was either drunk by the staff or sold off by the glass to people who were very happy to see such a high-end wine available by the glass.

And more generally, you don’t need to be worth tens of millions of dollars to pull a stunt like this. You just need to like good wine with good food, and to decide that in this particular restaurant on this particular day, a good glass of wine is worth more to you than $350. I can think of people I know earning six-figure salaries (as opposed to seven or eight figures) who are definitely capable of doing this kind of thing.

Of course, it’s also possible that Pandit put the meal on expenses. And you can see the logic: if a $350 bottle of wine would be an acceptable expense normally, it’s silly to polish the bottle off solely to justify the expense of ordering it. The main benefit of ordering a great bottle of wine is to taste the wine inside it; by the time you reach the sixth glass, you’ve already got that benefit, and at that point you’re mainly just getting drunker.

None of which stops the fact that the optics here are terrible. Pandit doesn’t behave this way in public any more, I’m sure — he’s super-alert to any signs of conspicuous consumption at this point. But I wouldn’t be surprised to learn that, in the privacy of his own home, he occasionally does exactly the same thing, and opens up a spectacular bottle only to drink a single glass. It’s a pretty modest vice, by contemporary standards of plutocratic excess.

One of the more thought-provoking bits of the Shleifer paper on financial innovation is this part of the model:

Optimism about the profitability of the new claim at t = 0 encourages the intermediary to over-invest in an unproductive activity, eventually triggering a loss… Investment in A occurs only if new securities can be engineered, so financial innovation bears sole responsibility for unproductive investment. It can be argued that the expansion in the supply of housing in the last decade was an example of such inefficient investment needed to meet the growing demand for securitization of mortgages.

To put it another way, it was the excessive and irrational demand for collateralized debt obligations which caused all those Miami condos and Phoenix tract homes to be built in the first place.

That makes sense to me, but it raises an interesting question about the damage caused by synthetic CDOs. Here’s Jesse Eisinger and Jake Bernstein, from their investigation of Magnetar:

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,” 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.”

Certainly the banks and investors who ended up on the long side of the synthetic CDO trade ended up losing lots of money to people like Magnetar and John Paulson who were on the short side of the trade. But in some ways the Magnetar-driven boom in synthetic CDOs was actually preferable to the boom in RMBS-based non-synthetic CDOs which preceded it.

Think about it this way: both CDOs and synthetic CDOs resulted in losses for investors on the long side. But In the world of CDOs, demand for paper ended up creating a disastrous building boom which diverted resources from more productive activity, skewed local tax revenues, and created the precondition for the wave of foreclosures which is likely to continue for the foreseeable future.

In the world of synthetic CDOs, by contrast, demand for paper just ended up making a bunch of shorts extremely rich: all the other real-world repercussions of the CDO market were actually avoided.

I’m not saying that the world of synthetic CDOs was a good thing. In fact, I’ve explained why I think that it was harmful. But the point that investors started moving from CDOs to synthetic CDOs marked the point at which the housing bubble stopped growing: the move played a significant role in ending the real-world housing insanity. If banks could create synthetic CDOs out of thin air, they no longer needed to encourage subprime originators in the Inland Empire to give $600,000 mortgages to itinerant strawberry pickers, just to keep their channels full.

When talking about credit default swaps, the material out of which synthetic CDOs are made, people often get very upset that you can have more CDS outstanding on a certain name than there is of the underlying instrument. But just think how much better off we would be if the amount of real-money subprime lending had never boomed at all, and if all the financial speculation on subprime mortgages had been confined to synthetic CDOs, all of which referenced a relatively small handful of subprime deals. We wouldn’t have had nearly as much of a housing boom, we wouldn’t be stuck with crumbling suburbs, we wouldn’t have a foreclosure crisis, and we would have invested our money in much more productive things than real estate for most of the last decade.

Of course, it would have been much harder to find people like John Paulson to take the short side of those trades: you needed a bubble to attract the hedge funds who fueled the synthetic CDO boom. But I still think it’s reasonable to consider synthetic CDOs to be less harmful, at the margin, than their real-money counterparts.

All that said, synthetic CDOs did make it much easier for banks, in particular, to take on enormous amounts of highly-leveraged exposure to the subprime market, by holding on to unfunded super-senior tranches. That was a particular problem in the case of Citigroup. When the likes of Citi and Merrill Lynch got out of the moving business and started going into the storage business, they were creating a lot of systemic risk where none had previously existed — and the rise of synthetic CDOs made it much easier for them to do so. As I say, synthetic CDOs were indeed harmful. But were they more harmful than normal CDOs? I’m far from convinced.

Nicola Gennaioli, Andrei Shleifer, and Robert Vishny have a great new paper out entitled “Financial Innovation and Financial Fragility”.* It doesn’t break a lot of new conceptual ground, but it’s very thought-provoking, and it helps to codify in a formal way the serious problems with financial innovation. Their conclusion is spot-on, I think:

Recent policy proposals, while desirable in terms of their intent to control leverage and fire sales, do not go nearly far enough. It is not just the leverage, but the scale of financial innovation and of creation of new claims itself, that might require regulatory attention.

The idea here is that financial innovation is, by its nature, inherently and predictably dangerous. If something’s innovative, it’s new. And if something’s new, it’s untested. Meanwhile, a very large part of what we consider “financial innovation” consists of “improving” on existing securities, usually by creating a source of new supply for in-demand securities while also providing some kind of pick-up in yield.

Eventually, a test comes along: the world behaves in a way that no one had expected, and the new securities prove to be less attractive than the traditional securities they replaced. When that happens, demand for them plunges, their price falls dramatically, and enormous losses ensue. This narrative has been played out many times — look at CMOs and junk bonds in the 1980s, or CDOs and money-market accounts more recently. Or look back on eight centuries of financial folly, for that matter.

In order to make the model in this paper work, you just need to make a couple of very reasonable assumptions. First of all, there’s the assumption that investors aren’t perfectly rational; instead, they use what’s known as “local thinking”, and don’t consider every possible eventuality when buying securities. Secondly, there’s the assumption (which isn’t even necessary, it just makes the results stronger) that investors prefer safety over risk. The authors dryly note that it would be possible to model such an assumption by considering “investors who have lexicographic preferences with respect to particular characteristics of investments (e.g., AAA ratings)”. Quite.

The results are predictable. First, you get far too many of the new securities:

When some risks are neglected, securities are over-issued relative to what would be possible under rational expectations. The reason is that neglected risks need not be laid off on intermediaries or other parties when manufacturing new securities. Investors thus end up bearing risk without recognizing that they are doing so.

And second, you get a spike in tail risk:

Markets in new securities are fragile. A small piece of data that brings to investors’ minds the previously unattended risks catches them by surprise, causes them to drastically revise their valuations of new securities, and to sell them in the market. The problem is more severe precisely because new securities have been over-issued.

Finally, if you add leverage to this toxic mix, that only serves to make everything a great deal worse.

More generally, a lot of what’s going on here is that banks are creating “private money”, and that while economists have generally considered that to be a good thing, “security issuance can be excessive and lead to fragility and welfare losses, even in the absence of leverage and fire sales”. Private money, it turns out, is a bit like public money, but not nearly as robust: think of it as a hundred-dollar bill which, unbeknownst to the holder, can occasionally simply self-destruct.

There’s implicit support in this paper for government attempts to intervene in the market during a crisis: under the model, it’s entirely possible that “investors’ valuation of the claim is low not because it is unappealing per se, but because it is not the claim they wanted to hold”. In that situation, intermediaries — banks — can step in to arbitrage the difference, but they often don’t have nearly enough money to do so. If the government steps in with extra liquidity to buy up the now-undervalued securities, that can help to avert a systemic meltdown.

Left to its own devices, a market with financial innovations is very likely to end up harming investors, while still making lots of money for the innovators:

In our model, innovation benefits intermediaries who earn large profits selling securities, but hurts investors, who are lured into an inefficient risk allocation and suffer from ex-post price drops… Investors’ losses from risk misallocation may be so large as to eliminate the social value of innovation altogether.

Realistically, I see very little chance that any financial regulatory reform will do anything to prevent or even slow down the pace of financial innovation. But maybe, if enough investors read and fully grok papers like this, they’ll learn to stay away from securities they don’t fully understand, or which are so new as to be untested in the real world. But I’m not holding my breath.

*Yes, I read this paper the journalistic way, ignoring the mathematics. But dude, it’s Andrei Shleifer. Surely we can trust his math.

(HT: guan)

Update: The paper also sparks some counterintuitive ideas about the utility of synthetic CDOs.

Update 2: Glenn Yago, author of a new book on the wonders of financial innovation, makes a couple of good points in the comments. The model, he says, is “unable to distinguish between the good, bad and ugly of financial innovation” — which is true. He also suggests that there are fundamental reasons why CLOs haven’t performed nearly as badly as CDOs, which is probably also true, with hindsight, although I’m not sure that the structures are so different that the outperformance would have been particularly predictable ex ante. Not all financial innovations blow up in every crisis, after all, but financial innovations do blow up. Glenn goes on to use credit ratings in support of his argument, which is kinda funny, I think.

Fundamentally, Glenn seems to be saying that if you “consider capital structure, overleverage, and impacts of regulatory arbitrage”, then you’ll somehow be able to weed out the bad financial innovations, and leave yourself with only the good ones. I’d be more willing to believe him if he didn’t go on to laud the wonders of leveraged loans, which are definitely more leveraged than the super-senior tranches of synthetic CDOs.

Pay for the FT with Foursquare points! — TBI

I tried the 3D burrito, but it gave me a headache — YouTube

“Chairman/CEO Russell Gerdin’s base salary in 2009 was $300,000. Once you add in all his stock awards, options, 2009 bonus, non-equity incentive plan, perks, gross-ups, and “All Other Compensation” his salary swelled to… $300,000.” — Footnoted

The continued influence of Bob Rubin — Politico

Labton moves from NYT to Squidville — NYO

John Hempton of Bronte Capital sent me a pushback note in response to my post on Greece this morning:

I do not understand. If you are going to default (and Greece is) you get all the credit rating stuff up etc – all the pain of default.

Why not try to maximize the benefits by defaulting REALLY PROPERLY. That is actually doing an Argentina. You stuff your credit rating anyway. Nobody will lend to you.

Promise not to pay ANYTHING back – maybe 10c in the dollar and then keep that promise to rebuild your rating.

Its like when you lose the house you might as well live in it for six months free before they kick you out. No point defaulting by halves.

Flatly I think you are wrong. Argentina is the right word as far as capital markets are concerned.

He’s in good company: Peter Boone and Simon Johnson actually think that Greece is in worse shape than Argentina was pre-default.

Greece is far more indebted, is much less competitive in global markets, and needs a commensurately greater fiscal and wage adjustment…

The odds, for Greece, are slim. It is impossible to say exactly what the odds are, but suffice it to say, Greece’s external debt and current fiscal difficulties, while tied into a fixed exchange rate regime, mean that nation needs far harsher adjustments than any of the sovereign major defaulters of the last 50 years. We cannot think of one comparable example of success. The social and political divisions in Greece, along with the penchant for debilitating strikes, also reduce the odds for success.

Boone and Johnson reckon that if Greece opted to default on its debt while staying in the euro, it would “call a stop to all interest and principal for, say, two years”, and then drive a hard bargain:

Financial collapse would mean Greek debt would need to be written down substantially. We would guess that a 65% write down of face value, bringing total Greek debt to around 50-60% of a lower new GDP, would be reasonable. Such write downs roughly match the terms that Argentina received after its debt restructuring.

Still, I’m not convinced. There’s another option here, which I haven’t seen mentioned: rather than Argentina 2001, why not go Uruguay 2002? Or at least somewhere in the middle, like Ecuador 1999? Given the choice — and of course they have the choice — I think that pretty much all politicians in Europe, including the Greeks, would opt to avoid the Argentine precedent.

There are a few different points to bear in mind here, but the first is that holders of Greek debt are powerful voters. Remember Warren Buffett’s words of wisdom:

Let’s go back to 1975 when New York City was on the edge of bankruptcy. At the time its bonds – virtually all uninsured – were heavily held by the city’s wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city’s fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York’s citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Replace “New York” with “Greece” and I think you see a plan much along the lines of Argentina’s much-maligned “megaswap” — the failed attempt to restructure the country’s debt which preceded the outright default. No principal reduction, but lots of pushing out of maturities and interest-rate grace periods, all with the intention of giving the country a bit of time to get back onto its fiscal feet. And while Greek politics are certainly dysfunctional, they’re not as dysfunctional as Argentine politics were at the time of the megaswap, and Greece’s politicians — at least the present ones — are likely to be able to avoid the kind of self-sabotaging comments which turned the Argentine deal into a fiasco. And Buffett’s point is that substantially all of Greece’s elite — not to mention most of its foreign lenders — would be pulling in the same direction if such a thing were tried: they all would know that the alternative would be far worse.

Even then, however, the alternative is not an Argentina-style default. The Kirchners have been masters at demonizing foreign lenders for short-term domestic political gain, but it’s going to be very hard for Greek politicians to do likewise. No one’s blaming Greece’s bondholders for the country’s current fiscal woes.

Argentina, to this day, is essentially an outcast on the international capital markets, and not only because any attempt to issue new debt would immediately be pounced on by the holders of $20 billion in defaulted bonds. A second swap is expected some time this month, which will help, but we’re now almost a decade on from the default, which is an insanely long amount of time to get around to dealing with the bonds you defaulted on.

Argentina therefore spent pretty much all of the oughts in a state of financial isolation: it always had to be super-careful not to place any sovereign assets abroad, lest they be attached; it could borrow only under its own domestic law; and even its own exporters frequently ran into large taxes and other obstacles to growth. It was a set of policies which might work for a proud nation at the tip of South America, but which could never work for a member of the European Union. That kind of default wouldn’t just mean leaving the euro; it would also mean leaving the EU. Which is something all Greeks would oppose, if only on the grounds that the Turks would love it.

The alternative is to have a sensible conversation with the sensible end of your creditor base — the banks and large institutional investors who understand the mathematics of debt sustainability and who want to make sure that if you default, you’re only going to do it once. When Ecuador defaulted in 1999, its creditors weren’t happy. But they could see why the default was fiscally necessary, and they overwhelmingly accepted a 30% haircut, which in hindsight was more than enough to make the country’s debt burden sustainable over the long term. (The fact that Ecuador went on to default a second time was entirely a function of politics and willingness to pay: it certainly had the ability to pay.)

Hempton is I think wrong when he says that a country’s credit rating will be “stuffed anyway” in the event of a default. If done elegantly, that’s not true at all: indeed, a successful restructuring can visibly improve a country’s balance sheet and its ratings. And Greece cares very, very, very much about being a high-income EU country and not an emerging-market basketcase. Remember that it’s still investment-grade today, from all three ratings agencies, despite its 114% debt-to-GDP ratio and 13%-of-GDP 2009 deficit. If it can use a reasonably creditor-friendly debt restructuring to get those numbers moving in the right direction, there’s no reason its credit rating shouldn’t improve.

Uruguay is a case study in how a country can default in an elegant manner, use financing from multilaterals to get it over a short-term hump, and then refinance that debt in the public markets as liquidity and positive sentiment returns.

Essentially, Greece faces two options. It can go the Argentina route, and become an emerging-market country which can support a debt level of no more than 50% or 60% of GDP. Or it can attempt to structure a solution in which it retains its status as a fully-fledged member of the EU and the eurozone, with commensurately low borrowing rates and the ability to support debt much closer to 90% or 100% of GDP.

My base-case expectation for any Greek default, then, will be a restructuring proposal offered with the full support of the EU and the IMF — including lots of liquidity from those two sources. It’ll involve a relatively modest NPV haircut of about 25%, and will probably involve no principal reduction at all — that way banks which don’t mark to market and who have Greek debt on their books won’t need to take a write-down.

The restructuring, if it happens, will be painful and noisy, of course: all defaults are. And Simon Johnson will hate it, saying that it’s insufficient and that Greece will have to reprise the whole operation all over again sooner or later. (Simon is like most present and former IMF staffers in that he loves imposing as much pain as possible on private creditors, since that means that the Fund needs to cough up less cash.) But the point is that it won’t be Argentina, and there will at least be a sliver of a chance that the other PIGS dominoes might not fall as a result.

Back in July, ProPublica announced it was hiring my friend Jesse Eisinger as an investigative financial journalist, and ever since then a lot of people have been very interested in what he’s been working on. Today, we find out, with the publication of a 6,600-word story on a hedge fund called Magnetar, co-written with Jake Bernstein.

Magnetar did well during the subprime bust, largely thanks to bets it made against subprime mortgages. If you’ve read the new Michael Lewis book, you’ll know all about this world: investors would buy credit protection on mortgage bonds they thought were likely to fail, happily paying small insurance premiums now in return for what they hoped — rightly — would be a massive payday when the bonds started defaulting.

The problem was that no one liked paying those premiums. Lewis details the enormous fights that one manager, Michael Burry, had with his investors: they hated the fact that lots of money was flowing out of his fund, in insurance premiums, and nothing was coming in. So other people tried to put together trades where they could make enough money in one part of the mortgage market to pay the insurance premiums elsewhere. Lewis writes about the most disastrous such trade, put on by Morgan Stanley’s Howie Hubler:

The crown jewel of their elaborate trading positions was the $2 billion in bespoke credit default swaps Hubler felt certain would one day very soon yield $2 billion in pure profits. The pools of mortgages loans were just about to experience their first losses, and the moment they did, Hubler would be paid in full.

There was, however, a niggling problem: The running premiums on these insurance contracts ate into the short-term returns of Howie’s group. “The group was supposed to make two billion dollars a year,” said one member. “And we had this credit default swap position that was costing us two hundred million dollars.” To offset the running cost, Hubler decided to sell some credit default swaps on triple-A-rated subprime CDOs, and take in some premiums of his own. The problem was that the premiums on the supposedly far less risky triple-A-rated CDOs were only one-tenth of the premiums on the triple-Bs, and so to take in the same amount of money as he was paying out, he’d need to sell credit default swaps in roughly ten times the amount he already owned.

This turned out, by the time the dust settled, to be without a doubt the single worst trade that any investment bank has ever entered into in the history of the world: it ended up losing Morgan Stanley $9 billion. It was a long-short trade: Hubler was long triple-A CDOs and short triple-B CDOs, and he ended up losing vastly more on the long side than he could possibly make on the short side.

Jesse Eisinger has found another hedge fund which was shorting mortgage CDOs, Magnetar. And it, too, avoided nasty phone calls from its investors by following a long-short strategy. But instead of losing billions, it ended up making them. Because while Morgan Stanley offset its short triple-B positions by going long the safest tranches, Magnetar offset its short positions by going long the riskiest tranches.

The equity bought by Magnetar represented just a tiny fraction of the overall CDO. If it costs, say, $50 million, an entire CDO could be 20 times that, $1 billion. And if the CDO begins to go south and you’re smart enough to have taken out enough insurance, you can make hundreds of millions of dollars. That, of course, would take a bit of the sting out of losing your original $50 million investment in the equity…

By buying the risky bottom slices of CDOs, Magnetar didn’t just help create more CDOs it could bet against. Since it owned a small slice of the CDO, Magnetar also received regular payments as its investments threw off income.

With this, Magnetar solved a conundrum of those who bet against the market. An investor might be confident that things are heading south, but not know when. While the investor waits, it costs money to keep the bet going. Many a short seller has run out of cash at the gates of a big payday.

Magnetar could keep money flowing — via its small investments in CDOs — and could use that money to pay for its bets against CDOs.

The point here is that the maximum downside on Magnetar’s long positions was much smaller than the maximum upside on its short positions. And when everything broke down and just about everything went to zero, Magnetar’s shorts ended up making it enormous profits.

At the time, it looked like Magnetar had made a bullish bet on CDOs, and got lucky when its offsetting short positions wound up being massively profitable. But Jesse and Jake see something a bit more nefarious — while still legal — going on. They reckon that Magnetar wanted to be short all along, but the only way of being short was by making sure that the synthetic-CDO machine kept on churning. And the way to keep the synthetic CDO machine churning was to sponsor the CDOs themselves, by buying the risky equity tranche. They write:

Magnetar’s purchases solved a crucial problem for the banks. Since the equity was so risky and thus difficult to sell, banks didn’t like to create new CDOs unless someone committed to buy them. Indeed, such buyers were so crucial that Wall Street referred to them as the CDOs’ “sponsors.”

Without sponsors, Wall Street’s mortgage bond assembly line could grind to a halt, and with it bank profits and banker bonuses.

This is true, but it’s not the whole truth. Yes, the banks needed to find someone to take the equity tranche — although often they simply took it themselves, if they could make more money in deal fees than they could possibly lose on the equity. The real problem, with all of these synthetic CDOs, was something known as the “unfunded super-senior tranche”. (What’s a super-senior tranche? Funny you should ask!) Where Magnetar seems to have been very clever indeed was in persuading banks that it made sense to throw all manner of crap into their CDOs, while not worrying for a minute that their super-senior risk — risk that the banks never intended to sell — would end up losing them billions of dollars.

Of course, if you can get paid $4 million a year not to worry about such things, it becomes easier to ignore them.

The smelly part of what ProPublica calls the Magnetar Trade is that because Magnetar was sponsoring the deals, they had an inordinate amount of control over what went into them, and even what they were named. And they seem to have made a vast amount of money from this information asymmetry.

But of course the banks knew exactly what was going into these deals too. And one of the biggest losers was JP Morgan, the banks whose CDS whiz-kids were lauded at book length as being especially alert to the problems of unfunded super-senior tranches. These were the people who knew better than to hold on to such things — yet they still managed to lose $880 million on a $1.1 billion CDO-squared they put together at the behest of Magnetar.

It’s worth noting here that these deals were derivatives all the way down. The JP Morgan deal was a CDO of synthetic CDOs — the number of actual subprime mortgages in there was tiny. Essentially, the clever traders at Magnetar did an insanely complex derivatives trade with the clever traders at JP Morgan and elsewhere, and Magnetar ended up coming out on top.

The saddest part of the whole story is the suckers — naive investors like IKB, a small German bank which had to get bailed out by German taxpayers in mid-2007. They thought they could get high yields on safe securities, and they were wrong. But I don’t think that it’s all that easy to blame Magnetar for the existence of players like IKB. In the world of derivatives, for every loser there’s always a winner. And in this case, Magnetar was smart enough to be that winner.

Update: Jesse writes to say that his story is only 5,900 words. And that it’s going to be on This American Life this weekend. Tune in!

Update 2: See the 6,000-word story reduced to a 100-second musical clip! It’s actually kinda genius.

Bet Against The American Dream from Planet Money on Vimeo.

Blog comment of the day comes from Ben Baldanza, the CEO of Spirit Airlines, with a crystal-clear explanation of why his fees for carry-on baggage make a lot of sense. It’s really worth reading the whole thing, but here’s the gist:

• The fees reduce the amount of time it takes to board and exit the plane, benefiting everyone.
• They reduce the chance that someone will be parted from their bag at the jetway because there’s no more baggage space left in the passenger cabin.
• They eliminate the perverse monetary incentive to carry on a bag.
• They make pricing transparent: Sprit has reduced fares “by at least as much, or even more than the amount of the carry-on fee”, says Baldanza. “Southwest makes you pay for checked bags even if you don’t check bags, since they have to cover those costs but give you no break if you don’t use the infrastructure. At Spirit, you spend only for what you use and don’t pay for what you don’t use.”

Baldanza says that Spirit’s sales “have soared” since the announcement was made; I’d love to see some numbers on that. And I can’t wait to see the reply to Baldanza from Bill Taylor, who wrote the original blog entry saying that the fee is “a horrible idea” and “a pretty interesting case study in the wrong ways for companies to respond to tough economic times–a reminder of how so many leaders manage to make bad situations worse”. Has Baldanza’s comment changed his mind at all?

Shahien Nasiripour is on a roll these days. Today he makes a great catch:

In a paper on the financial crisis he presented last month at the Brookings Institution in Washington, Greenspan did not mention the word “fraud”, in any of its forms, even once in the 66-page presentation.

His prepared remarks this week, though, mentioned it three times.

This is an extremely important issue when it comes to regulatory reform, because the history of financial regulation in the US is a history of regulators completely missing fraudulent behavior — with the relationship between the SEC and Bernie Madoff, of course, Exhibit A.

Greenspan is absolutely right here:

“[I]t is one thing to promulgate rules, and quite another to successfully implement them. Rules to prevent fraud and embezzlement have failed as often as not. Parenthetically, in the years ahead, we will need far greater levels of enforcement against misrepresentation and fraud than has been the practice for decades,” he told the investigatory panel.

Greenspan also called for “enhanced” enforcement against “misrepresentation and fraud” going forward…

But the Fed isn’t equipped to handle it, Greenspan testified this week.

“The Federal Reserve, remember, is not an enforcement agency,” he told the panel…

“It’s not a group that can ferret out embezzlement, fraud, misrepresentation — and indeed, when we get such examples, what we tend to do is recognize that we don’t have the facilities.”

When one thinks about the successful enforcers of financial crimes, the names which spring to mind are the likes of Rudy Giuliani and Eliot Spitzer, not anybody at the SEC or within the federal regulatory apparatus. There’s a very real risk that any financial reform bill will make all manner of harmful behavior illegal — and that all manner of financial fraudsters will go ahead and do it anyway, with a low risk of being caught and prosecuted.

It’s far from clear to me where the real locus of enforcement is in any of the financial reform proposals floating around Capitol Hill. The SEC has proven itself incapable of aggressively investigating such things, even under Mary Schapiro. Shahien seems to think that maybe the Consumer Financial Protection Agency can fill the vacuum; I’m not sure. But someone certainly needs to.

Landon Thomas today, in the lead story on NYTimes.com, comes out and uses the A-word with respect to Greece:

The sharp rise in rates has spurred increased talk of some form of debt restructuring. In such a situation, analysts said, holders of Greek debt could perhaps be forced to accept a loss of 20 percent or more on their bonds. That would be similar to what happened after Argentina defaulted on $93 billion in debt in 2001. Like Argentina, Greece has suffered from a fixed currency, fiscal deficits and a growing lack of industrial competitiveness.

OK, hang on a minute here. It’s bad, but it’s not that bad. Paul Krugman says that “there are no good answers here — actually, no nonterrible answers”, but at the same time I don’t think anybody’s seriously expecting Greece to go Argentina.

There are two outcomes which no one wants in Greece but which are still becoming increasingly likely: default and devaluation. Argentina did both in 2001. But these aren’t binary things: both can be relatively mild or extremely severe. In Greece’s case, they would surely be much more modest than they were in the Argentine.

The first option is default. If it happens, it’ll happen, as Thomas says, in the form of a debt restructuring, where holders of Greek debt would end up getting new bonds with new terms — lower interest payments, lower principal amounts, that kind of thing. Debt restructurings are messy and unpleasant things at the best of times, but what we’re really talking about here is the sovereign equivalent of a loan modification which, if it goes according to plan, makes both the borrower and the lender better off.

What we’re most emphatically not talking about here is an Argentina-style default, where the country simply unilaterally stops paying any interest on its debt, and then takes years to address the issue, trying to drive the hardest bargain it can all the while.

Then there’s devaluation. If Greece leaves the euro, that would allow it to devalue its currency. If it redenominated its debt from euros into drachmas, that alone would constitute a default, even without a bond exchange. But again, in the event that Greece did leave the euro, it wouldn’t see its currency plunge overnight to a third of its previous value, as Argentina did.

This is where being a member of the EU really does help — not least because of the large exposure that many European banks have to Greece. Even if Germany insists on a hardline refusal to bail Greece out, it equally doesn’t want a Greek failure to be the just the first of the PIIGS dominos to fall, in a series of sovereign collapses which would make the 1998 Asian crisis look positively tractable in comparison. As a result, even in the worst-case scenario, the EU and IMF are at least likely to step in somewhere to cushion the blow and to try to isolate Greece’s problems. What happens in Athens must stay in Athens: if it spreads to Rome and Lisbon and Dublin and Madrid, London would probably be next, and at that point we’d have a major global financial crisis at least as severe as the one we just went through.

So while it’s true that, as Mohamed El-Erian says, things will likely get worse for Greece before they get better, it’s worth being a little bit realistic here about just how much worse they could possibly get. For the time being, everybody’s still hoping that Greece will somehow manage to get through this crisis — and Greece’s debt spreads, while wide, aren’t yet trading at distressed levels. That’s grounds for hope. And it’s also an indication that traders see much less downside here than there was in Argentina.

US banks shrink their balance sheet at quarter-end — WSJ

Pixels — YouTube

Nick Denton on how to write a popular blog entry. Super-smart, and dead-on. Also, a little depressing — Village Voice

The link appears! The first line of the second graf here is now 100X more fabulous — NYT

On spirals, debt and otherwise — FT

Malcom McLaren (RIP) on tasting wine — NYT

Mick Weinstein leaving Seeking Alpha — SA

There have been many critiques of the financial system in the wake of the global crisis, blaming its structure for the severity of the problem. But it’s taken until now for an old-school Marxist to come along and co-opt all of those critiques as a call to embrace communism. David Harvey’s new book is just that. Here’s the official blurb:

Using his unrivalled knowledge of the subject, Harvey lays bare the follies of the international financial system, looking closely at the nature of capitalism, how it works and why sometimes it doesn’t. He examines the vast flows of money that surge round the world in daily volumes well in excess of the sum of all its economies. He looks at the cycles of boom and bust in the world’s housing and stock markets and shows that periodic episodes of meltdown are not only inevitable in the capitalist system but essential to its survival. The essence of capitalism is its amorality and lawlessness and to talk of a regulated, ethical capitalism is to make an error of reasoning of the most fundamental kind.

Harvey is happy to go so far as to title his final chapter “What is to be Done?” — which of course is also Lenin’s most famous work. He dismisses attempts at wealth redistribution or increased financial regulation as mere “socialism”, and pushes instead for something much stronger, which “seeks to displace capitalism” entirely. “An ethical, non-exploitative and socially just capitalism that redounds to the benefit of all is impossible,” he writes, in a passage which will surely dismay the likes of Matthew Bishop. “It contradicts the very nature of what capital is about.”

He concludes:

Communists are all those who work incessantly to produce a different future to that which capitalism portends… While traditional institutionalised communism is as good as dead and buried, there are by this definition millions of de facto communists active among us, willing to act upon their understandings, ready to creatively pursue anti-capitalist imperatives…

The struggle for survival with justice not only continues; it begins anew. As indignation and moral outrage build around the economy of dispossession that so redounds to the benefit of a seemingly all-powerful capitalist class, so disparate political movements necessarily begin to merge, transcending barriers of space and time…

Capitalism will never fall on its own. It will have to be pushed… Political mobilisations sufficient to such a task have occurred in the past. They can and will surely come again. We are, I think, past due.

All of this reminds me, in a weird kind of meta way, of Richard Florida’s new book, which I’m reading right now. Florida, of course, is no communist, and he’s certainly not a revolutionary who sneers at the uselessness of Velcro, like Harvey does. But he did enter the crisis with lots of Big Ideas, and he’s now written a book about how the crisis only confirms that those ideas were exactly right.

James Kwak has written, apropos Richard Posner, that it’s hard to get enormous credibility out of being wrong for decades. At the same time, however, it’s always nice to see people’s views change when the facts change — and rarely have facts changed as much as they did over the course of this crisis. I suppose that the crisis has naturally pushed most people’s views to the left, and it’s hard to get much further left than Harvey. But then again, I think that there’s definitely a causal connection between the financial crisis and the rise of the tea party: in extreme times, people often gravitate towards corner solutions.

In any event, it’s probably good that Harvey’s book has now been written, if only to fill out the spectrum of reactions to the crisis and to help make leftists like Joe Stiglitz and Dean Baker look positively Reaganite in comparison. And to remind us all that Keith Olbermann and Michael Moore are maybe not quite as far to the left as some soi-disant centrists would have you believe.

Well done to Cyrus Sanati for getting a bit of snark into Dealbook:

Byron Georgiou asked [Chuck Prince] about the ballooning of Citi’s leveraged loan exposure to $100 billion from $35 billion within a short period of time.

“If you were at all concerned about this business how come you allowed the limits to be tripled during that period?” he asked.

“My belief then and my belief now is that one firm in this business cannot unilaterally withdraw from the business and maintain its ability to conduct business in the future,” Mr. Prince said…

“If you are not engaged in business, people leave the institution, so it is impossible to say in my view to your bankers we are just not going to participate in the business in the next year or so until things become a little more rational,” he said. “You can’t do that and expect to have any people left to conduct business in the future.”

Just months after Mr. Prince’s dancing comment, Citi took a $1.5 billion write down tied to its leverage loan portfolio. Most of the bankers that did those deals are no longer employed at the firm.

Of course this is a prime example of Prince not answering the question. Georgiou didn’t ask Prince why Citi hadn’t quit the leveraged loan business entirely: he asked why Citi had trebled the size of its leveraged loan business during a time when Prince claimed to be concerned about the risks involved and indeed, by his own account, specifically asked regulators to step in and impose limitations.

It really ought to go without saying that the CEO of a company as big as Citigroup, especially when he’s being paid a hefty ten-figure salary, should be able to control his own businesses without crawling to regulators with a plea of “stop me before I issue another cov-lite bond, I can’t help myself”. If Prince would have been happy to see regulators crack down on his leveraged-loan operations, he should by rights have been even more happy to do so himself. After all, if regulators did it, there wouldn’t be any competitive advantage to the move, whereas if he did it and his competitors kept on making bad loans, then Citi would end up beating its competition.

But that’s not the way that bank incentives work: no one ever gets rewarded for not doing a bad deal. In fact, you’re much more likely to get rewarded for doing a bad deal: the investment-banking world rewards dealmaking much more than it rewards successful dealmaking.

The tragedy of Chuck Prince is that he was smart enough to understand how screwed up his incentives were, while at the same time being so weak that he felt powerless to do anything about it, beyond bleating pathetically to his regulators. The tragedy of Bob Rubin is that he stood loyally by Prince’s side the entire time, supporting him wholeheartedly in his milquetoast pusillanimity. And indeed remained loyal to Prince even through the FCIC hearings this morning.

And the tragedy for the rest of us is that we picked up the tab for the errors of Prince and Rubin to the tune of hundreds of billions of dollars, while letting them both retire with dynastic wealth. Tim Geithner, remember, bears almost as much responsibility for Citigroup’s implosion as Prince and Rubin do: after all, their job was to take risks in the service of shareholder returns. Geithner, as their regulator, had the job of protecting the downside.

This morning saw Chuck Prince and Bob Rubin hauled up in front of the Financial Crisis Inquiry Commission, and they didn’t do themselves any favors at all. Even in the wake of Citigroup’s systemically-devastating collapse, they insisted that Citigroup’s risk management systems were “robust and proactive”, to use Rubin’s words. And while Prince apologized for his actions, Rubin — who bears more responsibility for the crisis than Prince does — still refused to say that he was sorry, let alone accept any responsibility for anything, except in a vague “it was everybody’s fault” kind of way.

The commissioners, especially Angelides, Holtz-Eakin, and Georgiou, asked some very good and pointed questions, most of which were ducked by the former Citi executives. At one point, despite the fact that Brooksley Born was one of the commissioners, Rubin even declared that he wasn’t in favor of derivatives deregulation while he was at Treasury. (In fact, he clashed so strongly with Born on the issue at the time that he effectively pushed her out of her position as chair of the CFTC.) Rubin’s position on derivatives regulation is a bit like Hank Paulson’s position on bailing out Lehman Brothers: “I’d love to have done it, but it was impossible legally.” And it’s even less credible.

The fact is, as Rubin is clearly aware, that the risk management function at Citi failed spectacularly, not least in the way that senior executives weren’t even told about Citi’s monstrous subprime exposures until the end of 2007. When pushed on this, Rubin repeated many times what he said in his testimony:

I first recall learning of these super senior positions in the Fall of 2007… I learned that Citi’s exposure included $43 billion of super senior CDO tranches. The business and risk management personnel advised that these CDO tranches were rated AAA or above and had de minimis risk.

My view, which I expressed, was that… these CDO transactions were not completed until the distribution was fully executed.

That said, it is important to remember that the view that the securities could be retained was developed at a time when AAA securities had always been considered money good. Moreover, these losses occurred in the context of a massive decline in the home real estate market that almost no financial models contemplated, including the ratings agencies’ or Citi’s.

This is all very slippery indeed. For one thing, Rubin well knows that you can’t be rated “above” AAA, although the people structuring synthetic CDOs certainly tried to imply that was possible. For another thing, as Georgiou pointed out, a lot of this exposure came in the form of “liquidity puts”, which required Citi to put up no capital. In fact, however, the liquidity puts were essentially the same thing as a multi-billion-dollar contingent credit line from Citi to its off-balance-sheet vehicles, which would have required lots of capital. And yet both Prince and Rubin told the commission with a straight face that Citi wasn’t in the business of regulatory or capital arbitrage.

As for those models of Citi’s, which failed spectacularly, both Prince and Rubin said that they trusted them at the time, and neither of them expressed any regrets about doing so: indeed, both had nothing but praise for the risk managers who put the models together.

The fact is, as Sean Park points out, that Citi got in over its head in the CDO business precisely because it loved being able to add tens of billions of dollars to its balance sheet without anybody (Prince and Rubin emphatically included) noticing or caring. Citi executives revelled in the bank’s enormous size, and considered it one of Citi’s strongest competitive advantages. But they never bothered to spend much time asking just where the growth in the balance sheet was coming from, or what the attendant risks were. It was a monstrous dereliction of their fiduciary duties, and I still hold out some hope that they will be held accountable somehow.