Monday, April 16, 2012

Janet Tavakoli on Bank "Control Fraud", Credit Default Swaps, MF Global's Total Return Swap-to-Maturity Trade (and Missing Money)

If you want to know everything that's going on in the illiquid, opaque world of OTC derivatives and bank/broker-dealer fraud, Janet Tavakoli, founder and president of Tavakoli Structured Finance, is the one to listen to. She was interviewed by Lauren Lyster on RT's Capital Account on 3/26/2012 and discussed the shadow banking system, how "control fraud" blew up the investment banks during the credit bubble, how Jon Corzine's $11.5 billion (gross notional value) "total return swap-to-maturity" trade on risky European sovereign debt bankrupted MF Global via margin calls and ended up misappropriating $1.6 billion of client funds, and how credit default swaps are essentially leveraged bets with little money down and big upside potential (example: John Paulson's ABX trade betting against subprime MBS). She also said derivatives are now dominated by speculators that are distorting markets (example: JPMorgan lost money on a coal derivatives bet in 2010).

Janet Tavakoli has a new book out "Financial Oligarchy: The New Robber Barrons". It seems like her previous books, Credit Derivatives in 1998, Credit Derivatives & Synthetic Structures in 2001, and Collateralized Debt Obligations & Structured Finance in 2003 (a warning book), were idea generators for hedge fund managers looking to short the subprime mortgage market. At that time, credit default swaps were already hedging corporate bonds, so it was only a matter of time before banks and insurance companies (AIG) started hedging subprime mortgage-backed securities and CDOs with credit default swaps. Former hedge fund manager Michael Burry, who was featured in Michael Lewis' book "The Big Short", was one of the first hedge fund managers that bought CDS referencing subprime MBS, and he told the FCIC in an interview that he read Janet Tavakoli's book. Tavakoli even said Magnetar Capital, a hedge fund started by former employees of Chicago based hedge fund Citadel, used a similar strategy from her third book.

"In 2003, I wrote a book on the dangers of synthetic CDOs, called "Collateralized Debt Obligations & Structured Finance." It includes the structure used by Magnetar and other hedge funds in the recent mortgage debacle, but the example used corporate credit risk (Wiley, 2003, Chapter Pp. 181, 194-196 in particular, combined with short mezz Pp. 261-265). (HuffingtonPost)

She met with Citadel's structured finance group that included David Snyderman, who joined Magentar in 2005. But, she declined to get involved because her book was "written as a warning, not a manual for mischief," lol. Magnetar ended up fueling the mortgage bubble by buying equity tranches in CDOs (for deal sponsorship and high yield) and shorting other tranches at the same time. Magnetar called it a "market neutral" arbitrage bet, where they got long the riskiest tranche of the CDO (equity) for yield, and simultaneously went short, or bought CDS protection, on CDO tranches that were referencing toxic subprime MBS, which would hit the jackpot if they went to zero (correct me if I'm wrong). Some believe Magnetar distorted CDO equity demand, with the help of banks, so they could keep shorting CDO tranches and use the equity payout to fund their shorts! It's obvious that as time went on, this trade became a sure thing. Imagine how fun these trades would be on a regulated exchange, if at all possible. Here is the best part of ProPublica's investigation on Magnetar’s (Nearly) Perpetual Money Machine:

"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.

Similar, commonly traded, assets appeared in multiple Magnetar CDOs. Experts say the benefit of that overlap to Magnetar was that when the hedge fund bet against non-Magnetar CDOs, the CDOs still had similar characteristics to the ones Magnetar had invested in.

Soon enough, bankers and CDO managers had a sense of how it worked. "Everyone knew," said one person who managed Magnetar CDOs. "They used the equity to fund the shorts."

Magnetar further increased its odds by insisting that the CDOs it helped create had an unusual construction. Typically, cash flowing to the last-in-line equity buyers is cut off at the first signs of trouble -- such as a rise in mortgage delinquencies. Those at the top of the CDO -- who accepted lower returns for less risk -- received that cash, leaving none for the high-risk holders.

Magnetar wanted its deals to be "triggerless," meaning lacking these cash-flow dams. When the market turned shaky and homeowners began to default, money kept flowing down to the risky slices that Magnetar owned.

Even today, bankers and managers speak with awe at the elegance of the Magnetar Trade. Others have become famous for betting big against the housing market. But they had taken enormous risks. Meanwhile, Magnetar had created a largely self-funding bet against the market."
(continue reading at ProPublica)

Nice carry trade. I mixed up a bunch of similar topics on this post, but in the end, they are all related. Even Deutsche Bank trader Greg Lippmann, who was also featured in "The Big Short", dealt with both Michael Burry and Magnetar at one point. "At least nine banks helped Magnetar hatch deals" (ProPublica). Here are more articles about "control fraud" at the banks: Banks’ Self-Dealing Super-Charged Financial Crisis", 2) "The ‘Subsidy’: How a Handful of Merrill Lynch Bankers Helped Blow Up Their Own Firm" (all at ProPublica).

So, long story short, Janet Tavakoli is probably the one to listen to in this space.

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