Dancing to Wall Street’s tune

Thought the short sellers were up to no good? You’re not alone, at least when it comes to short-selling collateralised debt obligations (CDOs), one of the acronyms behind the financial crisis. And now you can sing along to the tune. US hedge fund Magnetar, according to an investigation by ProPublica, took a leading role in pumping up subprime debt by helping create the CDOs it then went on to short. Even better than the article, which should be a must-read for everyone involved with Wall Street, is the music, put together to go with it by This American Life (h/t Daily Intel).

However, we already knew that John Paulson’s Paulson & Co, together with Goldman Sachs, Deutsche Bank and other banks, had done something similar. But the scale of the Magnetar CDO creation seems to set it apart: it sourced the bulk of the CDO market in late 2006, shorting some of the CDO debt it had helped create while buying the super-toxic CDO equity, which CDO creators usually found tough to shift. Its losses on the equity were in at least one case more than covered by the eventual profits from the debt when the CDO tanked, ProPublica reports. Worth noting is Magnetar’s explanation: it insists it was net long all its own CDOs, which means it would lose money when they defaulted, and that it ran a market-neutral strategy, meaning it aimed to make money whether the mortgage/CDO market went up or down.

Shorting (at least some) of the CDOs they encouraged the creation of appears to be entirely legal, at least for Magnetar and Paulson. And it is hard to pinpoint exactly why it shouldn’t be – although it initially feels very, very wrong. If (supposedly smart, institutional) suckers want to buy worthless debt, and all the disclosures meet the legal requirements, well – that’s high finance.

Some, including me, would argue that there is a breach of trust by an intermediary such as an investment bank that pushes a product to their clients which they know is being created in part so it can be shorted by another client, as in the case of the banks that helped Paulson, or – worse – so it can be shorted by the intermediaries themselves. Full disclosure is called for here. But the hedge fund, assuming they are not involved in selling the debt? Caveat emptor, surely.

Consider an (imperfect) analogy with the equity markets: TrendyNewCo Inc has a big idea, which lots of people want to buy. A hedge fund agrees to buy some equity (but not enough to give it control, or supply the management). At the same time it issues lots of debt (yes, unlikely; that’s the imperfection). The hedge fund decides to “protect” itself against the risk of the company failing by using credit default swaps, CDS, to short the debt, or “insure” itself. So far, so normal: holders of corporate equity may well use CDS to protect themselves relatively cheaply against all-out disaster. If the hedge fund is not involved in selling the debt, or punting the company’s shares, surely that’s just life in the markets? On the other hand, if the broker to the company highlights the hedge fund’s involvement in the equity to attract investors, and does not disclose their position shorting the debt, that seems to me a breach of trust to their clients.

Markets only work if there is a buyer and a seller, and if one is smarter and/or did more work than the other, the general conclusion is: tough. Even if one party is both buyer and, in another sense, seller. The lesson for governments is not to let banks get so big that they need rescuing; then they, like any other hopeless investor, can be left to go to the wall when they get it this badly wrong.

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Christopher Cook is an FT editorial writer. Before joining the FT in 2008 as a Peter Martin Fellow, he worked for three years for the Conservative party.

Lorien Kite is deputy comment editor, a post he took up in 2009 after four years as a commissioning editor on the analysis page. He joined the FT in 2000.

Ian Holdsworth became assistant features editor in 2009 and was previously chief production journalist for the features pages.