Monday, April 19, 2010

What Janet Tavakoli Gets and Doesn't Get About CDOs and Regulators

Janet Tavakoli has an important article in today's HuffPo outlining that the problems with CDOs should not have come as a surprise and that very public analysis and warning were made very early on. She writes:
ProPublica, Planet Money, and radio show This American Life recently carried stories about Magnetar, a hedge fund that profited from the housing crisis. Unfortunately, many thought it was a fresh revelation. Magnetar wasn't a previously unknown hedge fund. Magnetar did not create the synthetic CDO structure, and the magnitude of Magnetar's role in the subprime crisis has been overblown.

The New York Times recently wrote that the synthetic CDO story has only begun to emerge in recent months, and referenced the ProPublica story. ("A Wall Street Invention Let the Crisis Mutate," April 16, 2010. I was mentioned as an early critic of synthetic CDOs.)

Yet, more than two years ago the Wall Street Journal featured Merrill Lynch, Magnetar, N.I.R. and others involved in a failed synthetic CDO called Norma in a PAGE ONE investigative report on December 27, 2007, and followed up with another article on Magnetar's strategy. Even earlier, on December 17, 2007, WSJ had a front page article in its markets section reporting a potential legal battle involving MBIA, Wachovia, Deutsche and UBS for the cash of Sagittarius, a synthetic CDO (in which Magnetar had also invested) that had declared an event of default. The Wall Street Journal had done many investigative articles on value-destroying CDOs, some even earlier.*

The Wall Street Journal did some brilliant investigative reporting in the fall of 2007, and Washington did nothing. The reports were early enough to plan for the worst, take corrective action, and minimize damage. The news appeared before Bear Stearns imploded in March 2008, and the financial crisis came to a head in September 2008....

 In May 2007, ten months before Bear Stearns imploded, Business Week's cover story exposed value-destroying synthetic CDOs in Bear Stearns Asset Management's hedge funds. (Bloomberg News also covered the story). The hedge funds imploded in June 2007, and Bear Stearns absorbed the hedge funds' "assets." In March 2008, JPMorgan Chase bought Bear Stearns to save it from collpase. Citigroup created synthetic CDOs with the failed Bear Stearns hedge funds. Cititroup also gave the hedge funds a $200 million loan...
In other words, any money manager reading basic financial sources, that every money manager should be reading, should have been aware of the problems with CDOs.

Thus, it is peculiar that Tavakoli writes that regulators weren't on the case and implies that regulation is now somehow going to solve things. She writes:
Officials did nothing while the banks damaged the's remarkable none of this came up in last week's FCIC hearings....there is still no meaningful reform.
Government regulation is simply not the answer. As Tavakoli makes clear, either the regulators missed some obvious signs (or they were captured by the industry). Why will things change in the future, when financial engineers game any future reform?

The real solution is to make those who buy into bad deals lose money and be wiped out of the industry. Tavakoli writes:
Wall Street banks stuffed bad loans and bad loan packages into even more complex packages--including synthetic CDOs--to disguise problems and continue to earn bonuses. As everything started to fall apart, banks accelerated the scheme. They produced the most complex value-destroying deals in the shortest period of time.
This is very likely true. But the solution is for the markets to play out. If Goldman and Citi continue to stuff bad paper into the system, at some point even the dimmest light bulb buying this stuff is going to either run out of money or realize that Goldman and Citi are shoveling some pretty bad product out the door.

No regulators needed. Indeed, what will happen is more and more money managers will realize that Tavakoli, and the like, know how to smoke the bad stuff out. And, I would pay to watch an investment banker try to capture Tavakoli's mind and get her to promote bad paper.

Bottom line: The dumbest of the lot, who bought the bad CDOs, should be wiped out of the business. The remainder will eventually count on the analysis of the Tavakoli's of the world to protect them from bad paper. No new regulation will be needed, regulation that will be subject to further  gaming of the system or result in further capture of the regulators. Eventually, the Goldmans and Citis of the world will be forced to clean up their acts in order to survive.

1 comment:

  1. Another big thanks for that Tavakoli piece Bob.
    You know, I still think you're wrong in saying there was no fraud...I think if they can bring in everything else - the ratings agencies and everyone else into the deal - then we'd begin to get a handle.

    But what I think is happening is a political stunt. This piece you've linked adds to my feeling.