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Where Are the Financial Crisis Prosecutions?

The White Collar Slump?

By Jesse Eisinger
ProPublica: jesse@propublica.org

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You may have noticed that prosecutors in this country are in something of a white-collar slump lately.

The stock options backdating prosecutions have largely been a bust [1], not because it wasn’t a true scandal. The Securities and Exchange Commission and the Justice Department investigated more than 100 companies. Over a hundred took accounting restatements. Yet only a handful of executives went to prison, with some high-profile cases fizzling out. Prosecutors also stumbled in other high priority corporate fraud prosecutions, like the KPMG [2] tax shelter and the stock-exchange specialists [3] cases.

Bear Sterns

The most spectacular prosecutorial flameout [4] was the case against the Bear Stearns hedge fund managers. The consequences of that disaster are still reverberating. The United States attorney’s office in Brooklyn rushed to haul low-level executives in front of a jury based on a few seemingly incriminating emails. The defense was easily able to convince jurors that these represented only out-of-context glimpses of fear as markets swooned, not a conspiracy to mislead. But, now we have a supposedly new push: the insider trading scandal.

Insider Trading

The United States attorney in Manhattan, Preet Bharara, and the United States Attorney, General Eric H. Holder Jr., are hyping their efforts. “Illegal insider trading is rampant and may even be on the rise,” Mr. Bharara dubiously pronounced in a speech [5] in October. The Feds are raiding [6] hedge funds and publicly celebrating their criminal investigations related to insider trading.

The storyline is that Wall Street now lives in fear. Hedge fund managers’ phones might be tapped, any stray remark is suspect, and old trades are being exhumed so that the entrails can be examined.

In fact, plenty of folks on Wall Street are happy about the investigation. A scant few — the ones with clean consciences — like the idea that the world of special access to favorable tips is being cleaned up.

But others are pleased for a different reason: They realize the investigation is a sideshow.

All the hype carries an air of defensiveness. Everyone is wondering: Where are the investigations related to the financial crisis?

Enron, Lehman, Merrill, Citigroup and Others

John Hueston, a former lead Enron prosecutor, wonders: “Have they committed the resources in the right place? Do these scandals warrant apparent national priority status?”

Nobody from Lehman, Merrill Lynch or Citigroup has been charged criminally with anything. No top executives at Bear Stearns have been indicted. All former American International Group executives are running free. No big mortgage company executive has had to face the law.

How about someone other than the Fabulous Fab [7] at Goldman Sachs? How could the Securities and Exchange Commission merely settle with Countrywide’s Angelo Mozilo [8] — and for a fraction of what he made as CEO?

The world was almost brought low by the American banking system and we are supposed to think that no one did anything wrong?

The most common explanation from lawyers for this bizarre state of affairs is that it’s hard work. It’s complicated to make criminal cases in corporate fraud. Getting a case that shows the wrong-doer acted with intent — and proving it to a jury — is difficult.

But, of course, Enron was complicated too, and prosecutors got the big boys. Ken Lay was found guilty (he died before he served his time). Jeff Skilling is in prison now, though the end result was bittersweet for prosecutors when much of his conviction was overturned by the Supreme Court. WorldCom’s Bernie Ebbers and Tyco’s Dennis Kozlowski are wearing stripes.

Complicated Cases

Sure, it takes time to investigate complicated cases. Many people think that the SEC, at the least, will bring some charges against top executives at Lehman Brothers. The huge, ground-breaking special examiner’s report [9] on Lehman Brothers laid bare problems with Lehman’s accounting. But that report came out back in March — on a bank that blew up more than two years ago. That seems awfully slow.

The most popular reason offered for the dearth of financial crisis prosecutions is the 100-year flood excuse: The banking system was hit by a systemic and unforeseeable disaster, which means that, as unpleasant as it may be to laymen, it’s unlikely that anyone committed any crimes.

Stupidity is No Crime

Or, barring that wildly implausible explanation (since, indeed, many people saw the crash coming and warned about it), the argument is that acting stupidly and recklessly is no crime.

As I ride the subway every morning, I often fantasize about criminalizing stupidity and fecklessness. But alas, it’s not to be.

Nevertheless, it’s hardly reassuring that bankers, out of necessity, have universally adopted the dumb-rather-than-venal justification. That doesn’t mean, however, that the rest of us need to buy it. It’s shocking how pervasive and triumphant this narrative of the financial crisis has been.

Link: http://www.propublica.org/thetrade/item/where-are-the-financial-crisis-prosecutions/

Assessment

Just as it’s clear that not all bankers were guilty of crimes in the lead-up to the crisis, it strains credulity to contend no one was. Corporate crime is usually the act of desperate people who have initially made relatively innocent mistakes and then seek to cover them up. Some banks went down innocently. Surely some housed bad actors who broke laws.

As a society, we have the bankers we deserve. Sadly, it’s looking like we have the regulators and prosecutors we deserve, too.

Conclusion

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Mortgage Investors Join Outcry Against Banks

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Coordinated Strategies Emerging

[By Karen Weise ProPublica: Oct. 18, 2010, 1:18 p.m.]

Homeowners, and at times the government, have long complained that banks and other companies that service mortgages aren’t good at their job of collecting monthly payments, modifying loans and processing foreclosures. Now, a new cast of characters are piling on the criticism: the servicer’s own clients, the investors that actually own the mortgages.

The Servicers

Servicers handle the day-to-day of working with homeowners on behalf of the investors, who bought bundled mortgages from Wall Street. But investors are now threatening servicers with legal action. Just like homeowners, investors are frustrated by the poor job in modifying loans that servicers have been doing. They also say servicers are looking out for themselves, not investors’ interests as their contracts typically require.

For example, Investor Bill Frey, who runs the securities firm Greenwich Financial Services, says servicers view investors as “a Thanksgiving turkey to be carved up and shared among them-selves.” Investors can range from foreign governments and hedge funds to college endowments and pension funds. During the housing bubble, they gobbled up AAA-rated bonds created by pools of mortgages. Now that defaults and foreclosure are mounting, investors argue that flaws in how loans are serviced are costing them billions of dollars.

They say servicers have often dragged out foreclosures to rack up fees and refused to reduce second mortgages to make modifications sustainable. Investors often prefer modifications to foreclosures. But for modifications that won’t ultimately prevent a homeowner from defaulting, investors still prefer quick foreclosures so they can recoup their money and move on.

Of Terminal In-Decision

“Terminal indecision is not good,” says Frey. “If it can be fixed, fix it. If it can’t, nix it.”

Servicers have been slow [1] to modify mortgages—something we’ve written [1] about many times [2] — and when they do modify loans, homeowners are still saddled with other debt from second mortgages and home equity lines. Even after modifications under the government’s program, homeowners typically still must spend almost two-thirds of their income to pay off their mortgage and other loans, like credit cards or second mortgages.

Emerging Paperwork Scandal

The current mortgage paperwork scandal [3] adds more fuel [4] to the fire as major servicers have halted foreclosures because of potential paperwork irregularities around the country. Concerns are also growing that banks may not have properly transferred loans into the mortgage pools in the first place. “This deficient approach undermines the integrity and the operational framework of the housing finance and mortgage system as it exists today,” the Association of Mortgage Investors wrote [5] in a press release.

(For more on the growing scandal, check out our recent explanation of the main players involved.)

The Mortgage Bankers Association, which represents most major servicers, did not respond to ProPublica’s request for comment.

Legal Strategies

Investors from across the country have been coordinating legal strategies for over a year ago, with the effort ramping up in early spring, according to Frey. Since then, more and more investors have formed a loose consortium, gaining momentum “like a snowball going downhill,” he says. In the last month alone, the group added other investors that own an additional $100 billion in mortgage bonds.

They have not filed any suits yet, Frey says, because the group is first trying to grow even more. Also, since each investor group has different, nonmortgage business with the banks, some investors have conflicting interests in how to proceed, he says. The consortium now represents investors that own more than $600 billion in mortgage securities, which is around a third of the entire mortgage securitization market. The group includes 65 major mortgage investors; Bloomberg reported that large investment companies including Black Rock, PIMCO and Fortress are part of the effort, as are the quasi-governmental Fannie Mae and the Federal Home Loan Banks, which both own private securitized loans.

Coordinating investors is no easy task, since the mortgage bonds were sliced and diced to be sold off to investors around the world. To assert legal rights, investors must coordinate to prove that they collectively represent a certain percentage of each mortgage pool, or in some cases, a certain percentage of each slice of each mortgage pool. (The Wall Street Journal [6] and Bloomberg [7] both describe how Texas-based attorney Talcott Franklin is coordinating a clearinghouse to keep track of the various investments.)

Once investors have standing in each pool, they have the legal right to pressure servicers and trustees to improve or face litigation. The group says they have the legal authority to act in over 2,300 deals.

Investors say servicers must reduce or cancel second mortgages entirely before adjusting the primary loan, since that follows the legal pecking order of how loans should be paid off. But investors say servicers have are dragging their feet in reducing second mortgages to protect their own books, since the largest servicers — Bank of America, Citigroup, JPMorgan Chase and Wells Fargo — also own almost 60 percent of the $1 trillion second lien market.

Bank

Congressional Oversight Panel

A Congressional Oversight Panel concluded in April that there is “tension” between Treasury’s goal of supporting reductions to second mortgages and Treasury’s interest in ensuring that writing down second liens doesn’t severely weaken banks’ balance sheets. The panel wrote than when a servicer owns the second lien, the “inexorable conflict of interest” will more likely lead to modifications on the first loan, “as it benefits the bank at the expense of the mortgage-backed security investors.”

We’ve previously reported [8] that mortgages servicers frequently tell homeowners that investors are the roadblock to loan modifications, even though few mortgage deals actually restrict modifications.

Servicers are also supposed to act like watchdogs and report back to investors when they identify loans they suspect didn’t meet the lending standards promised when the bonds were initially sold to investors. If the banks did misrepresent the quality of the loans initially, the banks would have to buy back the invalid mortgages from the investors. But in many cases, the servicers are subsidiaries of the banks that sold the bonds, which investors say helps explain why servicers have been dragging their feet. Bloomberg noted [7] an analyst’s report that said mortgage repurchases could total over $179 billion.

Original Link: http://www.propublica.org/article/investors-join-outcry-against-mortgage-servicers

Assessment

According to an investor letter cited [6] in the Wall Street Journal, in some mortgage pools that have high default rates, the banks have not repurchased any loans when the servicers are subsidiaries of the banks that sold the bonds. Investors say this is all no small matter. Since the country’s mortgage market is heavily dependent on government support right now, they insist servicers make good on their contracts before start buying loans and supporting the mortgage market again.

Related Articles:

  1. http://www.propublica.org/article/mod-program-falling-short-of-govts-vague-goals
  2. http://www.propublica.org/article/loan-mod-profiles-runaround
  3. http://www.propublica.org/blog/item/biggest-banks-ensnared-as-foreclosure-paperwork-problem-broadens
  4. http://www.businessweek.com/news/2010-10-13/document-flaws-may-lead-investors-to-fight-mbs-deals.html
  5. http://www.propublica.org/documents/item/association-of-mortgage-investors-press-release-oct.-1-2010
  6. http://online.wsj.com/article/SB10001424052748704814204575508143329644732.html
  7. http://www.bloomberg.com/news/2010-09-23/mortgage-investors-target-banks-using-texas-lawyer-s-novel-clearing-house.html
  8. http://www.propublica.org/article/when-denying-loan-mods-loan-servicers-often-blame-investors-wrongly

Conclusion

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Bank Deals Similar to Goldman Sach’s Gone Awry

Other Major Banks Participated, Too?

By Marian Wang, ProPublica – April 16, 2010 1:36 pm EDT

As you may have heard, or read on this ME-P, Goldman Sachs is being sued for fraud [1] by the Securities and Exchange Commission [2] for allegedly misleading investors about a deal that Goldman helped structure and sell. In the civil suit, the SEC specifically faulted Goldman for failing to disclose that a hedge fund was helping create the investment while betting big the deal would fail.

According to the SEC, Goldman Sachs knew about the hedge fund’s bets, knew it played a significant role in choosing the assets in the portfolio, and yet did not tell investors about it. (Goldman Sachs has called the SEC’s accusations “completely unfounded in law and fact.” And in another more detailed statement [3], it said it “did not structure a portfolio that was designed to lose money.”) 

[picapp align=”none” wrap=”false” link=”term=Goldman+Sachs&iid=8541566″ src=”0/4/f/8/The_Goldman_Sachs_7d6f.jpg?adImageId=12513388&imageId=8541566″ width=”380″ height=”568″ /]

In ProPublica

As we reported at ProPublica last week, many other major investment banks were doing a similar thing [4].

Investment banks including JPMorgan Chase [5], Merrill Lynch [6] (now part of Bank of America), Citigroup, Deutsche Bank and UBS also created CDOs that a hedge fund named Magnetar was both helping create and betting would fail. Those investment banks marketed and sold the CDOs to investors without disclosing Magnetar’s role or the hedge fund’s interests.

Here is a list of the banks that were involved [7] in Magnetar deals, along with links to many of the prospectuses on the deals, which skip over Magnetar’s role. In all, investment banks created at least 30 CDOs with Magnetar, worth roughly $40 billion overall. Goldman’s 25 Abacus CDOs — one of which is the basis of the SEC’s lawsuit — amounted to $10.9 billion [8].

One reporter Jake Bernstein explained the investment banks’ disclosure failures on Chicago Public Radio’s This American Life [9]:

On the Magnetar Hedge Fund

The role of Magnetar, both as equity investor and in their bets against the very CDOs they helped create were not disclosed in any way to investors in the written documents about the deals. Not the marketing materials, not the prospectuses, not in the hundreds of pages that an investor could get to see information about the deal was it disclosed that it was in fact Magnetar who’d helped create the deal, and who’d bet against.

That is, of course, along the lines of what the SEC is suing Goldman Sachs for now. The SEC’s suit also says CDOs like the ones Goldman built “contributed to the recent financial crisis by magnifying losses associated with the downturn in the United States housing market.”

Notably, the SEC did not sue the hedge fund [10] involved in Goldman’s Abacus deals — Paulson & Co. — or its manager, John Paulson. Instead, it’s going after Goldman. And as we pointed out in our reporting, there’s no evidence that what Magentar did was illegal [11].

Assessment

We’ve called the major banks involved in Magnetar CDO deals to see if they were concerned about similar lawsuits. Thus far, Bank of America, Citigroup, Deutsche, Wells Fargo (which bought Wachovia) and UBS have responded and have all declined our requests for comment. Here is Magnetar’s response [12] to our original reporting.

Conclusion

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Behind the Financial Reform Push

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Of Worries on Warring Regulators

By Jeff Gerth, ProPublica – April 14, 2010 12:07 pm EDT

Backers of financial regulatory reform are gearing up for the final stretch in a yearlong effort to construct a new, streamlined architecture. But, recent reports and testimony about the financial crisis suggest a crucial ingredient in any new structure is in short supply: cooperation among the watchdogs.

Office of Thrift Supervision

A proposal to eliminate one regulator seen by many as particularly weak—the Office of Thrift Supervision—could alleviate some friction. A soon-to-be-released federal examination of the Washington Mutual collapse found that OTS resisted efforts by a more skeptical regulator, the Federal Deposit Insurance Corporation, to take a closer look at WaMu, according to an account in The New York Times [1].

Reform legislation pending in the Senate [2] (PDF) would also create new agencies, including a financial stability council to assess risk and a consumer protection watchdog. To work as envisioned, the agencies would need new levels of information sharing and decision making. By contrast, history suggests agencies can be stingy with what they know and eager to point blame at sister regulators.

Fall of the House of Lehman

Lehman Brothers, the investment bank that collapsed in September 2008, presents a case in point.

A lengthy examiner’s report [3] for the judge overseeing Lehman’s bankruptcy found that the Federal Reserve Board and the Securities and Exchange Commission kept crucial data from each other even though they had “overlapping” functions. The heads of the Federal Reserve and the SEC reached a formal sharing agreement in July 2008, but the two regulators “did not share all material information that each collected about Lehman’s liquidity.”

SEC Queries

The SEC, asked by the Federal Reserve Bank of New York to provide data on Lehman’s commercial real estate exposure and liquidity, “affirmatively declined to share” the information because it was still in draft form, the bankruptcy report found. The reserve bank never turned down an information request from the SEC, but bank officials “did not perceive any duty to volunteer” information about a $7 billion shortfall in Lehman’s liquidity they uncovered in August 2008.

The reason? The report says it was “because the SEC did not always share information” with them. One official at the Federal Reserve Bank of New York told the examiner “there was not a warm audience” for information sharing between the New York Fed and the SEC.

Lehman fell under the scrutiny of the Fed after it was allowed to tap Fed lending facilities, normally reserved for banks, in the spring of 2008.

Oh … the Irony

Ironically, examiners at the Office of Thrift Supervision, which regulated Lehman’s bank subsidiary, concluded in July 2008 that Lehman had violated its own risk limits by placing an “outsized bet” on commercial real estate. But, the OTS appears as a bit player in the autopsy of Lehman’s collapse; top Federal Reserve officials “considered the SEC to be Lehman’s regulator,” the bankruptcy report found.

One of those officials, Timothy Geithner, was president of the Federal Reserve Bank of New York from 2003 until early 2009, when he became secretary of the Treasury. Shortly after he joined the cabinet, Geithner was asked by a senator about the Fed’s supervisory responsibility [4] in connection with the collapse of institutions like Lehman and the insurance giant AIG.

“I just want to point out,” Geithner told the Senate Finance Committee, “the Federal Reserve was not given responsibility for overseeing investment banks, insurance companies, hedge funds, non-bank financial systems that were a critical part of making this crisis so intense.”

networking_0

Fed Responsibilities

The Fed is responsible for supervising bank holding companies, such as Citigroup. Those holding companies include investment banks and, as a sister regulator quietly pointed out last week, the Fed shared responsibility with the SEC for overseeing the risky practices of Citigroup’s broker dealer.

John C. Dugan, who oversees nationally chartered banks as comptroller of the currency, told the Financial Crisis Inquiry Commission [5] (PDF) last week that most of the problems that led to a massive bailout for Citigroup took place under the umbrella of the weaker holding company regulated by the Fed—not at Citibank, the banking subsidiary under Dugan’s authority.

Most of the losses, Dugan said at the end of a lengthy report to the commission, were in subprime lending, leveraged loans and the structuring and warehousing of CDOs (collateralized debt obligations) that are supervised, either all or in part, “by the Federal Reserve.”

Geithner has acknowledged [6] that he could have done a better job of supervising Citigroup during his tenure at the New York Fed.

Assessment

If the Senate bill becomes law, Geithner would sit atop the new financial stability council, whose members will include representatives of several different agencies—including the Fed, the SEC and the Office of the Comptroller of the Currency.

Conclusion

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How One Hedge Fund Helped Keep the Bubble Going

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On the Magnetar Trade

By Jesse Eisinger and Jake Bernstein, ProPublica – April 9, 2010 1:00 pm EDT

In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.

Precise Timing

At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund [1] helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages.

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When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers.

Yet the hedge fund, named Magnetar for the super-magnetic field created by the last moments of a dying star, earned outsized returns in the year the financial crisis began.

The Magnetar Trade

How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade [2]. Nearly all of those approached by ProPublica declined to talk on the record, fearing their careers would be hurt if they spoke publicly. But interviews with participants, e-mails [3], thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street.

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations — CDOs. If housing prices kept rising, this would provide a solid return for many years. But that’s not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Chance Enhancement

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.

Magnetar says it was “market neutral,” meaning it would make money whether housing rose or fell. (Read their full statement. [4]) Dozens of Wall Street professionals, including many who had direct dealings with Magnetar, are skeptical of that assertion. They understood the Magnetar Trade as a bet against the subprime mortgage securities market. Why else, they ask, would a hedge fund sponsor tens of billions of dollars of new CDOs at a time of rising uncertainty about housing?

Key details of the Magnetar Trade remain shrouded in secrecy and the fund declined to respond to most of our questions. Magnetar invested in 30 CDOs from the spring of 2006 to the summer of 2007, though it declined to name them. ProPublica has identified 26 [5].

Independent Analysis

An independent analysis [6] commissioned by ProPublica shows that these deals defaulted faster and at a higher rate compared to other similar CDOs. According to the analysis, 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs. The study [6] was conducted by PF2 Securities Evaluations, a CDO valuation firm. (Magnetar says defaults don’t necessarily indicate the quality of the underlying CDO assets.)

From what we’ve learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn’t cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.

Major Players

Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses [5], the banks didn’t disclose to CDO investors the role Magnetar played.

Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.

Assessment

Of course, some bankers involved in the Magnetar Trade now regret what they did. We showed one of the many people fired as a result of the CDO collapse a list of unusually risky mortgage bonds included in a Magnetar deal he had worked on. The deal was a disaster. He shook his head at being reminded of the details and said: “After looking at this, I deserved to lose my job.”

Magnetar wasn’t the only market player to come up with clever ways to bet against housing. Many articles and books, including a bestseller by Michael Lewis [7], have recounted how a few investors saw trouble coming and bet big. Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.

Magnetar’s approach had the opposite effect — 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.

Conclusion

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,” [8] 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.”

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