Step 1. We write a check for 10 million dollars, hand the check to a Wall Street Bank, and ask them to make us a CDO.
Step 2. They create the CDO using risky stuff. Very risky stuff. Extremely risky stuff!
Step 3. Other investors commit hundreds of millions of dollars to the CDO.
Step 4. We bet against the CDO using a Credit Default Swap.
Step 5. The housing market crashes, the CDO’s value drops to zero, our bet pays off and we make hundreds of millions of dollars,
and before you can say, Step 6. We’re rich!
Betting Against The American Dream, by Robert Lopez
NPR’s Planet Money did a show recently about how Wall Street bankers created CDO’s that were designed to fail for a hedge fund. The hedge fund sponsored the CDO and made sure that the CDO was filled with extremely risky mortgages that were about to default. Then the hedge fund bet against the CDO. Of course, in order to convince other investors (the chumps) to buy the CDO, they had to withhold the information that the CDO was being sponsored by the hedge fund, who was betting against them.
This story clears up a lot of mysteries. For example, there was the illegal immigrant farm worker in Modesto, California with income of $27,000 per year was able to qualify for a $600,000 mortgage, over 20 times his annual gross income. How could this be? It is obvious to anyone that no one can afford a house 20x their income. The farm worker knows it. The mortgage broker knows it. Everyone knows it.
As far as the farm worker goes, he was just told that he could buy the house and live in it with no money down. In fact, he would receive cash money at the closing as part of the deal. They would even pay his monthly mortgage for him for the first few months.
As far a the mortgage broker goes, he knew that a Wall Street bank would buy the mortgage from him, so he didn’t care if it defaulted in six months.
The mystery was why would Wall Street banks want to buy a mortgage that had a 100% chance of default?
Now we know the answer. Wall Street bankers like Goldman Sachs needed these “extremely risky assets” in order to create something to bet against, the CDO.
This was called the Magnetar trade, after the hedge fund Magnetar which sponsored an estimated $23 billions of dollars worth of these CDOs that became nearly worthless. The Wall Street banks that created the CDOs for Magnetar included Citigroup, Lehman Brothers and Merrill Lynch.
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