In 2005, Alec Litowitz, was rested and relaxed from waiting out a non-compete clause from his previous employer. During his time off, he and his wife spent a year traveling the UK on the hunt for artifacts to add to their replica of an English manor in the Chicago suburbs. Apparently, the year abroad provided him some perspective. Now, at the helm of a new hedge fund, Magnetar, with $1.7 billion in assets, he spotted an opportunity of a lifetime.
It was clear that by 2000, technological change finally caught up with the massive US mortgage market. The sleepy loan market that had successfully funded the aspirations of home ownership for Americans for most of the Century was undergoing a profound change. The dissemination of technology within the banking industry now made it possible to turn a bank’s entire portfolio of illiquid mortgage loans into liquid mortgage backed securities (a “derivative” of the original loan).
The “securitizaton” process isn’t magic. Securitization is simply the process of crunching “big financial data” to convert mortgage loans with unique characteristics (the story of the borrower and the home) into a financial derivative with a simple numerical quality rating (risky to safe). These new, easy to use derivatives were a hit with investors worldwide. Demand soared and he process rapidly spread to the entire industry through the Internet.
Soon, the entire US mortgage industry was out in the field, beating the bushes to drum up new mortgages, with increasingly poor results. Further, bankers on the leading edge of technology had found ways to combined these derivatives into even more complex derivatives called CDOs. These CDO’s crunched big financial data to bundle securitized mortgages with different quality ratings into a single package that provided superior rates of return to buyers with presumably, little risk.
Of course, as we know, this entire edifice was a house of cards. Technology had accelerated this market so quickly, the entire bureaucracy — from government regulators to banking risk officers — were left in the dust. The biggest debt market in the world was now, inevitably, beyond bureaucracy.
Despite this unfettered trajectory, concerns over the quality of these derivatives was slowing the market in 2005 — a rare occasion when market forces did actually work, in this technologically juiced financial world. Left on its own, it might soon dry up. Alec saw this too.
Alec saw that the mortgage derivative market would soon crash and he wanted to make money on the way down. To do that he needed to short (make a bet on a decline in price) CDOs. The problem was that there weren’t enough being built anymore.
So, he decided to make more by partnering to rapidly build “improved” CDOs. To “improve” them, his firm bought the riskiest portion, making them appear, based on the big data financial data, less risky. These improved CDOs sold like hotcakes, giving Magnetar plenty of opportunity to bet on the downside. But it also extended the runaway amplification of the mortgage market for a couple of more years, radically increasing the damage to the entire system when it did eventually crash.
In sum, Alec and Magnetar made some money, by increasing the damage to the entire system and all the people in it, and we learned nothing. Nobody involved in any of the frauds associated with the crash (there were countless) went to jail.
As a result, the same conditions we had then, prevail today. The financial system is still being “managed” at bureaucratic speed with the expectation of normal results, despite the fact that technological change is increasingly producing non-linearity.
PS: Alec Litowitz made $280 m in 2007.
PPS: I’m writing a book online. This is a page of it. Will package it and the rest of the pages for Amazon. If you want to join me for free in the meantime, sign up with your e-mail in the space below.