Today I heard the tail end of a fantastic This American Life episode based on a ProRepublica story on the hedge fund Magnetar. The short version is that, when the housing market started to appear unstable in 2005, Magnetar realized that bad incentives at investment banks would allow it to make money by creating a resurgence of CDO investments in the housing market, prolonging the inflation of the housing bubble.
The bad incentives were that investment bankers were paid immediately in handsome fees for creating and selling these CDOs without the requirement of having “skin the game” when they might later became worthless. When the CDO collapses, the bank (and, through bailouts, the taxpayer) takes the loss, but the banker is long gone.
Magnetar made a name on buying the riskiest layer of CDOs, giving other investors the impression that they were a safe investment and causing the CDO market—and connected investments into the housing market—to take off again (when it could have otherwise returned to Earth slowly and less destructively). What was not made clear to CDO investors—and some say this constituted criminal activity by CDO managers—was the fact that Magnetar was simultaneously placing large bets against the same CDOs and actively encouraging banks to create them from much riskier loans.
I.e. Magnetar’s CDO investments were designed to allow future losses, but to temporarily pay the bills and give false information to the market, allowing Magnetar to later gain tremendously on its eventual downturn. Had the CDO creators and dealers passed on this information (by having incentive to do so), the investors would’ve realized these things were being designed to fail and stayed out of them.