MY COLLEAGUE at Free Exchange writes that he's beginning to feel a sense of "resigned cynicism" over financial reform, that effective policy responses may be out of the question and that the best we can hope for might be a cultural shift:

I'm increasingly of the belief that the best thing that might come out of the crisis would be the use of public anger to change the culture of Wall Street. It's hard to see how the world would be a worse place if outlandish bonuses were met with vocal public scorn, or if the brazen pursuit of financial wealth were looked down upon, or if regulatory weakness in the face of Wall Street pressure were greeted with hooting derision... If financial executives are going to behave as parasites, they should be shamed as parasites. Maybe nothing will change as a result, and they'll comfort themselves by drying their tears with gold leaf. But maybe it will have an effect.

I hope he's wrong, but if he's right (or, in fact, either way) we should all be doing more reporting like the extraordinary piece "This American Life" aired the week before last on the Magnetar trade. The piece, reported by Jesse Eisinger and Jake Bernstein of ProPublica, describes how a Chicago hedge fund named Magnetar entered the market for collateralised debt obligations (CDOs) in 2006, helped inflate the subprime bubble an extra year or two, and then cashed out by shorting the very bubble it had helped to create, to the tune of billions of dollars. Aside from Annie Lowrey at the Washington Independent, and James Kwak, few people in the blogosphere seem to have picked up on the ProPublica story; I can't understand how I missed it. It's fantastic. It's horrific. It's like a really good South Korean monster movie. Except that it really happened, and in the end, after watching all that destruction of value, you, the taxpayer, have to pay for it.

As Messrs Eisinger and Bernstein tell it, the essence of the Magnetar strategy was simple. As the subprime real-estate market slowed in 2005, it became increasingly difficult to put together CDOs. Investors could still be found to buy the supposedly less-risky senior and mezzanine tranches, but the bottom tranche containing the riskiest loans, known as the equity tranche, was becoming unmarketable. Without a buyer for the equity tranche, it was impossible to put together the CDO deal. But in late 2005, Magnetar, a new hedge-fund startup, began buying up large quantities of high-risk equity tranches, making huge numbers of new CDOs possible. At the time, few could figure out what Magnetar was up to. But at the same time, Magnetar was betting (or hedging, depending on how you look at it) heavily against the failure of the CDOs they were buying into. And according to Messrs Eisinger and Bernstein, Magnetar was also systematically intervening with CDO managers, who selected the mortgage-backed securities that were bundled into the tranches, and pressuring them to include higher-risk securities in the equity tranche. Messrs Eisinger and Bernstein contend that Magnetar was setting up the entire CDO to fail, so that all the tranches would collapse, and it could collect on the credit-default-swap bets it had placed against the CDOs it was putting together. In almost every case, that was what happened; Magnetar made billions of dollars in 2007 and 2008, as the CDO market was collapsing.

In principle, the CDO manager had a fiduciary duty to disclose to investors that Magnetar had persuaded them to include riskier securities in the CDO. But few did. Most of their earnings, millions of dollars a year in some cases, came from fees for closing CDO deals. They had no personal incentive to undermine their prospects of closing a deal. Magnetar, predictably, denies it tried to influence CDO managers; it claims it was neutral on the housing market, and would have made money whether housing rose or fell. Messrs Eisinger and Bernstein say the evidence belies the claim:

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. An independent analysis 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.

And with that I will stop summarising their work, because you should all go read the rest of it at ProPublica, and/or listen to it on "This American Life". But beyond Magnetar, Brad DeLong refers us to James Kwak's take on the Goldman Sachs fraud filing. As Mr Kwak writes of the Goldman case:

The type of transaction involved—in which a hedge fund makes a CDO as toxic as possible in order to then short it—is similar to the Magnetar trade, which I discussed earlier. One thing we learn from paragraph 5 is that Paulson sure knew how to pick ‘em: “The deal closed on April 26, 2007. Paulson paid GS&Co approximately $15 million for structuring and marketing ABACUS 2007-AC1. By October 24, 2007, 83% of the RMBS in the ABACUS 2007-AC1 portfolio had been downgraded and 17% were on negative watch. By January 29, 2008, 99% of the portfolio had been downgraded. As a result, investors in the ABACUS 2007-AC1 CDO lost over $1 billion. Paulson's opposite CDS positions yielded a profit of approximately $1 billion for Paulson.”

But people want liquidity, and they have to be willing to pay for it! Or something. What exactly was the purpose of the financial sector supposed to be, again? Because I'm pretty sure "inflating bubbles so as to bet on their collapse, thus forcing the taxpayers to bail out your counterparties" wasn't it. Anyway, if it's outrage you want, come and get it.