How Some Made Millions Betting Against The Market

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Lawrence Wright: Bin Laden's Death 'Long In Coming'

TERRY GROSS, host:

This is FRESH AIR. I'm Terry Gross.

When I heard the news that Osama bin Laden was killed by U.S. forces in
Pakistan, I had a lot of questions. And one of the people I wanted to talk to
was Lawrence Wright. He's joined us several times on the show. He won a
Pulitzer Prize for his 2006 book "The Looming Tower: Al-Qaida and the Road to
9/11," which is based in part on more than 500 interviews, including interviews
with friends and relatives of bin Laden.

After the book's publication, Wright continued to investigate the story of al-
Qaida. His film, "My Trip to al-Qaida," was shown on HBO last year. We called
him late this morning.

Lawrence Wright, thank you for joining us. You've devoted years of your life
researching bin Laden, tracking down people who knew him. What was your first
reaction when you heard that he was killed?

Mr. LAWRENCE WRIGHT (Author, "The Looming Tower: Al-Qaida and the Road to
9/11"): Well, honestly, Terry, there was a tremendous sense of relief. This
seemed like something that was so long in coming. And with all the changes that
had been going on in the Arab world right now, real change in some ways
couldn't come until this moment happened.

GROSS: Why? I mean, do you see this as having more symbolic difference or real,
genuine leadership difference?

Mr. WRIGHT: Oh, I think it makes a profound change, in part because bin Laden
and bin Ladenism stood in the way of the kind of reforms that are really needed
to take the Arab world to the place where it really wanted to be.

The reaction that al-Qaida was to the kind of ingrained, autocratic rule in
that part of the world was one approach. It was a failure, but it would still
had a residual constituency and I imagine will continue to have. But it'd be
much diminished by the death of bin Laden.

GROSS: But does al-Qaida really end or get much diminished without bin Laden?
There's still a leadership change. I imagine he was pretty physically disabled
toward the end of his life.

Mr. WRIGHT: Listen, bin Laden is - you know, he's not irrelevant. He was
important all along. Just the fact that he was able to elude capture or being
killed for nearly a decade, actually more than a decade if you go back to the
embassy bombings in 1998 when we first went after him.

He's been a symbol of resistance and also the failure of American policy to
reach out and stop this kind of terror. It emboldened other imitators all
around the globe. So getting bin Laden is immeasurably important.

GROSS: How did the reality of his demise compare with some of the scenarios
you'd imagined?

Mr. WRIGHT: Actually, Terry, I think it was in 2006, the CIA came to me to
write a scenario, in their words, about what would we do if we got bin Laden
because this has been a subject of concern within the intelligence community.

What if we did get him? How would we treat him? Where would we take him? Would
it be better to take him alive or dead? And because I had written this movie,
"The Siege," you know, and Hollywood had done a somewhat better job of
connecting the dots about terrorism and the threat to America than the
intelligence community.

The CIA was reaching out to screenwriters, such as I had done, and I said:
Well, you know, I'm a reporter. I can't go writing screenplays for the CIA. But
I'll tell you in the form of an op-ed for the New York Times what I think if we
were able to catch bin Laden.

First of all, remember that bin Laden is the most famous man in the world. He's
going to be one of the most famous men in history. So if you have the good luck
to catch him, you have to deal with the legacy, not just the man.

And if you catch him, don't kill him because he'll become a martyr, which is
what he seeks to be. But don't take him to America just yet.

First of all, take him to Kenya, where on August 6, 1998, he set off a bomb in
front of an American embassy, killing 224 people and wounding, blinding 150
Africans. Let him sit in a courtroom in Nairobi and tell 150 blind Africans
that he was just striking at a symbol of American power.

And then you can take him to Tanzania, where on the same day, he set off
another bomb in front of another American embassy, killing 11 people, all of
them Muslims. And bin Laden excused that because it was Friday, and good
Muslims would be in the mosque.

I think that would be a wonderful venue to talk about what a good Muslim
actually is. And then you could bring him to America and have him answer for
the death of the 17 sailors on the USS Cole in October, 2000, and the 3,000
Americans who died on 9/11.

But you don't have to stop there. You can take him so many places. You know,
Casablanca, Madrid, London, Bali. But just take him one last place. Take him
home and try him under Sharia law, which is the only law that he and his
followers would respect.

And if he's convicted, he would be taken to a square in downtown Riyadh, and
the executioner is a big man with a long sword, and it's Saudi custom for the
executioner to go out and ask the crowd, which is composed of the victims of
the condemned man, to forgive him.

And if they couldn't do that, then the executioner would do his job, and bin
Laden would be taken and buried in an unmarked Wahhabi graveyard. And I thought
in that manner, you could begin to roll back some of his awful legacy.

GROSS: Wow, but of course he's gone now. So that scenario's never going to
happen. What was the CIA reaction to that scenario?

(Soundbite of laughter)

Mr. WRIGHT: Well, they appreciated that I had attempted to write a response to
it, but their main concern was if we'd captured him, Americans would be
kidnapped and held in ransom. And that is a lively scenario, and I suspect that
there was not very much of an interest in capturing bin Laden.

Leon Panetta, the director of the CIA, said that if we did capture him, we
would put him at Guantanamo, which I think would have been a miserable
solution.

GROSS: But now that American forces have killed him, what are the odds that
he's going to become a martyr and continue to live as this potent symbol?

Mr. WRIGHT: He will continue to live as a potent symbol. There's no question
that he's going to have an enduring appeal for a number of people, not just
perhaps radical Muslims but other groups that will follow the template that al-
Qaida created. That's my main concern.

Bin Laden is dead. Al-Qaida eventually will die. But the model that al-Qaida
has created of an asymmetric terror group that has enormous consequences in the
world well beyond the size of the group, that's going to endure. Other groups
are going to try to follow that model.

GROSS: You know, you talked about some of the positive outcomes that you see in
the killing of bin Laden. Are there bad ripple effects you're expecting?

Mr. WRIGHT: I do expect it. The plans that may be in the pipeline will be
rushed into operation as soon as possible on the part of al-Qaida or its
affiliates or its wannabes. Just last week, we had the bombing in Marrakesh and
the arrests in Germany, both of which seem to be tied to al-Qaida or
affiliates.

And so, it shows that, you know, al-Qaida continues to be an active operation
with entrepreneurial followers who are looking for an opportunity to create
more damage.

GROSS: How surprised were you that bin Laden was actually hiding out, at least
recently, in a compound, in a neighborhood about an hour's drive from
Islamabad, the capital city of Pakistan, near a Pakistani military base and
military academy? He was not in a remote cave.

Mr. WRIGHT: Well, I was surprised, I would have to say, you know, that he was
living inside an urban area. But I'm not surprised to learn that he was
essentially sheltered by Pakistani intelligence and military units.

GROSS: Is that the assumption you're making, that they were complicit?

Mr. WRIGHT: I do make that assumption. I feel that, you know, that for years,
the Pakistani military and intelligence complex has been in the looking-for-
bin-Laden business. He was a priceless asset to them because we poured billions
of dollars into their pockets to try to find him.

If they found him, they'd be out of business. So he was an irreplaceable asset,
and Pakistan has a lot to answer for. This looks very incriminating. And I
think it reflects on our relationship with that country, and this gives us an
opportunity to reassess exactly what our relationship with Pakistan ought to
be.

GROSS: A lot of people are troubled about the continuation of the war in
Afghanistan. Can you envision a scenario where President Obama basically says:
We've got bin Laden, now we can declare victory and wind down that war?

Mr. WRIGHT: I think that that's a possible scenario. I mean, the Taliban was
not really our enemy. It has become so. The Times Square attempted bomber was
sent by the Taliban, for instance. That's the first time that's happened.

But by its nature, Taliban is essentially a nationalist group, and al-Qaida is
an internationalist jihad with a primary focus on the United States. We don't
need to make the Taliban our principal enemy. And it was because of this
alliance with al-Qaida that we turned our attention to the Taliban in the first
place.

If we feel that al-Qaida is a much diminished threat as it may be, we'll see,
then our interest in fighting the Taliban could be commensurably diminished, as
well.

GROSS: So, Lawrence Wright, thank you so much for talking with us.

Mr. WRIGHT: It was a pleasure, as always, Terry.

GROSS: Lawrence Wright is the author of the Pulitzer Prize-winning book "The
Looming Tower: Al-Qaida and the Road to 9/11." Our interview was recorded this
morning.

Coming up, an interview with Jake Bernstein and Jesse Eisenger. They just won a
Pulitzer Prize for National Reporting for their stories about how several Wall
Street firms and one hedge fund contributed to the financial collapse.

This is FRESH AIR.
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How Some Made Millions Betting Against The Market

TERRY GROSS, host:

This is FRESH AIR. I'm Terry Gross.

Reporters Jake Bernstein and Jesse Eisenger just won a Pulitzer Prize for
National Reporting for their series "The Wall Street Money Machine." They spent
months trying to penetrate a world where few records are public, and the
players have little interest in talking to reporters.

Their stories explained in detail how some Wall Street firms' manipulation of
exotic financial instruments contributed to the near collapse of the nation's
financial system. Eisenger and Bernstein work for the online investigative
reporting nonprofit ProPublica.

This was the first Pulitzer ever awarded for work that was published on the Web
but never appeared in print. However, Bernstein and Eisenger collaborated with
NPR's Planet Money team to present some of their reporting on ALL THINGS
CONSIDERED and THIS AMERICAN LIFE, explaining the hedge fund Magnetar's efforts
to spur the creation of risky mortgage-backed securities while placing huge
side bets that the securities would fail.

Jesse Eisenger and Jake Bernstein spoke with FRESH AIR contributor Dave Davies.

DAVE DAVIES, host:

Well, Jake Bernstein, Jesse Eisenger, welcome to FRESH AIR.

Okay, let's talk about the Magnetar story. Magnetar was a hedge fund, and you
published this story in April of last year. It had a huge impact. And this
involves their manipulation of collateralized debt obligations. First of all,
explain what that is.

Unidentified Panelist: Sure, so Wall Street had a boom in packaging mortgages
up. A mortgage would be made by a company and then sold to a Wall Street
investment bank, and Wall Street would combine it with thousands of other
mortgages and get it rated by the rating agencies, so the part was AAA and AA
and then all the way down. And you'd have return, more return the lower down
you were, because you were taking more risk.

The AAA piece was supposedly really safe, and so it didn't have much risk at
all and therefore not much return.

And then Wall Street took slices of those mortgage-backed securities and
repackaged them, did the whole thing again, got them rated by rating agencies,
combined them with thousands of other securities and then sold those pieces
off.

And so it was kind of recombination of already combined thing. And those were
called collateralized debt obligations or CDOs, and ultimately they were backed
largely by subprime mortgages.

DAVIES: All right. So what we have is a financial instrument in which an
investor buys this thing, and what they're buying is a promise of a future
revenue stream, which ultimate comes from thousands of homeowners who, right,
have mortgages, and they've been repackaged, and some parts are risky, and some
parts aren't so risky. But that's what the investors are getting is this
promise of future revenue, which ultimately comes from the homeowners, right?

Unidentified Panelist: Yeah, that's correct, and the investor can choose how
risky they want it to be. If they buy this bottom piece, it is the riskiest
piece, but it offers the highest return, sometimes as much as 20 percent.

But if their appetite for risk is less, then they buy higher up in the CDO, and
they won't get as great a return, but presumably they will court less risk. It
didn't turn out that way, of course.

DAVIES: Right. Now, of course, those of us who followed this know that many of
these mortgages that were issued were far too risky, that in the end, housing
prices didn't hold up. Many mortgage holders were unable to pay. They
defaulted, which meant that these financial instruments, which ultimately
depended on that revenue, began to collapse, and investors who bought them were
in trouble.

What Magnetar did was a little different, right? They came along late in the
cycle. Explain their approach and how it was different.

Unidentified Panelist: Yeah, so Magnetar realized in the spring of 2006,
roughly, that the housing market was precarious, overinflated, and they also
realized that Wall Street was desperate to do deals, to create more CDOs.

So they went to investment banks, and they said: We'll buy the piece that's
very hard for you to sell, the riskiest little piece at the very bottom of the
deal called the equity. The equity takes the first loss if anything goes bad.
And so it was very difficult to sell because of that.

Unidentified Panelist: And the person who bought the equity was so key to the
deal and to the creation of the deal that they actually called that buyer the
sponsor of the deal because the banks were very reluctant to create a CDO
without having someone to buy that first-loss piece, the equity.

Unidentified Panelist: Exactly, and so because you were the sponsor of the
deal, you had influence over how the deal was put together. Now, the investment
bank was really putting it together. Their name was on the prospectus. They
went to the rating agencies and got it rated and paid the rating agency for the
rating. They went to the investors and sold it and put their good name to it.

But Magnetar was, unbeknownst to a lot of people, really the influential, the
most influential player in this whole deal. They had approached the bank to
create it. And then what the central finding of our story was is that they
pushed the banks to put riskier and riskier stuff into the deals, stuff that
was more likely to blow up.

And that was a central mystery why would they do that?

DAVIES: Right, so we've got the banks with all of these financial instruments,
which look increasingly risky, and investors aren't buying them.

And Magnetar says: We'll buy some of those. We'll repackage them with some of
these other instruments, which are again all based upon mortgage, expected
future mortgage payments, and create new instruments, which we can then sell to
investors. And they seem to be asking for the crap, the riskiest stuff to be
thrown in. And therein lies the tale. What were they really up to?

Unidentified Panelist: What they were really up to was they had a much larger
bet, if you will, that these very instruments that they were helping to create
were going to fail.

And so with a smaller amount of money, they could cause the creation of this
thing, and then they could bet against it, and if it failed, they would make,
you know, many times what they had put into it.

DAVIES: So we've got Magnetar, and they're kind of inciting these investment
banks to put together these financial instruments that investors will buy and
think they're going to make money when in fact what Magnetar, it appears, is
doing is making sure that, in fact, they're likely to fail.

And then Magnetar goes around the backdoor. They're not the legal issuer of
these instrument. That's an investment bank. And there's even a manager who
technically, legally selects the asset. But Magnetar, as your story says, seems
to be influencing things or pulling strings.

Then they go around the backdoor, and you say they bet against them. They bet
and say: We will make money if these investments fail, and they default. The
instrument there is a credit-default swap, right?

Unidentified Panelist: Right.

DAVIES: And do you want to explain how that works?

Unidentified Panelist: And it's actually quite brilliant what they've done
because that bottom piece that they bought to spawn the creation of this CDO,
well, it throws off money in the beginning, you know, before the whole thing
collapses. And so, they use that money to finance their bet against the very
same CDO.

DAVIES: So explain how the bet against the CDO works, how the credit-default
swap works.

Unidentified Panelist: Sure. What they're doing, essentially, is it's an
insurance policy, essentially. And what Magnetar is doing is paying a little
bit of money, a premium, in order to be insured against the failure of the
instrument.

So it's just like homeowners insurance. You're paying a little bit each
quarter. And then if the house burns down, you get the insurance. Let's say it
was a million-dollar house. You get the million bucks after you've paid $1,000
a year for three or four years or however long it took.

So, Magnetar is paying a little bit of money, and then they're getting, in
return, they're buying protection in the derivatives market. They bought a
credit-default swap.

And one larger point here is that none of this was regulated activity. So
nobody could really see this activity. The SEC couldn't see it. Investors
couldn't see it. Only the investment banks and the people that actually did
these trades knew it.

But it was kind of known in the CDO market, especially among certain investment
bankers, that what their real bet was in buying protection through a credit-
default swap.

GROSS: Jesse Eisenger and Jake Bernstein will continue their conversation with
FRESH AIR contributor Dave Davies in the second half of the show. Eisenger and
Bernstein won a Pulitzer Prize for their series "The Wall Street Money
Machine." They write for the online investigative group ProPublica.

I'm Terry Gross, and this is FRESH AIR.

(Soundbite of music)

GROSS: This is FRESH AIR. I’m Terry Gross. Let’s get back to the interview
FRESH AIR contributor Dave Davies recorded with Jake Bernstein and Jesse
Eisenger about their series of articles, “The Wall Street Money Machine,” which
just won a Pulitzer Prize for National Reporting. They write for the online
investigative nonprofit, ProPublica.

When we left off, they were talking about how the hedge fund Magnetar spurred
banks to create mortgage-backed derivatives from risky subprime mortgage loans.
Once these derivatives, these CDOs were created, Magnetar then bet against them
by purchasing credit default swaps.

DAVIES: So, if you got Magnetar creating these things, for them to bet against
them, for them to buy a credit default swap, in effect an insurance policy that
says we’ll pay you a low annual premium and then you will pay us a big sum if
in fact this instrument defaults. Somebody's got to be on the other side of
that. I mean somebody has to be willing to look at that and say yeah, we think
that's worth the risk. And, you know...

Mr. BERNSTEIN: Yeah.

DAVIES: Alan Greenspan once said, in fact, this is actually a good thing for
the economy because it spread risks around. There are people who are willing to
write this insurance, these financial arrangements, and if they're wrong and
the deal's collapse than they pay in balance is restored. Why was this impact
the stabilizing rather than helpful?

Mr. EISENGER: Well, in fact, what was happening was there were these
concentrated positions. There were fewer and fewer investors willing to ensure
these CDOs. And so there were only a handful of insurance companies and banks
that did it. And what happened was in the CDO market, it turned out that the
exposure to this market, these hundreds of billions of dollars of losses, was
only in a small handful of banks. And first it was in these insurance companies
that actually were shells almost. They couldn't afford the insurance that they
had offered. So when they failed everything went back to the banks and the
banks then started to teeter.

Mr. BERNSTEIN: So ultimately, the party that is on the other side of this bet,
the Magnetar and others like them are doing, are either the CDOS, the actual
instruments, are taking along part of it, or the banks themselves which, you
know, in the end when it all explodes, the taxpayers have to bailout.

DAVIES: Because in the end they really don't have the financial resources to
pay off their bets, right? They're writing insurance that they're really not
able to make good on.

Mr. EISENGER: Yeah, well there's this two-step process where Magnetar is
entering this bet with the CDO and kind of unbeknownst to everyone the bank
that's creating the CDO is buying most of it. And so the bank is really on the
hook for it and when the bank teeters then taxpayers have to come in and bail
it out. And so we were bailing out the banks that had made this bad bet with
hedge funds like Magnetar.

DAVIES: Now, so how did Magnetar do? How did the hedge fund do? How did its
managers do financially in all this?

Mr. BERNSTEIN: They did spectacularly well. They were up 76 percent in 2006,
their main fund. They made hundreds of millions of dollars on this.

Mr. EISENGER: But again in quantifying exactly how much they made is very hard
to do because hedge funds are fairly opaque and they don't have to report a
great detail about the other performance.

DAVIES: Okay. And now broadened the lens for us and tell us why we care about
this. I mean people make hundreds of millions and lose hundreds of millions on
Wall Street. Why did what Magnetar was up to impact the economy as a whole?

Mr. EISENGER: Well, Magnetar created more than $40 billion worth of the stuff
at a time when this business on Wall Street it really should've petered out in
2006. There was a bubble, a housing bubble in this country and it was going to
pop. And whether Magnetar was involved or not that was going to happen, but the
size of it, the scale of it, the incredible damage to the economy in large
degree was because it went on for several more years than it should have been
Wall Street really just inflated the heck out of it. So Magnetar had a big role
in that.

Mr. BERNSTEIN: And as late as last year and still up to today, you hear that
the financial crisis was a hundred year flood, that no one had control over it,
no one could foresee it. And in fact, what we wanted to show with our stories
is that lots of bankers knew that things were in trouble, that the housing
market was going down and that demand was falling away for these securities and
they went on, they did it anyway. Some of them did it because they could bet
against it. Some of them did it because they would make fees helping clients
were betting against it. Some of them did it just to sort of keep the machine
going and making bonuses, huge bonuses in 2006 and 2007. 2007 was a record year
for CDO production in the early part of the year despite that there was almost
no real demand for this.

Mr. EISENGER: I mean the CDO market were then doubled from 2005 to 2006. It
reached $226 billion. And just in the first quarter of 2007, Wall Street
produced 70 billion of the stuff.

DAVIES: Now I want to make sure we get Magnetar’s side of this into the extent
that we can. And on your website, of course, you print Magnetar’s written
responses to you. Did you ever talk to any of the principles?

Mr. EISENGER: Yeah. We had, you know, extensive conversations with Magnetar and
were very very careful about trying to understand exactly what their point of
view was. And we had a lot of written communication; we published all of that,
including all of our written questions and their responses and then their
letter that they published and then a subsequent letter that they sent to their
investors. And I think you can summarize their argument like this: that they
never had a view on the housing market. They say we were not making a bet on
whether the housing market was going to fail or succeed. We were just doing an
arbitrage, a complex kind of investment where you eye one thing that you think
is cheap and you sell another that you think is expensive and you're making the
little spread, the difference between the two. And so we were just doing that
kind of trade because we thought that these things were more correlated than
Wall Street thought and we had never had a view that these things were going to
fail and we never were building anything to fail.

Mr. BERNSTEIN: Yeah, and that they were covered. If the housing prices
continued to go up than the stuff that they had purchased from the CDO would do
very well; and if they went down, then they would also do very well. So it was
just, you know, playing with spread.

DAVIES: This is, I believe, the first Pulitzer in this category awarded for
peace that never appeared in print. What were some of the bandages are
drawbacks to writing online?

Mr. EISENGER: I think one of the things that the Internet allowed us to do was
really be very creative in our storytelling, if you will. We didn't just write
a piece, a long story that we threw on online. We did do that, but we also had
a comic strip. We had interactive graphs. We had a song that was commissioned
by “This American Life.”

(Soundbite of laughter)

Mr. EISENGER: And a radio program, several radio programs actually. So the sort
of Internet gives you the freedom to do that kind of interactive, you know,
different kinds of ways of getting the same message and the same story across,
which is very liberating.

DAVIES: Now this is complicated stuff and you collaborated with NPR's Planet
Money team for them and they did this very memorable piece about the Magnetar
deal on “This American Life” and then there were other pieces, and these are
folks who take complicated stuff and try and become audio storytellers. Did
working with them affect the way you reported the story and even the way you
reported it in your own text versions?

Mr. EISENGER: Yeah. Not as much they reported as the telling. These guys are so
great at taking complex topics and really sort of boiling them down and making
them not only understandable but enjoyable. And a lot of this stuff, as you
said, is very complex and difficult to absorb. And so we actually we learned a
tremendous amount from working with them. And I think at least in the Magnetar
story particularly, it was a huge help. Alex Bloomberg, who’s the producer on
the “This American Life” piece, really spent a lot of time on the storytelling
of it and really influenced way we approach the story as well.

Mr. BERNSTEIN: One of the most amazing meetings we had as we sat down with
those guys and we walked through all this complicated stuff. Okay, the tranches
and the CDOs and their buying credit default swaps and we were, you know,
sweating to try to explain this very early on and Ira Glass says, you know, I
think we'd like to change, turn this into a musical.

(Soundbite of music)

Mr. BERNSTEIN: And it was so funny. It was like, oh my god.

Mr. EISENGER: Alex turns to Ira and says this is the hardest story we've ever
done and you want to layer on top of that a musical. You must be insane. And
Ira just would not let it go. And what he had done is he had really sort of
boiled it down to this idea that this was very much like the musical “The
Producers.” You know they were sort of creating a musical and betting against
it. And so we sort of put that aside, but Ira certainly didn't and he
commissioned two of the guys within the main guys doing “The Producers” and
they wrote a song and it was perfect.

DAVIES: We're taking with Jake Bernstein and Jesse Eisenger. Their series “The
Wall Street Money Machine” is the winner of the 2010 Pulitzer Prize for
National Reporting.

We’ll talk more after a short break.

This is FRESH AIR.

(Soundbite of music)

DAVIES: If you’re just joining us, our guests are reporters Jesse Eisenger and
Jake Bernstein of the nonprofit investigative reporting organization
ProPublica. Their series, “The Wall Street Money Machine,” has won the 2010
Prize for National Reporting.

We should talk about the second story, which you published in August of last
year. And this involved the way as the mortgage-backed security market wound
down, as there were more concerned about risky mortgages and less demand for,
by investors to buy debts based on these increasingly risky products, that you
concluded that the bank kept the market going by creating fake demand. What
does that mean? How did they do it?

Mr. BERNSTEIN: Well, what happened was investors were leaving the market as
early as late 2005, early 2006. Before this been selling to banks around the
world, to insurance companies. But those savvy investors, sophisticated
investors were dropping away; not completely leaving the market was going away.
And so Wall Street replaced that demand with new CDOs. So they would create a
CDO and the CDO would buy pieces of the CDO. Then the new CDO would have pieces
that were hard to sell and so they would create a new CDO. And the CDO would
buy pieces of that. And what we found was that the banks were actually
orchestrating these sales. They were swapping sales, so they were doing you by
mine and I buy yours type of deals. And they were essentially having this kind
of daisy chain of demand that people hadn't really understood before.

DAVIES: Here’s what puzzles me about this is if the banks are basically
repackaging the stuff and buying these newly minted CDOs from themselves and
from each other, I mean one of the reasons you explain they do that is that the
people who put the deals together get fees and bonuses and they're
signification - if there is a tiny piece of a multibillion dollar deal it's a
couple million, so there's an incentive. But what I'm wondering is if they're
not really getting new investors and bringing new money in, where do they get
the funds to pay the fees and bonuses?

Mr. EISENGER: I mean it's astonishing but the banking system was so levered.
The banking system was running on borrowed money. So when the bank itself kept
the top of the CDO he didn't actually have to put up a lot of money to maintain
that asset because it was supposedly AAA and safe as houses, you know, safe as
U.S. Treasury bonds. And so they could actually fund that position, as they say
on Wall Street, with very little actual money. And so there were lots and lots
of IOUs going through the system and that's why it collapsed so quickly and so
dramatically.

Mr. EISENGER: And the other piece of this is that these mortgages were throwing
off money initially. You know when the deals were created these CDOs are
actually producing some revenue, certainly enough revenue to pay off banker
bonuses. So...

DAVIES: Because the source of revenue is essentially thousands of homeowners
who have mortgages and some of them are still able to make payments, right?

Mr. EISENGER: Exactly.

DAVIES: Right. And so it, in effect, we do a new deal and we generate a few
million in commissions and bonuses, that's really coming out of what the
homeowners are paying?

Mr. BERNSTEIN: Not exactly. I mean what’s amazing about it is that the bankers
get paid before the investors get paid. They get paid based on the closing of a
deal. That's when the fee comes. So the fee is coming, essentially, from
borrowed money that is backed by the mortgages that will eventually supposedly
be paid off.

DAVIES: And they're borrowing from whom?

(Soundbite of laughter)

Mr. EISENGER: Well, they're initially borrowing from the CDO.

Mr. BERNSTEIN: But ultimately the banks are borrowing from each other in this
incredibly interlocking global financial system that seizes up in September,
2008, because of this very reason, that they're borrowing from each other,
which is mindbogglingly complicated, but they're borrowing in this very short-
term market, overnight market, where they're going back and forth with hundreds
of billions of dollars, back and forth overnight, and that seizes up in part
because the assets backing those promises to pay them back are CDOs that are
supposedly AAA but no longer AAA.

And this is actually the question that we tried to answer in our third story,
which we called "The Subsidy." And we looked at the biggest CDO producer during
this period, which was Merrill Lynch, and we wanted to know why they would take
so much of this stuff. You know, if there weren't investors for it, if it was
clear that the market was retreating, not advancing, why would they take 80
percent of a billion or a two billion dollar CDO?

And we found this very complicated financial arrangement, whereby the CDO
business was not allowed to keep the stuff they were producing. As they would
say, we're in the moving business, not the storage business. You know, it was
obviously a bad incentive for them to keep the stuff that they were creating.
So they created a special desk within the bank of traders and these traders
would take the CDO stuff that they couldn't sell.

Now, why would the traders take it, because traders want to make money and
what's their incentive to take a money-losing deal? And what was going on was
that the CDO group was sharing their bonuses, sharing their profit with this
new group of traders that had been created just to take it.

Mr. EISENGER: You know, just to follow up on Jake's point, I mean this whole
business was extraordinarily fake. It was based on demand that wasn't there and
promises that couldn't be kept. And so when we came out of meetings, starting
to get glimmers of understanding about this, that this business that had been
worth supposedly hundreds and hundreds of billions of dollars, was really on an
edifice of tissue, we were astonished. It was scary. It was terrifying. But
these were all deals largely that had no substance behind them.

DAVIES: Did people in the business realize this at the time?

Mr. BERNSTEIN: I think more people realized it than didn't, frankly. And the
way that they sort of rationalized it was, if it's really that bad, if it
really is such a tissue of sort of false promises, as Jesse said, then when it
goes bad, it's going to go bad for everybody and it'll be, you know, colossal.
And so we really don't have to worry about it.

But certainly by 2007 there was a real understanding of this.

Mr. EISENGER: Yeah. Yeah. On Wall Street they say IBG, YBG - I'll be gone,
you'll be gone. So let's just do the deal.

Mr. BERNSTEIN: We found that in the last two years of the boom, nearly half of
all the CDOs sponsored by Merrill Lynch, which was the lead CDO producer during
this period, bought significant portions of other Merrill CDOs.

So I mean clearly, when you're buying your own stuff, you know, and you're
moving one unsold portion into another unsold portion, you understand that
there's something seriously wrong.

DAVIES: We're speaking with Jake Bernstein and Jesse Eisenger. Their series
"The Wall Street Money Machine" has just won the Pulitzer Prize for national
reporting. We'll talk more after a short break. This is FRESH AIR.

(Soundbite of music)

DAVIES: If you're just joining us, our guests are reporters Jake Bernstein and
Jesse Eisenger. They work for the non-profit investigative organization
ProPublica. They've just won the 2010 Pulitzer Prize for national reporting for
their series on the financial crash called "The Wall Street Money Machine."

Among the things we've talked about is the lack of regulation over some of
these instruments like credit default swaps. I mean, nobody knew how many of
these insurance policies Magnetar was buying on bad debt because there's –
there are not public records. If there were a real regulatory system in place
at the time, with rules for transparency and integrity and some active
monitoring and enforcement, how might have all this gone differently, do you
think? Take the Magnetar case.

Mr. EISENGER: I mean that supposes - yeah, we could give everyone a pony too.
But...

(Soundbite of laughter)

DAVIES: Give them a pony for purposes of this question. I mean, seriously, you
know, because I think this is the thing that Congress looks at. You know, we
don't want this to happen again. You know, you want people to have the ability
to be creative and to make money and have a financial system which, in which,
you know, assets are used in creative ways, but we don't want this to happen
again, and we want rules that will make some sense. And so I'm kind of - I
mean, it's a big question, I know, but...

Mr. BERNSTEIN: One of the amazing things about what Magnetar did was, they did
it very quickly. They put together more than 40 billion worth of deals in about
a year's time. And so, I think it's always going to be hard for regulators to
sort of be that on top of what's happening to stop that kind of behavior, but
certainly if there had been more disclosure, if there had been more active
policing, if there had been more of a deterrent factor, I think a lot of this
would not have happened.

Mr. EISENGER: We've often said that the disclosure was the key here because if
an investment bank came to an investor with a disclosure and they said, OK,
we've got investment for you, a hedge fund actually asked us to create it, and
- oh, by the way, the hedge fund has had a lot of influence over what kind of
assets are backing this instrument - oh, and by the way, they're betting
against it, would you like to buy it - that's the kind of disclosure that I
think would have deterred an enormous amount of this activity.

DAVIES: Right. But the fact is that, I mean every - I mean, I've read bond
prospectuses before and there's a lot of disclosure. I mean, they talk about
every financial arrangement, potential litigation and relevant laws. You're
asking them to kind of disclose the sort of secret relationships. Can you
legislate that?

Mr. EISENGER: Well, this is - I mean this is actually one of the things about
disclosure, right? I mean, you look at these prospectuses, they're 300 pages.
They've got all kinds of ifs and buts and wherefores. A lot of legalese and a
lot of sort of hypothetical – or hypothetical in quotes - scenarios.

And that's obviously not helpful, but I mean, if there are specific things that
are happening in the construction of the deal, they should not be buried in a
300 page prospectus in a way that it's not clear that this is actually
happening.

DAVIES: Let me ask a specific question about credit default swaps. And we
talked about these. These are essentially insurance contracts. I mean, if I can
make an arrangement with an insurer which says that a multi-billion dollar
security that I don't even own, I can make a bet that it's going to collapse by
paying a little premium, and then the insurer writes me a contract that says,
OK, we'll take your money and if it does collapse you'll get X, you know,
hundreds of millions of dollars - now, in casualty insurance - I mean, that's a
regulated industry by states, right? And I don't think I can go and buy an
insurance policy on a warehouse down the street from me in which I make money
if it burns down. Should this be permitted? I mean, they are - it's a private
financial contract. But should these kinds of arrangements be permitted? Should
they be public records like a mortgage? I mean, you could look at mortgages in
country records offices.

Mr. BERNSTEIN: Well, you're certainly right that in the insurance business you
cannot take out insurance without an insurable interest. And so there's a good
argument that the credit default swap market shouldn't exist the way it does.
I'm not entirely persuaded. I think that if credit default swaps were traded on
an open market where the prices were visible to people, where there was some
disclosure of the ownership or exposure, and where - and this is the key - you
had to put up some capital, then I think that the market would be a lot safer.
And we're moving in that direction. I'm not entirely convinced that we're going
to get there.

But the problem with credit default swaps was largely that you didn't have to
put up anything. You could just promise to pay off the insurance at some point.
And AIG did this to the tune of hundreds of billions of dollars, saying we'll
just pay this off when and if there's any problem, and then they couldn't, and
when the crisis happened, and that's why the government had to take them over.

Mr. EISENGER: I mean credit default swaps completely magnified what happened. I
mean, you could take a mortgage bond that was, say, worth ten million dollars
and there could be 50 times that in credit default swaps on it. So when that 10
million dollar mortgage bond went bad, the impact of that was not just 10
million dollars, it was many, many millions of that.

Mr. BERNSTEIN: Right. And the problem was not the buyers of the insurance,
largely, although with Magnetar they were bringing these things into creation
that were going to fail and amplify the losses and that would not have
otherwise been created.

But the real problem was the sellers, the people who were offering to insure
things, they were concentrated. They were the big insurance companies, they
were the big banks, and when they couldn't make good on their promises, that's
when they collapsed and then when the global financial system collapsed and
when we had to have all the bailouts.

Mr. EISENGER: And what's amazing is in the deregulatory mania of the early
2000s, Congress actually forbade the SEC from regulating this stuff. So for 10
years there was no regulation of this, and it sort of blossomed into this
mammoth market. And I think it's sort of a case study on the danger sometimes
of deregulation.

DAVIES: Well, Jake Bernstein, Jesse Eisenger, thanks so much for speaking with
us.

Mr. EISENGER: Thanks so much for having us.

Mr. BERNSTEIN: Thank you, Dave.

GROSS: Jake Bernstein and Jesse Eisenger spoke with FRESH AIR contributor Dave
Davies. Bernstein and Eisenger just won a Pulitzer Prize for national reporting
for their series "The Wall Street Money Machine," which was published by online
investigative non-profit ProPublica.

We'll close with the song they mentioned that was commissioned by THIS AMICAN
LIFE for their Magnetar story. If was composed by Robert Lopez, who co-wrote
the songs for "Avenue Q" and the Broadway hit "The Book of Mormon." The singers
are John Tracy Egan and Christian Borle.
..COST:
$00.00
..INDX:
135846486

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