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SEC Investigates Magnetar, Sponsor of CDO Program That Pumped Up the Subprime Bubble

Readers of this blog may know that we broke story in our book ECONNED of the role that the hedge fund Magnetar played in increasing the severity of the subprime bubble through its program of hybrid CDOs (meaning composed of actual tranches of subprime bonds plus credit default swaps).

To recap: Magnetar embarked on an unheard-of program of CDO creation to enable it to take a no-lose bet. It sponsored CDOs by funding the equity tranche, the riskiest layer that received high interest payments, typically 18-20%. It used the cash flow from the equity to sponsor an even larger short position, using the instruments in the CDO. It balanced its exposures so it would show a thin profit as long as the CDO performed, and a much larger return when it failed. Sponsorship of the equity trance most importantly gave Magnetar influence over the parameters of the deals (such as the ability to reject certain exposures). As an industry source said:

At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .

Magnetar’s idea was that CDOs were destined for long term failure—that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from
RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.

The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions—i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.

Magnetar made A TON of money . . . I’d expect every bit as much as Paulson [a hedge fund manager who earned $15 billion shorting subprime mortgages in 2007].

The discussion of the Magnetar program in ECONNED includes:

• How a seemingly small amount of BBB tranches from subprime bonds used in Magnetar’s CDOs, had a devastating impact on the subprime market. Consistently conservative analyses indicate that in the peak years of 2006 and early 2007, Magnetar’s program drove the demand for roughly 35% of subprime bonds. Industry sources have estimated that the number to be as high as 50% to 75%.

• Magnetar’s trade was imitated by other hedge funds and dealers, further increasing the systemic impact.

• The deals were mostly hybrids, typically with 20% cash bonds and 80% credit default swaps; why this structure was advantageous for Magnetar.

• The links between the demand for CDOs and the “negative basis trade” that was arguably a widespread form of bonus fraud. (When a AAA instrument was insured by an AAA guarantor, internal reports typically treated it as if all the expected income in future years was discounted to the present. As we know now, in the overwhelming majority of cases, bonuses were paid on income that was never earned. This mechanism was THE reason many banks would up holding so much AAA CDO inventory – it was more lucrative for the traders to retain and “hedge” it than sell it.)

• The masquerade of almost entirely BBB subprime risk as AAA suppressed CDS spreads on BBB subprime bonds, the most actively traded tranche of the original bonds. Via arbitrage, this also influenced subprime bond pricing, which in turn lowered the yield on the loans themselves. In this manner, the mezzanine CDO market directly influenced spreads in the subprime housing market.

The Wall Street Journal tonight reports that the SEC is investigating Magnetar:

Investigators carrying out the SEC’s broad examination into these securities, known as collateralized-debt obligations, are holding face-to-face meetings with Wall Street executives about deals involving hedge fund Magnetar Capital, according to people familiar with the matter….

Critics have said that the actions of players such as Magnetar helped fuel the boom in mortgage-linked securities after cracks had begun to show in the subprime housing market. That subsequently worsened the financial crisis when Wall Street banks incurred heavy losses from CDOs they bought or were unable to sell.

Magnetar offset its risk by betting against the default of these securities using instruments called credit default swaps. Magnetar ended up making big profits when these CDOs collapsed, while the investors in the supposedly safer parts of the security suffered big losses.

Among other things, investigators want to know how the assets that were put into the CDOs were valued at the time, what the terms of the deal were, what triggers were put in place to determine whether investors would incur losses and at what point did firms involved in the deal bet against the assets in the CDO, people familiar with the matter say.

Yves here. Note that the subsequent expose on Magnetar by ProPublica disclosed that many of Magnetar’s deals were “triggerless”, a particularly bad feature for the AAA investors. Normally, CDOs had “triggers” built in to change how the cash flows in a CDO were distributed if the deal started to suffer credit losses. They were analogous to the way the body responds to hypothermia, by restricting blood flow to the extremities to preserve the brain and vital organs. In CDOs, the triggers would restrict payments to the equity and lower-rated tranches. Eliminating them worked to the advantage of Magnetar, since it would keep getting good payouts even as the deal was starting to crater.

Back to the Journal:

People familiar with Magnetar’s deals say the firm actually played a role in how the securities were put together, encouraging these independent managers to pick mortgage assets with certain characteristics to put in them.

Magnetar told its investors in April that it “did not control asset selection in CDOs in which it participated” but said it “often communicated” with the bank and asset managers when the deals were being put together.

Yves here. Magnetar’s defense is technically accurate but spurious. Yes, an asset manager picked the assets that went into the deal, but those choices had to be satisfactory to Magnetar. Everyone knew that if the equity sponsor didn’t like the assets chosen, it would withdraw, and that would kill the deal. To the Journal again:

Magnetar rejected the characterization of its deals as bets on a collapse of the mortgage market. “It was not a ‘bet’ that any CDO, any group of CDOs, or the housing or mortgage markets as a whole would fail either in the short term or long term,” the firm said in its letter.

Yves here. Again legalistic. No, Magnetar was not betting on the housing market, it was betting on certain highly correlated BBB subprime exposures. And it can claim it wasn’t betting “against” the CDO, since it had a long as well as a short position in them.

I hope the SEC is able to see through Magnetar’s dubious claims. It’s time that the role of the sponsors of toxic CDOs were brought to justice.

  •  Paul Repstock says:

    June 19, 2010 at 4:03 am

    LOL Yves…
    Bases on my belief that greed is by definition insatiable; I would suggest that if the investigators really want to solve and prosecute these cases. They should look for the secondary and tertiary layers. I am certain they exist.

    There may be evidence showing that financial executives accually pumped/pimped the story of the mortgage meltdown.

    There will somewhere be links to other benefit streams, both personal and corporate, where gains were pocketed from the collapse of the CDOs. There will probably be short positions on the companies most affected and possibly even some type of second layer of default swaps??

    Questioning the managers will only result in years spent in circular testimony and obstruction, where everyone is covering mutual butts.

  •  psychohistorian says:

    June 19, 2010 at 5:32 am

    Also thanks to Yves for her part on putting pressure on our government to do the right thing. Lets hope they follow through and some people go to jail.

  •  Rex says:

    June 19, 2010 at 7:07 am

    Small point in this bigger discussion, but…

    Yves mentions, “the subsequent expose on Magnetar by ProPublica”

    I found it annoying, at the time, when other blogs started mentioning ProPublica as the source for their information about Magnetar, yet I had recently read Econned which told me about Magnetar before the ProPublica piece, especially considering the book’s writing and publication delays.

    Props to you Yves. Keep up the good work.

  •  anon says:

    June 19, 2010 at 8:19 am

    What’s the reason for the cash/swap mix?

    Why not 100 per cent swaps?

  •  Doug Terpstra says:

    June 19, 2010 at 8:39 am

    Thank you and congrats, Yves! This is your scoop … and coup. May it lead to more, and even light a torch under our AWOL DOJ. Thankfully, it appears the SEC has found enlightment in your book, ECONNED and perhaps Naked Cap. It’s time to make it part of Prez Obama’s PDB reading. Now that would offer real hope.

    You starkly exposed Magnetar and Wall Street cronies as malevolent malefators—corrupt gamblers intent on self-enrichment at the premeditated expense of others. This terrorism and defilement of the Earth must not, cannot continue.

    “Where there is no vision, the people perish” (Solomon’s Proverbs 29:18)

    Too many people and too much creation is perishing today (with great heartache), so we need renewed vision badly. But that is so conspicuously absent in current American leadership (political, financial, or journalistic). So it is blogs like NC, not captive to asylum management, with sharp analysis, well formed ideas, and rigorous debate, that offer our best hope to re-awaken our vision.

    Go Yves!

  •  Siggy says:

    June 19, 2010 at 12:00 pm

    The problem with Magnetar is that it appears to have missrepresented the CDO’s it sold. Penalties for that and beyond that I’m uncertain.

    The trade itself, create a failure, insure it and then collect the insurance may well be a criminal act. But then, recognizing that the housing markets in several locales were in a bubble is a very interesting proposition. Is/was there a viable short against the housing market bubble other than the CDO and its companion the CDS?

    What should have been the appropriate method of correction of the over priced housing market? In that correction, who should have sufferred losses?

    I don’t think we’ll ever address those issues.

  •  Moose says:

    June 19, 2010 at 12:01 pm

    I think that unless you can prove that the asset manager is in cahoots with Magnetar there is no legal case.
    “Everyone knew that if the equity sponsor didn’t like the assets chosen, it would withdraw, and that would kill the deal.” That is true but the other side is that it makes no sense that asset managers want CDOs they are associated with to fail.
    I also have read other books that say banks retained AAA CDOs for short term lending collateral in the repro market.

    I as well you want justice, but where was the injustice you claim – be specific.
    Too much mob mentality and rage will obscure meaningful solutions to preventing another financial crisis.

  • The Magnetar Trade How One Hedge Fund Helped Keep the Bubble Going - ProPublica

    by Jesse Eisinger and Jake Bernstein, ProPublica - April 9, 2010 1:00 pm EDT

    In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates. Subprime mortgage company shares were falling. Investors began to balk at buying complex mortgage securities. The housing bubble, which had propelled a historic growth in home prices, seemed poised to deflate. And if it had, the great financial crisis of 2008, which produced the Great Recession of 2008-09, might have come sooner and been less severe.

    At just that moment, a few savvy financial engineers at a suburban Chicago hedge fund [1] [1] helped revive the Wall Street money machine, spawning billions of dollars of securities ultimately backed by home mortgages.

    When the crash came, nearly all of these securities became worthless, a loss of an estimated $40 billion paid by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers.

    Yet the hedge fund, named Magnetar for the super-magnetic field created by the last moments of a dying star, earned outsized returns in the year the financial crisis began.

    How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade [2] [2]. Nearly all of those approached by ProPublica declined to talk on the record, fearing their careers would be hurt if they spoke publicly. But interviews with participants, e-mails [3] [3], thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street.

    According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations -- CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

    Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.

    Magnetar says it was "market neutral," meaning it would make money whether housing rose or fell. (Read their full statement. [4] [4]) Dozens of Wall Street professionals, including many who had direct dealings with Magnetar, are skeptical of that assertion. They understood the Magnetar Trade as a bet against the subprime mortgage securities market. Why else, they ask, would a hedge fund sponsor tens of billions of dollars of new CDOs at a time of rising uncertainty about housing?

    Key details of the Magnetar Trade remain shrouded in secrecy and the fund declined to respond to most of our questions. 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 [5] [5].

    An independent analysis [6] [6] 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. The study [6] [6] was conducted by PF2 Securities Evaluations, a CDO valuation firm. (Magnetar says defaults don't necessarily indicate the quality of the underlying CDO assets.)

    From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time. And the hedge fund didn't cause the housing bubble or the financial crisis. But the Magnetar Trade does illustrate the perverse incentives and reckless behavior that characterized the last days of the boom.

    Some bankers involved in the Magnetar Trade now regret what they did. We showed one of the many people fired as a result of the CDO collapse a list of unusually risky mortgage bonds included in a Magnetar deal he had worked on. The deal was a disaster. He shook his head at being reminded of the details and said: "After looking at this, I deserved to lose my job."

    Magnetar wasn't the only market player to come up with clever ways to bet against housing. Many articles and books, including a bestseller by Michael Lewis [7] [7], have recounted how a few investors saw trouble coming and bet big. Such short bets can be helpful; they can serve as a counterweight to manias and keep bubbles from expanding.

    Magnetar's approach had the opposite effect -- by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn't alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

    Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, "Econned," [8] [8] that "Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder."



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