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The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going

The hedge fund Magnetar helped create mortgage-based securities, pushed for risky things to go inside them and then bet against the investments, resulting in billions in losses for investors and ultimately making the financial crisis worse. It’s a story of the perverse incentives and reckless behavior that characterized the last days of the boom.

A hedge fund, Magnetar, helped create arcane mortgage-based instruments, pushed for risky things to go inside them and then bet against the investments. (Ethan Miller/Getty Images)

 

Update June 21, 2011: JP Morgan Chase has agreed to pay a $154 million penalty to settle SEC charges that the bank misled investors about a complex mortgage-securities deal during the waning days of the housing boom. The SEC charged that JP Morgan neglected to tell investors that the hedge fund Magnetar helped create the deal and was betting against it. This story was the first to detail Magnetar's role.

Update Oct. 29, 2010: This story has been corrected in response to a recent letter from Magnetar. Read their letter, along with our response.

 

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 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. 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, 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.) 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.

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. The study 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.

Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. (From left: Daniel Barry/Getty Images; Jonathan Fickies/Bloomberg News; Seokyong Lee/Bloomberg News)At least nine banks helped Magnetar hatch deals. Merrill Lynch, Citigroup and UBS all did multiple deals with Magnetar. JPMorgan Chase, often lauded for having avoided the worst of the CDO craze, actually ended up doing one of the riskiest deals with Magnetar, in May 2007, nearly a year after housing prices started to decline. According to marketing material and prospectuses, the banks didn't disclose to CDO investors the role Magnetar played.

Many of the bankers who worked on these deals personally benefited, earning millions in annual bonuses. The banks booked profits at the outset. But those gains were fleeting. As it turned out, the banks that assembled and marketed the Magnetar CDOs had trouble selling them. And when the crash came, they were among the biggest losers.

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, 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," 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."

Janet Tavakoli

April 11, 2010, 2:51 p.m.

My 2003 book, “Collateralized Debt Obligations & Structured Finance,” includes the “Magnetar” structure as applied to corporate CDOs.  I don’t know the first person to use that structure, but contrary to many finance articles and recent books, the “Magnetar” structure itself wasn’t new when it was applied to mortgage loans and other asset backed securities.  For example, it wasn’t developed by any of the people in Greg Zuckerman’s book, The Greatest Trade Ever.  Furthermore, there are a large variety of structured products and a huge network of players.  Magnetar was a cog in the wheel, but the story is much bigger then just this one hedge fund.

One of the key people at Magnetar, David Snyderman, was in the structured products group at Citadel in August 2004.  At that time, the group asked me to meet with them and asked if I would help them with this structure for the ABS market after reading about it in my CDO book (Wiley, 2003, Chapter 6 (especially Pp. 184-194, and this information is also in the 2008 updated edition).  They said my book gave them the idea to apply the structure to the other loan markets.  As I recall, Snyderman did not attend his group’s meeting on that day. 

My CDO book was written as a caution to investors not a handbook for guys like this.  I declined to get involved.  In my opinion, the investment banks that got involved in these structures should have declined to do so, too.  To the best of my knowledge, Citadel got rid of the entire group and they scattered to various shops.

The SEC should have shut down this kind of activity, but the SEC dropped seminal investigations into CDOs and failed to act on information in the public domain. 

The Magnetar strategy story was already told by the Wall Street Journal, before Bear Stearns imploded (March 2008), and before Fannie, Freddie, Lehman, AIG, and TARP.  This was before the meltdown, when it mattered most, but regulators and most of main stream media ignored the significance of these issues.
The following is a link to a December 2007 Wall Street Journal story explaining the creation and implosion of a CDO called “Norma” with which Magnetar was involved.  It was written by Serena Ng and Carrick Mollenkamp.  http://online.wsj.com/article/SB119871820846351717.html
The following is an excerpt of story the same reporters did for WSJ on Magnetar’s strategy on January 14, 2008 (link at bottom).  (I am also quoted in this article.)  The WSJ has to work within space limitations, but it got the word out on many of the key issues, and it did a good job.
There is obviously a lot more to this. I wrote about many of the structures and players in STRUCTURED FINANCE (Wiley, 2008) and in my book on the financial crisis and how to fix it, DEAR MR. BUFFETT (Wiley, 2009).
A Fund Behind Astronomical Losses
By SERENA NG and CARRICK MOLLENKAMP
January 14, 2008
The trading strategy of a little-known hedge fund run by an astronomy buff contributed to billions in losses on Wall Street, even as the fund itself profited from the subprime-mortgage crisis.
Its trading highlights the important role some hedge funds played in the great debt unwind that is now plaguing financial markets. Many hedge funds realized early on “that the loans and securities that went into CDOs were extremely toxic, and they designed structures to exploit that,” says Janet Tavakoli, a structured-finance consultant.
http://online.wsj.com/article/SB120027155742887331.html?mod=hpp_u

Janet Tavakoli

April 20, 2010, 9:08 a.m.

I wrote a further comment on the Huffington Post On Paril 29, 2010 (link below).

ProPublica’s “Untold” Magnetar Story Creates Excuses for Wall Street and Washington

ProPublica, Planet Money, and radio show This American Life recently carried stories about Magnetar, a hedge fund that profited from the housing crisis.  Unfortunately, many thought it was a fresh revelation.  Magnetar wasn’t a previously unknown hedge fund.  Magnetar did not create the synthetic CDO structure, and the magnitude of Magnetar’s role in the subprime crisis has been overblown.

The rest of my commentary is available here:

http://www.huffingtonpost.com/janet-tavakoli/propublicas-and-ny-times_b_542441.html

This article is part of an ongoing investigation:
The Wall Street Money Machine

The Wall Street Money Machine

Enticed by profits and bonuses, Wall Street took advantage of complicated mortgage-based instruments to reap billions, only to exacerbate the eventual crash.

The Story So Far

As the housing market started to fade, bankers and hedge funds scrambled for ways to maintain the lavish bonuses and profits they had become so accustomed to, repackaging mortgages in complex securities called collateralized debt obligations. The booming CDO market masked how weak the housing market was, and exacerbated its collapse.

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