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Your Magnetar Questions, Answered

Timothy A. Clary/AFP/Getty Images

 Editor's Note: This morning, The New York Times reported that the Securities and Exchange Commission filed a civil suit accusing Goldman Sachs of securities fraud. The suit claims that at the request of a hedge fund, Goldman created a mortgage-backed investment that had essentially been designed to fail. The hedge fund, run by John Paulson, was not named in the suit. In a statement, Goldman said it would "vigorously contest [the accusations] and defend the firm and its reputation." The allegations are similar to what we reported in our Magnetar story, and we'll have more on that soon.

Last week, we reported on the hedge fund Magnetar, which helped create mortgage-based securities, pushed for risky things to go inside them and then bet against the investments, resulting in billions in losses that ultimately made the financial crisis worse. The story was co-produced with Chicago Public Radio's "This American Life" and NPR's "Planet Money."

 

We asked you for your questions on the story. Here are a few of them, along with our responses.

How is it that so few people have heard of Magnetar?

Magnetar operated in what many call the "shadow financial system." The investments at the center of our story -- collateralized debt obligations -- are private transactions, and much of the information on them is available only to direct investors.

Credit default swaps, which Magnetar used to bet against many of the same CDOs they invested in, are also private transactions and difficult to track. Wall Street is a very insular community and not a particularly self-reflective one. For these reasons and others, it has been difficult for outsiders to gain a fuller understanding of what Magnetar did.

Nonetheless, there was a bit of reporting on Magnetar before our story. For example, The Wall Street Journal wrote a short but notably early story in January 2008. And the pseudonymous blogger Yves Smith wrote about Magnetar in her new book,"Econned."

Aren't others to blame for the bubble -- e.g., the Federal Reserve's refusal to raise interest rates, or Fannie Mae and Freddie Mac?

Absolutely. The Magnetar CDOs likely prolonged and exacerbated the financial crisis, but they did not cause it or the housing bubble. There were many factors that led to the bubble, among them poor lending practices and the Fed's loose monetary policy.

Who was on the other side of Magnetar's bets? Isn't it their fault for being gullible?

The simple answer is: We don't know for sure. As we noted above, credit default swap trades do not have to be disclosed.

We are fairly certain that AIG, which was a big seller of credit default swaps, was not selling them to Magnetar. AIG had largely exited the subprime mortgage securities market by the end of 2005. Also, we didn't find any Magnetar CDOs among the assets the Federal Reserve bought as part of the government's bailout of AIG.

Who was on the other side of Magnetar's trades is an interesting question and one we're continuing to investigate for future stories.

Magnetar didn't see the financial crisis coming; it just saw that one part of the market was overvalued. Otherwise, why wouldn't Magnetar simply short AIG or Citi? It would have been an easier bet to make.

We don't know for sure what Magnetar was thinking, but the evidence we have of its bets does suggest that it thought the housing market was heading for trouble. So why didn't it just bet against the market or short AIG?

The short version is that Magnetar's bets were in some ways smarter than a simple one-directional bet against mortgage bonds. Even if the housing market had continued to boom, Magnetar could have done well -- just not as well as if the housing market had collapsed.

Magnetar did that by buying the riskiest bottom portion of the CDOs, called the equity. As the underlying mortgages paid off, that equity threw off income. If the housing market continued to rocket upward, the income from those equity purchases would have more than offset the small insurance premiums the fund was paying for its credit default swaps. Of course, in the world of hedge funds, small profits don't count for much. Investors in hedge funds want big profits and can pull their money if they don't get them.

How was Magnetar so influential in the makeup of the CDOs, when its investments were such a small fraction of the total deal?

It's because Magnetar bought the equity of CDOs. This was the bottom portion of the deals and the riskiest. The buyer was on the hook for the first losses. Investment banks found it difficult to find investors to take such a risky portion. Therefore, the equity holder received informal influence to oversee the portfolio. Magnetar often used that position of influence to press for riskier assets to be included in the deals. That's how, with such a relatively small amount of money, Magnetar could have such a large influence over the deals.

In the same fashion, that's why Magnetar's deals were so crucial for the Wall Street mortgage assembly line. CDOs bought pieces of residential mortgage-backed bonds. Wall Street banks constructed those bonds by buying thousands of individual home loans from mortgage banks. Having sold their loans to Wall Street, mortgage banks could go out and make more loans to homebuyers.

It's like the old nursery rhyme: For want of a nail, the kingdom was lost. In other words, little things can make a big difference: Without Magnetar's purchase of the hard-to-sell equity, the CDO might not have been created. If the CDO didn't exist, it couldn't buy the mortgage-backed bonds. If the bonds didn't exist, there would be less demand for the mortgages to stuff in them. And if the mortgage banks couldn't repackage and sell off their mortgages, they would have offered fewer loans.

Now we get to a wrinkle: Magnetar's CDOs were made up largely of side-bets on mortgage securities -- and not bundles of mortgages themselves. Such investments were known as "synthetic," and they were created using the other side of the insurance-like credit default swap bets. Think of it as being like an insurer and repackaging the regular premiums customers are paying.

 
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