The guiding force behind Magnetar was Alec Litowitz, a triathlete, astronomy buff and rising star in the investing world. In 2003, Litowitz retired from a Chicago-based hedge fund, Citadel, one of the most successful in the world, where he had spent most of his career and became a top executive. He promised to stay out of the business for two years.
As he waited for his non-compete agreement to expire, Litowitz and his wife traveled through Europe collecting antiques to stock a big house they were building on the shores of Lake Michigan.
By spring 2005, Litowitz's wait was over. Then 38 years old, Litowitz quickly raised money to start his own hedge fund. The fund, Magnetar, attracted $1.7 billion from investors and opened in April.
Litowitz, who declined to be interviewed, had an approach to investing that emphasized scale and simplicity. He told those he hired: "Figure out a way to make money and figure out how to repeat it and do it over and over again," according to a former employee. The firm handed out T-shirts emblazoned with a confident slogan: "Very Bright, Very Magnetic." Employees privately joked about working for a fund named after something like a black hole.
Litowitz brought on board David Snyderman. A New Yorker with a serious mien, Snyderman, in his mid-30s, began hunting for investment opportunities in Wall Street's burgeoning market in mortgage-backed securities.
It didn't take them long to find something promising.
Snyderman and Magnetar focused on Wall Street's mortgage assembly line, which had been super-charged during Litowitz's time away from the business. Banks bundled pools of mortgages into large bonds, which they combined to create even larger investments. These were the now-infamous collateralized debt obligations. Each month, homeowners paid their mortgages. Each month, payments flowed to investors. (Here is an excellent video explaining CDOs.)
Large investors across the globe snapped up the CDOs, which took the hottest investment around -- the U.S. housing market -- and transformed it into something that supposedly had little or no risk. Wall Street preached that the risk had been diluted because it was spread out over such large collections of mortgage bonds. (CDOs can also be based on side bets that rise and fall with the value of other mortgage bonds. These are known as "synthetic" CDOs. Magnetar’s deals were largely synthetic.)
Just as they did with mortgage-backed securities, investment banks divided CDOs into different layers, called tranches. As the mortgages were paid, money flowed to investors holding the top tranche. Since they were the first to get paid, and thus took the least amount of risk, they earned low interest rates. Next came the middle levels -- the so-called mezzanine tranches.
Last in line for money were investors in what's known as the equity. In return for being at the bottom, equity investors got the highest returns, sometimes 20 percent interest -- money they would receive only as long as the vast majority of mortgage holders made their payments.
Even back then, Wall Street insiders called the equity "toxic waste," and as anxiety built in late 2005 that the housing boom was over, investment banks struggled to find takers.
To Magnetar, the toxic waste was an opportunity.
At a time when fewer investors were stepping up to buy equity, the little-known hedge fund put out the word that it wanted lots and lots of it. Magnetar concentrated in a particularly risky corner of the CDO world: deals that were made up of the middle, or mezzanine, slice of subprime mortgage-backed bonds. Magnetar CDOs were big, averaging $1.5 billion, about three times the size of earlier deals built on subprime mortgages.
Magnetar's purchases solved a crucial problem for the banks. Since the equity was so risky and thus difficult to sell, banks didn't like to create new CDOs unless someone committed to buy them. Indeed, such buyers were so crucial that Wall Street referred to them as the CDOs' "sponsors."
Without sponsors, Wall Street's mortgage bond assembly line could grind to a halt, and with it bank profits and banker bonuses. A top CDO banker could earn $3 million to $4 million annually on the CDOs he created and sold.
Usually, investment banks had to go out and find buyers of the equity. With Magnetar, the buyer came right to the bank's doorstep. Wall Street was overjoyed.
"It seemed like a miracle," says one mortgage market investment banker, because "no one" had been buying equity.
"By the end of 2005, the general sense was that the CDO market would slow down. These trades continued to fuel the fire," says Bill Tomljanovic, who worked for a firm that helped build a Magnetar CDO. Magnetar was "a driving force in the market."
According to JPMorgan data, Magnetar's deals amounted to somewhere between a third and half the total volume in the particularly risky corner of the subprime market on which the fund focused.
Outsiders thought Magnetar was piling in at exactly the wrong time. A March 2007 Business Week article titled "Who Will Get Shredded?" would later put Magnetar near the top of its list. The hedge fund, said the magazine, "showed bad timing."
How could Magnetar hope to make money on such risky stuff? It had a second bet that was known only to insiders.
At the same time it was investing in the equity, the fund placed bets that many of the same CDOs it had helped create would actually blow up. It did that using one of the most opaque corners of the investment world: credit default swaps, which function as a kind of insurance on CDOs and other types of bonds.
Credit default swaps work roughly like an insurance policy: You pay a small premium regularly, on any bond you want -- whether you own it or not -- and if it goes bust, you get paid off in full.
Nobody but Magnetar knows the full extent of its bets. Hedge funds are private and they don't disclose the details of their trades. Also, credit default swaps are mostly unregulated and not publicly disclosed. Magnetar says it didn't bet only against its own CDOs. The majority of its credit default swaps, says Magnetar, were on other CDOs. (Update April, 9:We have added additional detail from Magnetar’s response in which the hedge fund says it was “net long” on its own CDOs, an assertion on which the fund has declined to elaborate.)
Since it was the sponsor, Magnetar had privileges. Placing the risky equity was so important to banks that they typically gave those who bought it a say in how the deal was structured. Like all investors, equity buyers had to weigh risk and reward, the goal being to maximize returns while minimizing the chances that your investment will blow up.
But people involved in Magnetar's deals say the hedge fund took a different tack, pushing for riskier bonds to go inside its CDOs. Doing that would make it more likely that Magnetar's bets against the CDO would pay off.
The equity bought by Magnetar represented just a tiny fraction of the overall CDO. If it costs, say, $50 million, an entire CDO could be 20 times that, $1 billion. And if the CDO begins to go south and you're smart enough to have taken out enough insurance, you can make hundreds of millions of dollars. That, of course, would take a bit of the sting out of losing your original $50 million investment in the equity.
Magnetar Does Its First Deal
As Magnetar set up its CDO shop, the hedge fund hired Jim Prusko, a smart and affable investor who had worked previously at the Boston money-manager Putnam Investments. He would shoulder much of the work of courting Wall Street bankers and managers who worked with the hedge fund. He operated out of Magnetar's office in midtown Manhattan around the corner from Saks Fifth Avenue. In an office of 20-somethings, Prusko, then 40 years old, stood out as the "old man."
Prusko and his boss at Magnetar, Snyderman, began approaching investment banks, offering to buy the riskiest, highest-yielding portion of CDOs. They always wanted a middleman, known as a CDO manager, on their deals. Many CDOs are operated day to day by such independent firms, who are often brought in by investment banks.
The managers also played a vital role in creating deals. When an investment bank created a CDO, it would often give what amounted to blueprints to the managers, who would then go out and find the exact bundles of bonds to fill the CDO. The managers had a fiduciary duty to represent the CDO fairly to all investors, ensuring investors got accurate and equal information.
Magnetar's deals were numerous and big, and just like for investment banks, the bigger the deal, the larger the fee for managers.
"Prusko's job was to butter up the CDO managers and the bankers," said one banker who dealt with him.
By relying on a manager rather than managing the deal itself, Magnetar had no legal obligations to the CDO or others who bought it.
Magnetar completed its first deal in May 2006. In what became a habit, it named the CDO after a constellation, in this case, "Orion," known for the trio of stars that form the mythological Greek hunter's belt. For its maiden CDO, Magnetar enlisted a partner to buy risky equity alongside it, an internal investment fund within Deutsche Bank.
Deutsche and Magnetar didn't reach for a Wall Street powerhouse to put the deal together. Instead the investors worked with Alex Rekeda, a young Ukrainian immigrant who was then working for Calyon, the investment banking arm of the French bank Crédit Agricole.
Magnetar and Deutsche were deeply involved in creating Orion. "We want to make sure we control the deal," a banker who worked on it recalls them emphasizing.
One person involved in Orion recalls Deutsche's point person, Michael Henriques, and Magnetar's Prusko pressuring the CDO manager, a division of the Dutch bank NIBC, to include specific lists of bonds in the deal.
Prusko and Henriques told this person that the investors "needed more spread in the portfolio." More "spread" means more return and more risk.
This person recalled Magnetar asking, "Would you consider these bonds?" Their suggestions were invariably for riskier bonds. "Let's just say we didn't think their suggestions made a lot of sense," the person said.
He said the CDO manager refused Magnetar's requests to put riskier bonds in the deal. Still, it was an eye-opening experience. "I began to realize there were things you had to defend yourself against," he said.
Magnetar and Deutsche declined to comment on Orion specifically. Magnetar says it made suggestions about the general outlines of the CDOs. But, the hedge fund says, it "did not select the underlying assets of the CDO at any time prior to or subsequent to transaction issuance."
Other buyers of the CDO could have figured out they were getting relatively risky bonds, but they would have had to look hard at the minutiae of the deal. By this point in market history, the ratings had less and less meaning. Two sets of bonds rated AA could have very different levels of risk. Most investors chose not to dig too deeply.
One investor in Orion was a fund affiliated with IKB, a small German bank. Eventually, it invested in at least four more Magnetar deals. In mid-2007, because of the disastrous investments in subprime securities, the German government was forced to bail out IKB. The failure of the bank was an early warning sign of the global financial crisis.
Deutsche's Henriques would later quit the bank and join Magnetar.
Orion lost value but never defaulted. That was better than every subsequent CDO that Magnetar helped create, according to ProPublica's research.