6:31 p.m.: This post has been corrected.
A Financial Crisis Inquiry Commission document shows the hedge fund Magnetar selected hundreds of millions of dollars' worth of assets that went into a billion dollar Merrill Lynch mortgage securities deal, despite having long asserted otherwise.
As we reported last year, Magnetar helped Wall Street investment banks create at least $40 billion worth of mortgage securities deals known as collateralized debt obligations, or CDOs. The hedge fund also bet against many of those CDOs as part of an investment strategy that paid off handsomely when the housing market crashed and those CDOs collapsed. (Our story was done in collaboration with NPR's Planet Money and Chicago Public Radio's This American Life.)
The hedge fund has consistently denied that it selected assets for the CDOs in which it invested and often bet against. Last April, in response to questions from ProPublica, the hedge fund said that "Magnetar did not choose the assets in any CDO." ProPublica's story on the Magnetar trade detailed how the fund had an active role in building these CDOs and in choosing assets that were riskier than might have otherwise been chosen.
The Financial Crisis Inquiry Commission released its final report today on the causes of the financial and economic crisis in the United States. The report quotes from a letter in a lawsuit that contradicts Magnetar's assertion.
Magnetar used a CDO called Norma to create a $600 million bet against subprime mortgage securities, according to the document. The CDO itself took the other side of the bet, and ultimately cost investors in Norma hundreds of millions of dollars. Merrill Lynch underwrote and marketed the $1.5 billion Norma.
According to the commission report, Magnetar made the selections without the knowledge of the manager legally charged with picking the assets for the CDO or the risk department of the bank that helped create the deal.
The collateral manager, NIR Capital Management, was paid to manage the deal and was supposed to be independent of the investment bank and act in the interests of the CDO as a whole. The Norma offering document says that NIR would select the assets that went into the CDO, and no mention is made of other parties' roles in asset selection.
"When one Merrill employee learned that Magnetar had executed approximately $600 million in trades for Norma without NIR's apparent involvement or knowledge, she e-mailed colleagues, 'Dumb question. Is Magnetar allowed to trade for NIR?' " according to the report.
The Merrill employee was one of the risk managers in charge of policing the firm's CDO business.
"NIR abdicated its asset selection duties to Magnetar with Merrill's knowledge," the FCIC report states.
The e-mails relating to Magnetar's selections of assets for Norma were revealed as part of a lawsuit between Netherlands-based Rabobank and Merrill Lynch. After the e-mails and other documents were produced during discovery, Merrill Lynch settled the lawsuit for an undisclosed amount.
The e-mails were quoted in a letter from Rabobank's lawyer, and they provide new evidence that Magnetar stood to gain substantially more from its bets against the CDO, or short positions, than from its investment in the CDO. And Merrill Lynch was aware of the hedge fund's motivations.
"Merrill recognized that such short positions were more important to Magnetar than its long investments," states the letter.
Magnetar's investment in Norma totaled less than $50 million, according to the letter. "This meant that Magnetar stood to make 10 times more from its $600 million short position if Norma failed than Magnetar had invested in equity."
Interestingly, Magnetar received $4.5 million in what a Merrill document described as the CDO's "expenses." According to the FCIC report, Merrill failed to disclose that to other investors. Magnetar's counsel explained the $4.5 million to the FCIC as "a rebate" on the hedge fund's purchases.
Magnetar and NIR didn't immediately respond to requests for comment.
The FCIC ran into a roadblock in its investigation of the Norma transaction. Bank of America, which now owns Merrill Lynch, "failed to produce documents related to this issue requested by the FCIC," the report says.
Bank of America's counsel told the FCIC that it was "a common industry practice" for equity investors to have input during the collateral selection process and that the collateral manager had the ultimate decision regarding asset selection. A spokesman for Bank of America declined to comment to us on the specifics of the Norma deal.