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How One Hedge Fund Helped Keep the Bubble Going

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On the Magnetar Trade

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.

Precise Timing

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

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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.

The Magnetar Trade

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]. 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], 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.

Chance Enhancement

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]) 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].

Independent Analysis

An independent analysis [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] 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.

Major Players

Magnetar worked with major banks, including Merrill Lynch, Citigroup, and UBS. 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 [5], 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.

Assessment

Of course, 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], 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.

Conclusion

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] 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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16 Responses

  1. Magnetar Letter to Investors About Our Story—And Our Response
    By Paul Steiger, ProPublica – April 20, 2010 10:46 am EDT

    On last Monday, the hedge fund Magnetar sent a letter to its investors defending its practices and criticizing our story about it (We received the letter from Bloomberg News). The letter largely amplifies the statements its representatives made to us during our reporting, and which we included at length with our story. We are happy to link below to the Magnetar letter for those who want to see those arguments in fuller detail.

    Magnetar’s letter doesn’t deny that it purchased collateralized debt obligation (CDO) equity, that it bet against many of those CDOs, or that it exercised influence over the construction of the portfolios.

    In particular, it doesn’t deny and in one case admits that it pushed for higher returns and hence greater risk in the portfolios. At root, Magnetar says it did nothing illegal. Our story said that this is probably correct; violations of law or rule if any, were more likely the responsibility of others.

    In short, we see nothing in our story to correct.
    Read Magnetar’s letter and our story.

    Link: http://www.propublica.org/feature/magnetar-letter-to-investors-about-our-story

    ProPublica

    Like

  2. “Goldman-Sachs” and “Fiduciary” Uttered in Same Sentence?

    Do the recent Senate hearings with Goldman Sachs increase the likelihood that a fiduciary standard for stock brokers will be incorporated into Senator Christopher Dodd’s financial regulatory reform legislation?

    http://registeredrep.com/news/goldman_case_boosts_odds-for_fiduciary_standard_in_senate_bill_0427/

    Say it ain’t so!

    Arnie

    Like

  3. For each hedge fund that performed well during the recent market downturn, there were many other hedge funds which imploded. Individual investors are best served by following this simple advice –

    “Don’t invest in any vehicle that you cannot explain in simple terms to your mother … or your grandmother.”

    Brian J. Knabe MD CMP™

    Like

  4. Dr Knabe,

    Are Hedge FoFs Worth It?

    Funds of hedge funds appear to be a way to manage risk, but they got slammed harder than individual funds during the financial meltdown.

    http://www.fa-mag.com/component/content/article/38-features/5773.html?Itemid=178

    So, what’s up with that? Is it di-versification or di-worsification?

    James

    Like

  5. About Merrill, too!

    The builders of mortgage securities at industry giant Merrill Lynch couldn’t find buyers for their wares. So they paid another group at Merrill to take billions of dollars of the unwanted assets.

    http://www.propublica.org/article/the-subsidy-how-merrill-lynch-traders-helped-blow-up-their-own-firm

    Or, how Merrill Lynch blew up their own firm.

    Jack

    Like

  6. Why George Soros stepped away from Hedge Funds?

    George Soros’s decision to step away from the hedge fund industry was greeted with lots of discussion recently about the effect of Dodd-Frank on the industry.

    The general take was that the upcoming hedge fund registration requirement was onerous enough for him to transform his operations into a family office and relieve himself of the requirement.

    But, it was likely more complex than that.

    http://www.fiercefinance.com/story/why-george-soros-really-stepped-away/2011-07-31?utm_medium=nl&utm_source=internal

    James

    Like

  7. Paulson’s Hedge Fund Said To Lose 34% This Year

    John Paulson, the billionaire who is betting on an economic recovery by the end of 2012, lost 34 percent this year in his largest hedge fund, according to those familiar with the firm.

    http://www.fa-mag.com/component/content/article/47-pw-news-online/8455.html?Itemid=178

    Richard

    Like

  8. On Bubbles

    Complacency is what fuels stock market bubbles in their final stages, enabled by the “cure-all” of cheap money.

    And, when bubbles pop, the first indications of trouble are an increase in market volatility and a drop in commodity prices.

    Is this happening now?

    Major

    Like

  9. Bubbles Tomorrow, Yesterday, But Never Today?

    Standard asset price models have generally failed to detect bubbles, with enormous costs to the economy.

    http://www.frbsf.org/economic-research/publications/economic-letter/2013/september/asset-price-bubbles-theory-models/

    Any thoughts?

    James

    http://www.amazon.com/Financial-Planning-Handbook-Physicians-Advisors/dp/0763745790/ref=sr_1_1?ie=UTF8&s=books&qid=1275315635&sr=1-1

    Like

  10. Bubbles and Herds

    It is well known that money managers, FAs and the entire financial services sector could pose threats to the US financial system when reaching for higher returns, herding into popular asset classes or amplifying price movements with leverage.

    Think QE: any thoughts?

    Jessie

    Like

  11. Investors Are Chastened
    [That’s A Good Thing]

    Looking back over the bubbles that have burst, investors are understandably skeptical of today’s strong capital markets.

    http://www.propublica.org/thetrade/item/investors-are-chastened-thats-a-good-thing?utm_source=et&utm_medium=email&utm_campaign=dailynewsletter

    An essay by Jesse Eisinger.

    Hope R. Hetico RN MHA

    Like

  12. S&P 500 Extends Record

    DOW 17,083.80 -2.83
    NASDAQ 4,472.11 -1.59
    S&P 1,987.98 +0.97

    http://money.msn.com/business-news/article.aspx?feed=BLOOM&date=20140724&id=17803146

    On Facebook Rally Amid Earnings!

    Jack

    Like

  13. Investigators Say $100 Million Hedge Fund Was a Fraud

    Prosecutors and the SEC say that hedge funds set up by a man named Mark Mallik were part of a plan to scam investors.

    http://www.msn.com/en-us/money/video/investigators-say-dollar100-million-hedge-fund-was-a-fraud/vi-AA9RvOo?ocid=iehp

    Darmond
    http://www.amazon.com/Comprehensive-Financial-Planning-Strategies-Advisors/dp/1482240289/ref=sr_1_1?ie=UTF8&qid=1418580820&sr=8-1&keywords=david+marcinko

    Like

  14. If Trump is right, the election just made it worse.

    Of course, I’m certain that if Trump were asked what he thought of the market now, he’d be singing a different tune. Since Trump won the presidency, small-cap stocks and cyclical sectors have been on an absolute tear. We went from investors fearing a Trump Crash to a Trump Melt-Up. The narrative changes as price changes. Always remember that the reasons for why markets go up or down change based on whether markets are up or down. The futility of predicting the long-term is somehow always forgotten.

    Are we in a bubble? I have no idea. No one does. A bubble to me is best defined as an irrational belief held by the vast majority of participants which reaches a fever pitch. I think by that standard, there probably is a bubble forming in the overriding belief that everything Trump attempts to accomplish will be uniformly positive and bullish. The market seems to always get secondary and tertiary effects wrong. Unintended consequences are a part of everything in life, particularly so in large complex systems. To think with such euphoria that the next four years will be an economic boom because we have a businessman in the oval office disregards the fact that the future is never quite what we imagined. It is only hindsight bias and narrative which makes us think that it always was.

    Momentum in the moment is always nice to participate in, but not getting caught up in it is the key to tactical portfolio management. In the near-term, it looks like market movement could continue higher given that yield sensitive areas continue to underperform. Generally (with the exception of the last few years), yield parts of the investable landscape tend to outperform anticipating a period of higher volatility instead. Thus far, given that credit spreads remain tight despite the yield move higher, there are no near-term signs of stress. That doesn’t mean necessarily that stocks won’t close the year out lower than they are now. It just means the odds favor continuation in trend.

    This has been a wild year. We went from the worst start for stocks in history (remember that??) to a pretty damn good year. From Treasuries posting huge gains, to giving it all back. And all the while, the reasons for why these moves happen seem like they were destined to. We are all story tellers when it comes to tomorrow, but we often forget that the story is only written after the fact.

    Michael A. Gayed CFA
    [Portfolio Manager]
    http://www.pensionpartners.com

    Like

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