The Magnetar Trade: how one firm made the bubble worse

Doctor Glyndwr · **Joined:** 30th Mar, 2008 **Posts:** 32624

http://www.propublica.org/special/the-a ... etar-trade
http://www.propublica.org/feature/the-m ... bble-going

This is a long read. But it's worthwhile. If you prefer to listen to it, it's covered in detail on this week's This American Life.

Basically, the authors of the piece claim that one particular hedge fund (Magnetar) simultaneously pushed through deals of CDOs -- financial instruments backed by insecure mortgages -- by buying the riskiest bit of the CDO itself, whilst bigger banks bought the safer bits. It then quietly also bought insurance against the entire CDO. When the whole lot came tumbling down in 2007, whilst the rest of the industry was going to hell in a handbasket, Magnetar was recording profits of hundreds of millions and returns on its managed funds of 70-80%.

Zardoz · **Posted:** Wed Apr 14, 2010 9:28

Could we get together and do something similar?

Bobbyaro · **Joined:** 18th Apr, 2008 **Posts:** 11897

Seems brilliant. Did they actually do anything wrong? (haven't had chance to read everything)

Cras · **Joined:** 30th Mar, 2008 **Posts:** 49244

Legally? No. Morally? Well, depends who's reading, I guess.

kalmar · **Posted:** Wed Apr 14, 2010 10:45

Zardoz wrote:

Could we get together and do something similar?

*bets against BEEX investment*

Doctor Glyndwr · **Joined:** 30th Mar, 2008 **Posts:** 32624

Craster wrote:

Legally? No. Morally? Well, depends who's reading, I guess.

There's a case to be made that the CDO administrators understood that Magnetar was betting against the CDOs they were selling, that they should have informed their investors that this was going on, and that in not informing them they broke the financial ethics laws they are supposed to be bound by to inform potential investors of all the information they need to make their decisions.

Magnetar maintain they were simply adopting a long-short position, which is not uncommon, and that they simply got very lucky when the house of cards came down. Very lucky. The investigators counter that with a number of CDO administrators who say, when splitting up the tranches and constructing the CDOs, Magnetar was actively pressuring them to put more and more risky bonds into the CDO; this is an unusual thing to do, particularly in a market that was already getting iffy on the entire concept of CDOs backed by subprime mortgage bonds. Unless, of course, you wanted to deliberately construct CDOs that would fail.

Doctor Glyndwr · **Joined:** 30th Mar, 2008 **Posts:** 32624

This is a good example of the stuff they did.

Quote:

A few months later -- in early 2007 -- Magnetar and JPMorgan banged out a deal. Unlike the earlier CDOs it helped create, Magnetar didn't name this one after a constellation. Opting for a more literal name, they called the deal "Squared," after the term for a CDO that was made up of other CDOs. Squared was filled in part with other CDOs Magnetar had helped create.

According to a person familiar with how the deal came together, Magnetar committed to purchase $10 million worth of Squared's equity. Magnetar's purchase allowed JPMorgan to create and sell a $1.1 billion CDO. As it had on previous deals, Magnetar pushed the bankers to select riskier bonds. "They really cared about it," said the person involved in the deal. "They wouldn't pull punches. It was always going to be crappier."

JPMorgan earned $20 million [in fees] in creating Squared, according to the person involved in the deal.

JPMorgan's sales force fanned out across the globe. It sold parts of the CDO to 17 institutional investors, according to a person familiar with the transaction. The deal closed in May 2007, nearly a year after housing prices had peaked. Within eight months, Squared dropped to a fraction of its initial value.

Just about everybody lost out, including Thrivent Financial for Lutherans, a Minnesota-based not-for-profit fraternal organization, whose $10 million investment was wiped out. Thrivent declined to comment.

Small pieces of Squared, as well as Magnetar's CDO Norma, also ended up in mutual funds run by Morgan Keegan, a regional investment bank based in Memphis, Tenn.

The funds, advertised as conservative investments, cratered after betting on various exotic assets. Morgan Keegan was sued by individual investors who claimed that they were misled about the risks. Among the investors was former Chicago Bulls player Horace Grant, who was awarded $1.4 million in arbitration. This week, the SEC accused [2] [2] two Morgan Keegan employees of misleading fund investors about the value of its holdings in CDOs. Morgan Keegan called the charges "factually inaccurate" and promised to defend itself "vigorously." Morgan Keegan did not respond to a request for comment on the specifics of the two Magnetar CDOs.

The biggest loser was JPMorgan Chase itself, which had kept the large, supposedly safe top slices of Squared on its books, without hedging itself. The bank lost about $880 million on the CDO. JPMorgan declined to comment on the details of the transaction.

Magnetar came out a winner. The fund earned about $290 million on its bet against Squared, according to a person familiar with the deal. Magnetar declined to comment.

This is one CDO, of 30 that Magnetar had on its books. The investigative team have traced 26 of those and say they are all, today, almost worthless. So this story is repeated again and again, each time with numbers like this.

Cras · **Joined:** 30th Mar, 2008 **Posts:** 49244

Doctor Glyndwr wrote:

Craster wrote:

Legally? No. Morally? Well, depends who's reading, I guess.

There's a case to be made that the CDO administrators understood that Magnetar was betting against the CDOs they were selling, that they should have informed their investors that this was going on, and that in not informing them they broke the financial ethics laws they are supposed to be bound by to inform potential investors of all the information they need to make their decisions.

I can guarantee you they'll be able to demonstrate that those who were placing the insurance 'bets' were notionally separate from those who were deciding what CDOs were being sold, and were therefore under no such obligation.

End of an Era · **Joined:** 25th Nov, 2008 **Posts:** 1041

I haven't had time to read it all yet, but was their basic plan:

Buy crap, knowing it's going to fail.
Heavily insure the crap.
Watch crap fail and lose initial investment.
Collect several times the initial investment in insurance payouts.
Rinse and repeat, and just to make sure of a quick turnover "engineer" the crap to be total crap?

Doctor Glyndwr · **Joined:** 30th Mar, 2008 **Posts:** 32624

Yes, that's the basic plan. There is a wrinkle: on any given CDO, worth maybe $1bill, they would only buy the very riskiest bit of it (typically around $10m) but they would insure it all, not just the bit they bought. That's why they could recoup many times their losses.

Free market economists will say that shorting (the insurance process, basically; betting with someone else that a given price will go down) is a way for the market to restore balance to inflated valuations. It allows the market to apply a downward pressure on prices to balance an upward one created by lots of investors. And in so doing, it allows the market to attempt to get rid of overpriced, risky crap.

But here, if the investigators are correct, Magnetar wasn't helping the market identify overpriced, risky crap; it was creating crap specifically so they could profit from it going bang. From that point of view, they found a neat little hole in the middle of capitalism, and sailed right through it.

One of the bankers interviewed on the radio show said that as soon as Magentar started doing this, he and all of his colleages should have "run for the hills", because it was going to make a bad situation much worse.

kalmar · **Posted:** Wed Apr 14, 2010 11:47

It's like going to the bookies and asking for 100 to 1 odds on your car mysteriously catching fire one night.

Who the hell offers bets like that?

Cras · **Joined:** 30th Mar, 2008 **Posts:** 49244

kalmar wrote:

It's like going to the bookies and asking for 100 to 1 odds on your car mysteriously catching fire one night.

Who the hell offers bets like that?

Not quite. It's asking for 100 to 1 odds on your car and a load of other people's cars mysteriously catching fire one night, whilst carrying an empty jerrycan and flicking a lighter open and closed.

End of an Era · **Joined:** 25th Nov, 2008 **Posts:** 1041

I'll have to listen to the radio programme later, but what always gets me when I hear about these financial exploits are:

The single minded focus on profit these people have, and the total disregard they have for anything else.
That they manage to persuade so many other, supposed, experts to go along with them.
The complete lack of transparency behind any of it.

I don't think I could work in that sort of finance. I just don't think I'm cunning or selfish enough to succeed. I also wonder what chance politicians have of stopping any of this - I'm quite fond of having a pop at Labour for failing to stop this sort of thing happening, but to be honest if other financial types get fooled by the schemes concocted by these exceptionally wily people, what chance did they have? And given the real expertise employed by them is finding loopholes in the law/process/whatever and then keeping quiet about it you can pretty much guarantee that any new legislation will be quickly worked around and the true extent of any damage won't be known for years to come.

Bobbyaro · **Joined:** 18th Apr, 2008 **Posts:** 11897

As I said, it's brilliant. am I correct in saying that these CDOs were in existence anyway, they just bought them, repackaged them and insured them. Or am I missing something big (very likely)?

Doctor Glyndwr · **Joined:** 30th Mar, 2008 **Posts:** 32624

Bobbyaro wrote:

am I correct in saying that these CDOs were in existence anyway, they just bought them, repackaged them and insured them.

As the investigators tell the story: the concept of the CDO existed, and had been quite enthusiastically traded in the few years before this. However, when a CDO is sold, it's split into pieces (tranches), graded by risk. In 2006, investors were getting leery of these[1], and it was harder and harder to find a buyer for the most risky tranch (called the equity). Magnetar entered the scene and started aggressively acquiring these tranches, which revitalised the CDO industry. Their role, as acquirers of the lowest tranch, was so vital to the process that they were often called the sponsor for the entire CDO.

Exactly what is and isn't in the CDO isn't decided by anyone who is buying it (Magnetar and other investors) or the banks who own the bonds that the CDO is made of. A third party, the CDO administrator, is responsible for that, and is supposed to negotiate a fair deal from both sides, and make sure investor protection legislation is followed. Often, Magnetar would push these administrators into including more and more risky assets in the CDO -- the radio show has an interview with one such administrator who refused to give in Magnetar's demands, and ultimately the entire deal collapsed when they walked away.

[1] the radio show includes interviews with a couple of senior investors and bankers who say the spreads were widening on CDO purchases in 2005 and after several years of growth they were preparing for a slowdown in this market.

JBR · **Joined:** 2nd Jun, 2008 **Posts:** 3304

There's a lovely scene in The Power of Yes where a man wheels on a blackboard to draw out an equation used to quantify risk. The equation is loosely explained - principle rather than details - and the conclusions are given.

- He won a Nobel prize
- Hedge funds used the equation to allow them to minimise their risk
- Equation was found to only work under some situations (when things are good, generally)
- Writer was sent to jail
- Hedge funds are *still using* his equation

Zardoz · **Posted:** Wed Apr 14, 2010 15:44

JBR wrote:

- Writer was sent to jail

Why was that?

JBR · **Joined:** 2nd Jun, 2008 **Posts:** 3304

Zardoz wrote:

JBR wrote:

- Writer was sent to jail

Why was that?

I am king of the part-remembered story. It must have been more than the equation itself being bollocks, but can't remember and really must not speculate.

Doctor Glyndwr · **Joined:** 30th Mar, 2008 **Posts:** 32624

Craster wrote:

I can guarantee you they'll be able to demonstrate that those who were placing the insurance 'bets' were notionally separate from those who were deciding what CDOs were being sold, and were therefore under no such obligation.

I will quote you the book I just finished reading: "when someone says to me 'Chinese wall' what I hear is 'I'm a fucking liar'". That book is excellent, by the way. I now feel like I have at least half a handle on what exactly happened to the world's economy. I've been wittering on about CDSs, CDOs, asset-backed bonds, subprime loans, and international financing to anyone who'll stand still for long enough -- which isn't very many people. That's mostly why I made this thread.

Also: http://www.nytimes.com/2010/04/17/busin ... an.html?hp

Quote:

Goldman Sachs, the Wall Street powerhouse, was accused of securities fraud in a civil lawsuit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly intended to fail.

The move was the first time that regulators had taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market.

The suit also named Fabrice Tourre, a vice president at Goldman who helped create and sell the investment.

In a statement, Goldman called the commission’s accusations “completely unfounded in law and fact” and said it would “vigorously contest them and defend the firm and its reputation.”

The focus of the S.E.C. case, an investment vehicle called Abacus 2007-AC1, was one of 25 such vehicles that Goldman created so the bank and some of its clients could bet against the housing market. Those deals, which were the subject of an article in The New York Times in December, initially protected Goldman from losses when the mortgage market disintegrated and later yielded profits for the bank

Naturally, Goldman claims it was just maintaing a typical long/short position; whereas the SEC claim they misinformed investors. So far it's a civil suit, although it sounds like the SEC are angling to spin a criminal suit out of it.

BikNorton · **Joined:** 30th Mar, 2008 **Posts:** 10173

My boss sent me a link to this thing about gold. I'm not sure I put much truck in it, but still. I can't really be bothered creating a new thread about it, and this thread is reasonably suitable.

Hearthly · **Joined:** 11th May, 2008 **Posts:** 13386

There's nothing out there that would surprise me.

I reached the conclusion many years ago that the financial institutions of the world are fundamentally corrupt, that this is by design, that governments are complicit, and that there is no force in the world large enough that can, or even dares, to take it on. The latest recession and the revelations that have followed, merely confirmed what I already believed (and have been gobbing off about for years).

If we can get through our time on this earth without being personally mangled by the genuinely horrifying greed, avarice, corruption and basic inhumanity of the systems that control our societies, we've done well.

My honest feeling is that this 'civilisation' around, humanity has got it wrong, and that naked capitalism will destroy most of us - maybe the next wave of human beings will fare better.

I've posted these links before at BEEX, but some folks might not have seen them, and they are relevant in particular to the article about gold.

http://www.youtube.com/watch?v=vVkFb26u9g8&feature=fvst (Money as Debt)

http://www.youtube.com/watch?v=_doYllBk5No (Money as Debt II)

End of an Era · **Joined:** 25th Nov, 2008 **Posts:** 1041

I watched a video recently called "The Money Masters". Now I think it was significantly a crank video written and produced by tin-foil hat wearing anti-New World Order conspiracy theory nuts, but it did have a point about fiat currencies. I wonder just how many of these "scams" (or as Gordon Brown once put it, "ingenuity") could actually happen if money was backed by something more than goodwill and the laws on lending/usury were a lot more stringent.

If anyone can recommend a decent, more reliable, source on the subject, I'd appreciate it.

Cras · **Joined:** 30th Mar, 2008 **Posts:** 49244

Doctor Glyndwr wrote:

Craster wrote:

I can guarantee you they'll be able to demonstrate that those who were placing the insurance 'bets' were notionally separate from those who were deciding what CDOs were being sold, and were therefore under no such obligation.

I will quote you the book I just finished reading: "when someone says to me 'Chinese wall' what I hear is 'I'm a fucking liar'".

Of course. You'll note the choice phrases "be able to demonstrate" and "notionally separate" in my quote above. Still, it's amazing the lengths we go to with technology to maintain the fiction of a chinese wall that can be quite easily scaled by two people sharing a toilet.

ApplePieOfDestiny · **Joined:** 17th Dec, 2008 **Posts:** 8293

Craster wrote:

Doctor Glyndwr wrote:

Craster wrote:

I can guarantee you they'll be able to demonstrate that those who were placing the insurance 'bets' were notionally separate from those who were deciding what CDOs were being sold, and were therefore under no such obligation.

I will quote you the book I just finished reading: "when someone says to me 'Chinese wall' what I hear is 'I'm a fucking liar'".

Of course. You'll note the choice phrases "be able to demonstrate" and "notionally separate" in my quote above. Still, it's amazing the lengths we go to with technology to maintain the fiction of a chinese wall that can be quite easily scaled by two people sharing a toilet.

<Big Firm> once explained to my client the lengths that they had gone to in order to create chinese walls internally through a competitive takeover place, and how they, and we as other advisors, had to work hard to maintain it.

They had several individuals working the same role on both teams, before, during, and after the transaction.

Hearthly · **Joined:** 11th May, 2008 **Posts:** 13386

Ooohhhh aren't Goldman Sachs doing well!

http://www.telegraph.co.uk/finance/news ... t-row.html

Can anyone think of a reason why the world wouldn't be a nicer place without for-profit banks? Because I can't.

Cras · **Joined:** 30th Mar, 2008 **Posts:** 49244

Well I'd be unemployed, for one. And the country would lose out on a fucking ton of corporation tax and income tax.

Doctor Glyndwr · **Joined:** 30th Mar, 2008 **Posts:** 32624

The ramifications of never having had credit or fiat currencies or various other instruments of the modern financial world go back three hundred years and would simply result in a bizarrely, radically different timeline. We'd have had no British Empire, for starters, as we'd have had no naval supremacy during the 18th century over the French (who had most of the gold) and the Spanish (who had most of the silver). Britain would have remained a resource-poor backwater nation, as London would never have become the hub of international commerce.

I find it easier to play "what if" with scenarios like "we invented time travel" than I do with "we didn't invent credit".

Be Excellent To Each Other

The Magnetar Trade: how one firm made the bubble worse

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