Tuesday, April 13, 2010

The Magnetar trade

Just when I thought I was out, they pull me back in...

I thought I was done discussing all of this horrible CDS, CDO, credit crisis stuff, but here we go again. Yesterday I listened to this podcast from This American Life, which details the activities of a large hedge fund called Magnetar. See here for the original reporting done by ProPublica.

The Magnetar team ("Smart. Very smart"), it is claimed, put on a very clever trade in 2006, after spending 2005 surveying the MBS market and realizing that subprime was an irrational bubble. Magnetar actually created demand for CDO structures by agreeing to fund the riskiest equity tranches. By putting up $10 million (according to the reporting) they could help initiate the construction of a $1 billion dollar security. (If the models show that the expected loss is small, and someone is willing to expose themselves to it, other investors can come in later and take the senior tranches, which could have AAA ratings.) Magnetar apparently lobbied the banks assembling the CDOs to include the riskiest subprime mortgages in the structure, because they intended to bet against the more senior tranches using CDS contracts. The underwriters and asset managers went along with this in order to book fees (also in the tens of millions of dollars) collected at completion of the transation. These transactions generated fake alpha -- short term profits for the banks, at the cost of taking on hidden tail risk. The guys who did these deals made huge bonuses. When the CDOs tanked, Magnetar made huge profits through its CDS contracts. The senior tranches were typically sold to other banks, pension funds, investors, but a large portion were actually kept on the books of the banks that underwrote them. The CEOs of these banks were often unaware of the tremendous risks (potential losses of tens of billions of dollars, hidden in the AAA senior tranches) they were taking on in order to book hundreds of millions of dollars in fees during the bubble.


1. Cognition is bounded. Magnetar understood what it was doing. Some of the structurers at the banks understood what was going on, but their incentives were to take the short term fees and do the transaction (who cares? IBG YBG = "I'll be gone, You'll be gone"). The counterparties who bought the senior tranches didn't know what was going on, and neither (I'll bet) did the CEOs of the banks that did the structuring. Certainly the shareholders of these firms didn't understand the risks. Mr. Market priced all these deals terribly.

2. Nobody in 2006 said "Paulson / Bernanke / Obama / Geithner / ... will definitely bail us out if this gets too hairy. We're too big to fail!" Most of the MBS guys lost their jobs in the crash. But they made plenty of money while the getting was good.

3. Some people violated their fiducial responsibilities in this game. But it appears they're going to get away with it.

For more, see Naked Capitalism and Yves Smith's book Econned.

Small correction for the NPR guys: a magnetar is a neutron star (pulsar) with very high magnetic field. It's not a black hole.

Note added: In letters to ProPublica Magnetar claims it was employing a market neutral stat arb strategy, and that the CDOs they sponsored were not built to fail. See here and here. My interest in this story is not Magnetar, per se, but rather what it reveals about the MBS industry in general, leading up to the credit crisis.

Here is what Yves Smith has to say about the stat arb strategy:

... While Magnetar paid roughly 5% of the total deal value for its equity stake, it took a much bigger short position by acting as a protection buyer on some of the credit default swaps created by these same CDOs. This insurance in turn was artificially cheap because over 80% of the deal was rated AAA. Most investors did not understand what Magnetar recognized: this concentrated exposure to the very riskiest type of bond associated with risky mortgage borrowers, each of these CDOs was a binary bet. It would either work out (in which case Magnetar would still show a thin profit) or it would fail completely, giving Magnetar an enormous profit and wiping out even the AAA investors who mistakenly believed they were protected by having other investors sit below them and take losses first. Thus the AAA investors were only earning AAA returns for BBB risk.

The Magnetar trade part one, two, three.

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