The Magnetar Trade

By Felix Salmon
April 9, 2010
announced it was hiring my friend Jesse Eisinger as an investigative financial journalist, and ever since then a lot of people have been very interested in what he's been working on. Today, we find out, with the publication of a 6,600-word story on a hedge fund called Magnetar, co-written with Jake Bernstein.

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Back in July, ProPublica announced it was hiring my friend Jesse Eisinger as an investigative financial journalist, and ever since then a lot of people have been very interested in what he’s been working on. Today, we find out, with the publication of a 6,600-word story on a hedge fund called Magnetar, co-written with Jake Bernstein.

Magnetar did well during the subprime bust, largely thanks to bets it made against subprime mortgages. If you’ve read the new Michael Lewis book, you’ll know all about this world: investors would buy credit protection on mortgage bonds they thought were likely to fail, happily paying small insurance premiums now in return for what they hoped — rightly — would be a massive payday when the bonds started defaulting.

The problem was that no one liked paying those premiums. Lewis details the enormous fights that one manager, Michael Burry, had with his investors: they hated the fact that lots of money was flowing out of his fund, in insurance premiums, and nothing was coming in. So other people tried to put together trades where they could make enough money in one part of the mortgage market to pay the insurance premiums elsewhere. Lewis writes about the most disastrous such trade, put on by Morgan Stanley’s Howie Hubler:

The crown jewel of their elaborate trading positions was the $2 billion in bespoke credit default swaps Hubler felt certain would one day very soon yield $2 billion in pure profits. The pools of mortgages loans were just about to experience their first losses, and the moment they did, Hubler would be paid in full.

There was, however, a niggling problem: The running premiums on these insurance contracts ate into the short-term returns of Howie’s group. “The group was supposed to make two billion dollars a year,” said one member. “And we had this credit default swap position that was costing us two hundred million dollars.” To offset the running cost, Hubler decided to sell some credit default swaps on triple-A-rated subprime CDOs, and take in some premiums of his own. The problem was that the premiums on the supposedly far less risky triple-A-rated CDOs were only one-tenth of the premiums on the triple-Bs, and so to take in the same amount of money as he was paying out, he’d need to sell credit default swaps in roughly ten times the amount he already owned.

This turned out, by the time the dust settled, to be without a doubt the single worst trade that any investment bank has ever entered into in the history of the world: it ended up losing Morgan Stanley $9 billion. It was a long-short trade: Hubler was long triple-A CDOs and short triple-B CDOs, and he ended up losing vastly more on the long side than he could possibly make on the short side.

Jesse Eisinger has found another hedge fund which was shorting mortgage CDOs, Magnetar. And it, too, avoided nasty phone calls from its investors by following a long-short strategy. But instead of losing billions, it ended up making them. Because while Morgan Stanley offset its short triple-B positions by going long the safest tranches, Magnetar offset its short positions by going long the riskiest tranches.

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…

By buying the risky bottom slices of CDOs, Magnetar didn’t just help create more CDOs it could bet against. Since it owned a small slice of the CDO, Magnetar also received regular payments as its investments threw off income.

With this, Magnetar solved a conundrum of those who bet against the market. An investor might be confident that things are heading south, but not know when. While the investor waits, it costs money to keep the bet going. Many a short seller has run out of cash at the gates of a big payday.

Magnetar could keep money flowing — via its small investments in CDOs — and could use that money to pay for its bets against CDOs.

The point here is that the maximum downside on Magnetar’s long positions was much smaller than the maximum upside on its short positions. And when everything broke down and just about everything went to zero, Magnetar’s shorts ended up making it enormous profits.

At the time, it looked like Magnetar had made a bullish bet on CDOs, and got lucky when its offsetting short positions wound up being massively profitable. But Jesse and Jake see something a bit more nefarious — while still legal — going on. They reckon that Magnetar wanted to be short all along, but the only way of being short was by making sure that the synthetic-CDO machine kept on churning. And the way to keep the synthetic CDO machine churning was to sponsor the CDOs themselves, by buying the risky equity tranche. They write:

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.

This is true, but it’s not the whole truth. Yes, the banks needed to find someone to take the equity tranche — although often they simply took it themselves, if they could make more money in deal fees than they could possibly lose on the equity. The real problem, with all of these synthetic CDOs, was something known as the “unfunded super-senior tranche”. (What’s a super-senior tranche? Funny you should ask!) Where Magnetar seems to have been very clever indeed was in persuading banks that it made sense to throw all manner of crap into their CDOs, while not worrying for a minute that their super-senior risk — risk that the banks never intended to sell — would end up losing them billions of dollars.

Of course, if you can get paid $4 million a year not to worry about such things, it becomes easier to ignore them.

The smelly part of what ProPublica calls the Magnetar Trade is that because Magnetar was sponsoring the deals, they had an inordinate amount of control over what went into them, and even what they were named. And they seem to have made a vast amount of money from this information asymmetry.

But of course the banks knew exactly what was going into these deals too. And one of the biggest losers was JP Morgan, the banks whose CDS whiz-kids were lauded at book length as being especially alert to the problems of unfunded super-senior tranches. These were the people who knew better than to hold on to such things — yet they still managed to lose $880 million on a $1.1 billion CDO-squared they put together at the behest of Magnetar.

It’s worth noting here that these deals were derivatives all the way down. The JP Morgan deal was a CDO of synthetic CDOs — the number of actual subprime mortgages in there was tiny. Essentially, the clever traders at Magnetar did an insanely complex derivatives trade with the clever traders at JP Morgan and elsewhere, and Magnetar ended up coming out on top.

The saddest part of the whole story is the suckers — naive investors like IKB, a small German bank which had to get bailed out by German taxpayers in mid-2007. They thought they could get high yields on safe securities, and they were wrong. But I don’t think that it’s all that easy to blame Magnetar for the existence of players like IKB. In the world of derivatives, for every loser there’s always a winner. And in this case, Magnetar was smart enough to be that winner.

Update: Jesse writes to say that his story is only 5,900 words. And that it’s going to be on This American Life this weekend. Tune in!

Update 2: See the 6,000-word story reduced to a 100-second musical clip! It’s actually kinda genius.

Bet Against The American Dream from Planet Money on Vimeo.

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Comments
14 comments so far

This is exactly the story that Yves Smith retailed in appendix II of her book Econned. She didn’t name any names, though, and she added some colorful ornamentation, claiming that the hedge fund was front-running the CDS protection on the mezzanine tranches.

I still can’t work up any sympathy for the view, which you share with Smith, that there something peculiarly evil about synthetics. Sure, the super-senior in the synthetic was unfunded (a VFN), but the same was effectively true for cash deals because in that case the SS was sold off to an SIV at zero capital charge. The key requirement in both cases was that there was unlimited demand for the AAA tranches. And it was really only the cash mortgage bonds that could push up house prices, so from a social perspective synthetics were less harmful than cash.

Posted by Greycap | Report as abusive

Wow, all of that just because investors don’t like paying insurance premiums? Hell, I don’t like losing money every month paying my car insurance premium but I am not going to run to Vegas and risk my life savings hoping to hit a multi-million dollar jackpot just so the money won’t come out of my paycheck instead.

But then again I don’t make ridiculous amounts of money so the value of a dollar still means something to me.

Posted by iflydaplanes | Report as abusive

Greycap, I don’t think I said that there’s something particularly evil about synthetics. Ask Jesse Eisinger — he’ll tell you I’ve been a defender of them!

1/3 of all foreclosures now are strategic

Posted by STORYBURN_site | Report as abusive

Greycap: “there was unlimited demand for the AAA tranches”

Please. The only reason there was so much cash demand for AAA CDOs was because the yields were so high. And the only reason the yields were so high was because the large synthetic super-senior tranche in hybrid CDOs meant that the typical AAA CDO cash investor had exposure to $4 of synthetic losses for every $1 of investment. If you understand what a hybrid CDO is, then you know that synthetics were used to create the leveraged AAA yields that were necessary to keep cash investors in the market.

If all CDOs were all cash, AAA CDO yields would have had to be much lower on average, and I don’t think anybody would be talking about “unlimited demand”.

Posted by csissoko | Report as abusive

i think the “unlimited demand” was a simple function of the pure ignorance of the buyers of the instruments. the paper was mis-rated as AAA, and the buyers didn’t do the work to figure this out. Magnetar knew this and capitalized on it.

Posted by KidDynamite | Report as abusive

I’m disappointed with Burry. I thought he was super-clever. But he couldn’t even think of this trade to get investors off his back.

Posted by EmilianoZ | Report as abusive

csissoko, you are mistaken: there was exactly as much leverage in an all-cash deal, as I explained. From the dealer’s point of view, the synthetic was only useful because the supply of underlying bonds was insufficient.

Yes KD, of course the AAA rating was bogus! And I would not be so quick to make the comfortable assumption that all buyers were deluded on that score, although as Lewis says of Hubler, most were not cynical enough.

Posted by Greycap | Report as abusive

wait Greycap – are you suggesting that you think that some buyers of the AAA tranches knew that the paper was overrated and bought it anyway? why? please elaborate…

that’s the beauty of the Magnetar trade – THEY bought the equity tranche fully expecting it to blow up, and knowing they’d still win. I don’t think anyone bought the top rated tranche thinking it was risky though… ???

Posted by KidDynamite | Report as abusive

FWIW, the equivalent trade was possible, though not as profitable and hence not done as often, in the underlying RMBS. A handful of people (apparently including Goldman) did it in Europe, where CDOs of RMBS weren’t anything like as common. You’d buy the BBB or BB tranche to earn some positive carry, then short the AAA tranche for 10 times the volume. Those people made out like gangbusters in the crisis – hardly any of the BBB tranches have actually defaulted in Europe (some of the UK non-conforming paper, a few prime deals in Spain, but that’s about it), yet triple-A spreads went out to neary 1000bp at one point. Anyone who closed out the trade back in early 09 would have made a fortune

Posted by GingerYellow | Report as abusive

Greycap:

I am not mistaken. You appear to be claiming that the dealers would not have had to find buyers for the “super” senior tranche in an all cash deal. All cash means cash buyers who are willing to accept those negligible yields must be found. They did not exist.

When you state that the supply of underlying bonds was insufficient, the implication is the yields on those bonds needed to fall in order for supply and demand to be in balance. Synthetics were clearly used to delay the operation of the market forces of supply and demand in the mortgage.

Posted by csissoko | Report as abusive

Greycap:

With more time on my hands I read through the thread more carefully. If you are claiming that SIVs could have purchased all the super senior CDOs that were issued, I don’t know where you get data from, but it must be very different from mine.

The funded portions of the structured finance CDO market (i.e. the part that wasn’t super senior) were $300 billion in 2006 and $260 billion in 2007 per SIFMA. It’s seems safe to assume that we’re talking about at least $1 trillion in super senior tranches of structured finance CDOs.

The SIV market on the other hand was only $400 billion total and most of its assets were tier 2 bank capital. According to Bear Stearns only 11% of assets were CDOs and only 1% were ABS CDOs. How are buyers of $4 or even $40 billion in ABS super seniors, supposed to expand to cover a $1 trillion market?

Posted by csissoko | Report as abusive

Greycap:

“This is exactly the story that Yves Smith retailed in appendix II of her book Econned. She didn’t name any names, though”

Ehhh?? Chapter 9 of ECONNED is all about *Magnetar*. Did you miss that bit?

Posted by RichardSmith | Report as abusive

GingerYellow: looks like Goldman did similar in the U.S. market also: http://variousprovocations.blogspot.com/ 2010/04/curio.html

Posted by dariustahir | Report as abusive
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