Felix Salmon

Revisiting the Magnetar Trade

By Felix Salmon
April 21, 2010

In the wake of the SEC charges against Goldman Sachs, a lot of people have been wondering whether Magnetar, or its bankers, might be next up in the SEC’s crosshairs. Moe Tkacik has been looking into Magnetar for a couple of months now, and I spent a lot of time on IM with her today, learning just what it is about Magnetar which seems to drive people crazy — to the point at which they’ll happily spend seven months on a journalistic investigation of the company.

I’m not going to even attempt to get into all the nooks and crannies and conspiracy theories which surround Magnetar, but I think, after talking to Moe at some length, that I have a much better grasp of the very big picture than I did after reading the ProPublica report.

The story begins in 2005, when Greg Lippmann of Deutsche Bank gets ISDA to create some standardized language for credit default swaps on subprime mortgages. That was the spark that lit the fire — and one of the first people to realize the enormity of the potential conflagration was Alec Litowitz of Magnetar. Lots of hedge funds had the bright idea of shorting mortgages: you can read Michael Lewis’s book on many of them, or Greg Zuckerman’s on the biggest one of all, Paulson & Co.

But that was a simple trade. Someone like Michael Burry or John Paulson or Andrew Lahde would go up to Deutsche Bank or Goldman Sachs, and say “hi, I want to buy credit protection on the BBB-rated tranches of subprime RMBS”. And then those banks would have to find someone else willing to take the other side of the trade, which wasn’t always very easy. And the market never really got very big or important.

But then Litowitz hit on the idea of a mezzanine subprime hybrid CDO — and that was a real game-changer.

First it’s worth explaining exactly what such a strange beast is. A CDO is just a collection of fixed-income instruments, aggregated and tranched. In this animal, all the instruments are “mezzanine” — which means they carried the very lowest investment-grade rating, triple-B. They were also all subprime. And “hybrid” means that the CDO was a mixture of cash bonds and artificial credit default swaps, normally in a ratio of roughly 4 CDSs for every bond.

There were subprime synthetic CDOs before Litowitz came along — Greg Lippmann had created some — but they were generally linked to the broad ABX index, which meant that you couldn’t construct them with anything like the level of specificity and granularity that Litowitz was looking for. And Litowitz’s insight was that the ratings agencies’ models didn’t look at loan-level data on the contents of CDOs, they just looked at the ratings of the contents of CDOs. So you could fill a CDO up with all manner of subprime NINJA nuclear waste, and it would look to the ratings agencies exactly the same as if it held much safer BBB tranches of prime fixed-rate mortgages.

Once the ratings agencies blessed the structure with their magic-fairy-dust triple-A ratings, there was always someone willing to buy it at a modest pickup over Treasuries or Libor. That was the nature of bond investors during the Great Moderation: they simply didn’t have the time or the inclination to investigate the contents of every triple-A bond they were shown. Instead, they were busy dreaming up clever structures of their own: if they funded themselves short in the ABCP market, and invested the proceeds long in the subprime CDO market, they could make a fortune. And they could always get funding in the ABCP market because their collateral had the precious triple-A rating. In many ways it didn’t really matter what was inside it, just so long as the rating was there and it ended up paying off in the end.

Magnetar’s subprime CDOs started appearing in the spring of 2006, as the first cracks were beginning to appear in the housing market, and continued through the summer of 2007. The likes of Michael Burry had already put on their short positions at this point, and were just waiting for the inevitable market plunge and their handsome paydays, as the value of their default protection soared.

But Litowitz threw a weird spanner in their works. He kept on buying up cash mortgage bonds to put into his CDOs, which kept that market high. And he bought up the toxic equity tranche of the CDOs too, which no one in their right mind wanted to touch with a bargepole. (Although, scandalously, naive public pension funds were buying equity in these things too, right up until the end.) And he was creating these CDOs in such enormous volumes that even with him providing a huge amount of the short interest, there was still a lot more to go round, to the likes of Burry and Paulson, who would get offered the opportunity to buy protection at lower rates than they were used to.

That’s a mixed blessing for a hedge fund manager like Burry. On the one hand, he wanted all the protection he could lay his hands on, the cheaper the better. But on the other hand, he had to mark his holdings to market, and the price of protection was going down rather than up. And so his investors started getting very antsy indeed: not only was he paying out millions in insurance premiums, but the value of his insurance was falling.

Meanwhile, on the long side of things, the fact that subprime CDS prices were staying cheap, even after the real-world subprime housing market had started falling apart at the seams, only served to confirm in the minds of bond investors and monoline insurers that the models were right and that there was nothing to worry about. So they kept on buying those triple-A bonds, even when they were made up of nothing but triple-B dreck. After Magnetar was happy to buy the equity, which was specifically designed to insulate the bondholders from any harm.

In a narrow sense, then, the Magnetar Trade did indeed involve capital-structure arbitrage of custom-designed synthetic CDOs, as they say it did. Litowitz saw that there was a mispricing in the market, and that insurance was being sold too cheaply, so he created as many vehicles as he could just so that he could buy insurance on them.

The bigger picture, however, was that Magnetar’s vehicle production line helped to perpetuate the bubble, and almost certainly reassured not only bond investors but even the likes of Hank Paulson and Ben Bernanke that the problems in the subprime mortgage market were confined to a few mortgage companies, and wouldn’t have knock-on effects in the financial system. After all, the market knew exactly what was going on in California, and didn’t seem to be worried in the slightest!

Here’s part of what Moe IMed me today:

Magnetar sponsored $40 billion worth of the worst of the worst CDO deals, thus propping up the whole damn market, and Paulson did $5 billion, at the end, only after (I imagine) he caught onto Magnetar’s trade. In the end Paulson looks guiltier because he made more money. BUT. What Magnetar did was much more akin to what the investment banks do every day, which is spin rampant-conflicts-of-interest into megasurefire profits.

In Magnetar’s case, however, they only had their investors to answer to, so they have not had to bother making up some mendacious bullshit explanation of their role in the broader economy such as “efficient allocation of capital”.

From a systemic perspective, Magnetar had a much bigger effect — and a much worse effect — than Paulson. That’s what makes people like Moe and Yves Smith angry. (Much of what Moe learned she got from Yves and her book.) Magnetar was in many ways the engine which was responsible for many of the worst losses from New York to Dusseldorf. Those losses didn’t directly become Magnetar profits, because Magnetar was long equity and generally hedged in a way that Paulson and Burry weren’t. But they did end up helping to cause the biggest recession in living memory.

Update: Just to clarify, both ProPublica and Smith have done amazing work uncovering the Magnetar Trade and its sheer enormity. It’s a really hard story to crack, and they did an enormous amount of heavy lifting and deserve everybody’s gratitude. ProPublica, especially, is a case study in how to put source documents online and lay complicated things out in a wonderfully transparent manner — while at the same time being accessible enough for This American Life on NPR. I  didn’t mean to denigrate their excellent reporting in any way, but it came out that way and I apologize for that.

23 comments so far | RSS Comments RSS

Great Job explaining this Felix. I’d add – a lot of people on the long side of the market were concerned about home prices and bad loans, etc. in 2006 and confused why spreads were staying so low. Many cash buyers had backed off completely. But even as the Fed was rates the Fed Funds rate, mortgage rates stayed low and credit spreads stayed tight. It was, according to the Fed, a ‘conundrum”. Magnetar played a big role in this. some investors moved up in risk in response – taking a lower and lower yield at the AAA level because they didn’t want the BBB risk at those prices. Basically, however, none of those subprime loans should have been made – it was a total distortion of the market: rates falling as risk was increasing. And no one could explain it at the time.

Posted by tja3 | Report as abusive

The puzzling thing is that buying all the credit default swaps didn’t affect the market much. If I try to do something similar with a stock, I buy some stock and a bunch of puts on the stock. But then someone hedging the put will sell the stock, driving the price down.

Somehow the flow of information in these markets was badly broken. Prices (and transactions) are supposed to carry information, but the message got lost. If that part of the market had worked properly, Magnetar’s buying equity tranches would have had less effect than buying the CDSes, and the bubble would have ended sooner. The ratings agencies probably have a lot to do with that, actually.

Posted by jleonard | Report as abusive

“(Much of what Moe learned she got from Yves and her book.)”

Oh, so this isn’t actually information then. Perhaps you too should consider reading Smith’s book, Felix, then you wouldn’t have to get it second-hand from Moe.

Having originally written Smith off as a nut, her book more or less brought me around. But what neither you nor she have succeeded in explaining is why Magnetar’s interest in shorting should have increased the mortgage market by a single penny. Hybrid CDOs were hybrid because by 2007, pure synthetics would generally not be rated. So a synthetic deal did demand some cash component. But that is not the same as increasing demand for mortgage bonds, because a cash deal did not require any synthetics. I think you’ll find that dealers liked the synthetics because they were able to charge higher total fees, not because they couldn’t profitably structure cash deals.

Posted by Greycap | Report as abusive

With the deepest respect for your work:

Isn’t it time to revisit CDS as insurance deals with an inherent moral hazard ingredient? Isn’t it time to regulate CDS insurance without or in excess of your long position out of existence?

There is a very good reason it isn’t legal or possible to take out a fire insurance on your neighbour’s house (potentially in excess of its value) and being able to construct that house from gas soaked wood. Is it conductive to business, to be able to create a company, keep a certain amount of control over it and insure it against default in mulitples of your equity stake and exposure?

If moral hazard is tolerated it will be realized. This is the true case for regulation and a fraud case on a much wider scale.

Posted by Finster | Report as abusive

finster – the problem here has nothing to do with the moral hazard regarding the lack of insurable interest in the misplaced “insurance on your neighbor’s house” analogy… Magnetar didn’t effect anyone’s ability to pay his mortgage.

the problem is that the insurance SELLERS sold too much and couldn’t make good on it – which has nothing to do with this overused, flawed analogy.

Felix – you need to make sure that all of your readers realize that in these deals, where Magnetar put up maybe 10% of the notional at most for the equity tranche of the deal, there were others putting up NINETY percent of the deal – so let’s hang them out to dry as being the ones really “responsible.”

Posted by KidDynamite | Report as abusive

who were those “insurance” sellers for the super senior CDS? the bond insurers only did 3 or 4 of the 30 magnetar deals and AIG didn’t do any, nor did IKB. Who did the other deals? I suspect it was the banks, stuffing them into their own SIVs, which were then bailed out, effectively, by the taxpayers.

Posted by tja3 | Report as abusive

sure tja3, but I was only trying to point out that again the problem has nothing to do with the flawed “buy insurance on your neighbor’s house and burn it down” analogy – that’s not at all what happened.

What happened is that someone sold insurance on your house to many different people, thus increasing their exposure when your house burned down.

The problem has absolutely nothing to do with the moral hazard potential that arises from owning insurance on something when you don’t own the underlying. Thus, if people are going to argue that CDS is the problem, they need to get the argument right – the problem is not moral hazard, it’s systemic risk.

Posted by KidDynamite | Report as abusive

I excuse for having oversimplified, but I stand by my point that insurance deals are a special beast and thus are regulated extensively.

The article hints that Magnetar had a market controlling position in developing these vehicles and its involvement perpetuated the bubble, while significantly distorting prices of both the underlying securities and the protection.

There is a case for insurance fraud as well as market manipulation in this, multiple layers of complexity do not change that basic point.

Disintermediation of risk and information, the issue at the heart of securitization have brought this about, enabled by the rating agencies and the naivity of the buyers under a low interest regime.

Posted by Finster | Report as abusive

Is the other side of the entry for ‘mezzanine’, junk bonds ? To be honest, I don’t think I will ever understand all of this, it is too layered with deceit, the golden thread seems to be the ratings agencies, who runs them ?

Posted by Ghandiolfini | Report as abusive

Thank you Greycap for calling out Felix for his pathetic omission of the work of Yves Smith (both her blog and her book) on Magneto (sarcasm…though it seems the hedge fund is a greater threat to humanity than the X-Men bad guy).

After all your swipes at BusinessInsider et al for denigrating the work of others online, you have quite a big of egg on your face for not acknowledging the work of Yves until nearly the end of your post.

While I am a little disappointed Yves held back some of her best stuff on Magnetar for her book, the timing was near perfect since posts last fall would not have had the resonance they have now with the SEC’s Goldman suit providing momentum.

Yves did great work and deserves to get shout-outs AT THE TOP OF YOUR POST whether or not she has a book to promote or not. If the book is great and useful, why not promote it???

Are you trying to keep traffic from spilling over to Yves’s blog? Is Reuters telling you to downplay the excellent work of others to keep pageviews over here? I expected more of you Felix (and if you innocently are ignoring the work done by Yves, then you just show how sloppy you are).

Posted by Sad_Oligarch | Report as abusive

The SEC is a joke

Posted by Storyburncom_is | Report as abusive

I was wondering if Felix would like to apologize to readers for his earlier superficial ranting covering the Goldman / SEC case. Now that the dust has settled and more rationale analysis of the situation is emerging in higher quality papers, it looks increasingly inconsequential and many of the “scandalous” facets reflect a lack of understanding, or a dishonest representation, of how these instruments work.

Why don’t journalists know what they don’t know? You should take a more measured approach before launching into ranting. You might want to consider if you’re tapping up a rapid-fire, shoot-from-the-hip criticism of the “obvious” faults you’ve found in that press release, if the entire top layer of Goldman intellectual capital signed off on it, perhaps Felix might be missing something here?

I would like to challenge Felix, and a number of the bloggers here, to get a job trading at a Wall Street firm. “Banksters” are obviously overpaid, stupid people, who do nothing but cause financial crises and force Americans to take on debt against their will. Why don’t you prove it by using your far greater skills to get a job there and then reveal their incompetence?

Posted by BarryLyndon | Report as abusive

Greycap: “I think you’ll find that dealers liked the synthetics because they were able to charge higher total fees, not because they couldn’t profitably structure cash deals.”

I’m very curious as to where you think the cash buyers for “super” senior tranches of cash CDOs paying just a few bps over Libor could be found in 2007.

Posted by csissoko | Report as abusive

I was wondering if Felix would like to take a bow for staying uptop this whole wonderfully sordid affair and trying to explain complex transactions in terms people outside the Wall ST. clique can understand. Kudos and keep up the good work. Even if Goldman buys its way out, this has been great entertainment, and certainly shines a light on facets of Wall St. that the people there would prefer to see stay buried…so they can make even more money.

Posted by REDruin | Report as abusive

so, Felix has a lack of understanding “how these instruments work” Barry-Lyndon?

I would say that we are all getting an education on how the ‘instruments’ work and that I wouldn’t want to be as educated as the investors who lost huge money from the application of the knowledge of Wall Street Bankers. I would never be a trader with unethical standards, nor would I knowingly work for an institution that allowed corruption, put myself and my commissions and bonuses before the client I work for or fostered any of that mentality. Which means I could never work there.

As scandalously and blatantly flawed instruments they were, you would rather defend wall street for their misleading and corruption and berate Felix for his opinions, which is what a blog is supposed to be?

Your rant is just that and Felix has at least included excellent information and talking points, whereas you are just being belittling.

Posted by hsvkitty | Report as abusive

csissoko, I’m curious what you think was special about 2007. When could you ever find a natural cash buyer for SS? That is what SIVs were created for – an indirect method of funding SS with commercial paper at zero capital charge. And haven’t we been through this before?

Posted by Greycap | Report as abusive

Isn’t a magnetar a super neutron star/pulsar, the pre-cursor to a black schole, that thing that swallows everything, never to return ?

Posted by Ghandiolfini | Report as abusive

…but possibly spat out via a wormhole in another universe, or if the world (econonomy)is folded over double, like a fools cap, quickly jumps out at, let’s say, the Icelandic Banking System.

Posted by Ghandiolfini | Report as abusive

Greycap: Didn’t mean to emphasize 2007. I really just don’t understand how the SIV market which only ever invested about $44 billion in CDOs (of all varieties and all tranches) could have been the cash buyer for the super senior. Are you confusing SIVs with leveraged super senior CDOs? Because the latter ABCP vehicles only worked because they were financing synthetic super seniors.

Posted by csissoko | Report as abusive

Goodness gracious csissoko, I thought the health and frail care debate was over.

Posted by Ghandiolfini | Report as abusive

Ghandiolfini: Just trying to understand Greycap’s point of view. Unfortunately still bewildered. Greycap’s the only individual I’ve ever heard claim that the super seniors could have been funded cash. Would really like to understand where he’s coming from.

Posted by csissoko | Report as abusive

csissoko, the whole point is that super seniors were always unfunded. If they were funded they were old-fashioned AAA tranches.


Felix, I don’t think the question here is the terminology of the most senior tranche, but whether it would have been possible to maintain the profitability of CDOs in the absence of an unfunded (and therefore very low cost) most senior tranche. I think that cash investors were demanding higher yields than unfunded “investors” and that there’s no way that all the deals that took place with unfunded super senior could have been issued as cash deals.

Posted by csissoko | Report as abusive

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