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Doth Magnetar Speak With Forked Tongue?

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By Tom Adams, an attorney and former monoline executive; Andrew Dittmer, a mathematician who has worked for a hedge fund; Richard Smith, a UK-based capital markets IT consultant, and Yves Smith

As described in ECONNED and in later reports by ProPublica, a Chicago-based hedge fund, Magnetar Capital, entered into a program of sponsoring subprime-based CDOs that was unprecedented in its scale. The hedge fund supplied a disingenuous, legalistic defense of its strategy, in an effort to depict the ProPublica reports as having failed to integrate some of the information Magnetar claims to have provided to ProPublica.

However, a close reading of their letter shows that it does not effectively rebut the overarching charge, that Magnetar-sponsored CDOs were designed to fail, but is also consistent with our analysis of the strategy (which came to Magnetar’s attention more than three weeks ago).

Magnetar’s efforts to defend itself consist of some seemingly straightforward arguments, as well as two dense paragraphs. We’ll deal with the more accessible bits first:

1. Its strategy was “market neutral” and would show a profit whether the subprime market did well or badly

2. Magnetar was merely the “initial equity purchaser”; the “Collateral Manager” (often know as the CDO manager) and the dealer were independent, and the Collateral Manager was responsible for selecting the assets and exposures in the CDO and had a financial incentive for the deals to succeed

3. Magnetar’s analysis of its CDO’s performance, contra that of ProPublica, shows that its CDOs performed better than that of “like securities”.

Let us debunk each in order.

1. merely means the trade was profitable whether the underlying market went up or down, not how the profit potential was distributed across the two outcomes. We have indicated, based on the input of market participants, including individuals who worked on Magnetar’s deals, that the ABS (subprime-related) CDO trade was constructed to show a comparatively thin profit if the CDOs continued to perform, and a much greater return if the bonds in or referenced by the CDO failed. This bias is consistent with the 76% returns for this strategy reported by ProPublica.

2. is simply disingenuous. Substantial equity investors were given considerable rights to influence the overall design of a transaction, with the notion that any steps the equity investor took to protect the value of his investment would benefit all other investors. There is ample evidence that Magnetar used the influence it gained over transaction to influence its parameters to its benefit, to the detriment of the other investors/funders on the long side. For instance, it used triggerless deals (in a typical CDO, the cash flow distribution to the equity trance would be cut when losses reached certain thresholds. In a triggerless deal, the equity tranche investor would have the same rights to payment right up to when the CDO defaulted or was liquidated.

Some accounts indicate that Magnetar provided lists of suggested securities to the CDO manager, it would not have been necessary to go that far to influence CDO design. For instance, merely calling for a very high average coupon would have forced the CDO manager to buy only particularly “spready” or high yield, meaning crappy, bonds. The ProPublica article includes an e-mail message from Magnetar’s James Prusko to a CDO manager, Ischus, where Magnetar not only pushed for higher spread (meaning riskier) CDS on subprime bonds to be included, but also provided a spreadsheet with a “target portfolio”. Magnetar would achieve its ends if the CDO manager used many of the instruments its suggested portfolio, or simply constructed one that had the same characteristics.

While we have taken issue with some elements of Michael Lewis’ The Big Short, his book does provide a good description of the role the CDO manager played: that of creating the appearance of independent, objective asset selection. In reality, many CDO managers were closely affiliated with particular investment banks and were so thinly staffed that the idea that they were actually doing much analysis is questionable. CDO manager fees were 0.10% to 0.20%, meaning $1 to $2 million per annum on a $1 billion CDO for doing very little.

3 is ridiculous. Moat of the deals have hit an event of default and the average rating is well into the CC range. The deals all failed,so whether they failed in 10 months or 12 months is not a measure of success. The weighted average Moody’s rating of senior bond of magnetar deals is Ca (CC equivalent). 64% of the deals had their ratings withdrawn. Arguing that their deals performed better than some other deal is meaningless semantics.

Now we will parse the denser section of their argument, with Magnetar’s text in italics:

Magnetar would not have invested the way it did if it had concluded that the housing and residential mortgage markets were near collapse. If Magnetar had that view, it would not have needed to devote resources to its strategy of combining long positions with hedges. Short positions were easy to obtain.

True, but a misdirection. Note the word “near” in “near collapse.” Short sellers almost never are able to short a bubble right before its peak. Magnetar’s strategy was designed to address the usual problem that vexes short sellers, that they often wind up being early, and conventional strategies for shorting show losses until the market turns. Magnetar’s strategy was designed to avoid the problems other shorts had had who had underestimated how long it would take for the bubble to pop.

Magnetar’s strategy for investing in CDOs was based on a market neutral mathematical statistical model, and was designed to have a positive return whether housing performed well or poorly.

This is consistent with what ECONNED and ProPublica have written. This statement does not mean “Magnetar’s strategy would have a positive return no matter what,” since no such strategy exists. It is a labored way of saying “there were scenarios in which housing performed well under which Magnetar’s strategy would be profitable, and there were also scenarios involving a housing collapse under which Magnetar’s strategy would show a profit.” Most likely, all of this just means that Magnetar was long
correlation and that the return from their equity position in the CDOs was fat enough to fund
their short positions.

Magnetar’s statistical models looked at all equity tranches and all hedges in the portfolio simultaneously in a global framework and not on a deal by deal basis.

Again, this is not inconsistent with what we have written. None of this contradicts the thesis that Magnetar knew very well that certain types of CDOs were better for their strategy than others, and actively pushed to make sure those sorts of CDOs were more likely to be created.

Magnetar explained this market neutral strategy to its investors beginning in early 2006. Magnetar’s strategy was not based on fundamental analysis expressing any view that values in the housing market would go up or down.

The catch here is “fundamental analysis..of the housing market.” The insight that drove this arb was that risky subprime loans looked pretty certain to come to a bad end, and that the price of insurance on this credit looked to be wildly underpriced. You didn’t have to believe the housing market would decline to think this trade was a good bet.

Magnetar’s model instead focused on the structures of the mortgage securities and the CDO markets.

…. i.e. the fact that CDO assets were massively correlated, which meant that the AAA tranche of a CDO was badly mispriced.

Magnetar employed no fundamental analysts to make its investments in CDOs.


As of the end of September, 2007, the majority of the notional value of Magnetar’s hedges referenced CDOs in which Magnetar had no long investment.

This statement is tricky. The Wall Street Journal has noted that Magnetar took short positions in addition to the shorts it constructed using the CDOs it sponsored. One interpretation is that Magnetar is referring to CDS written by third parties against CDO tranches, meaning those cases where Magnetar bought protection on a CDO tranche from a protection seller of some sort. These transactions were unusual, and would be likely to be only a minor component of Magnetar’s overall position. It could also mean is that Magnetar bought CDS against CDOs containing the same sub bonds that appeared (in synthetic form)
in the CDOs that they sponsored.

Notably, focusing solely on the group of CDOs in which Magnetar was the initial purchaser of the equity, Magnetar had a net long notional position.

Magnetar is trying to give the impression it did not have a net short position on the CDOs it sponsored, but the writing awfully tortured. For instance, “initial purchaser of the equity” (as opposed to more straightforward terminology like “sponsor”) may narrow the universe under discussion to a small subset of the trades we and ProPublica have identified. It might even mean simply that their short had positive carry.

To put this into perspective, Magnetar would earn materially more money if these CDOs in aggregate performed well than if these CDOs performed poorly.

This statement appears to be broad (as in arguing that Magnetar would do better if the CDOs it sponsored did well) when it could be very narrow. For instance, we are now discussing “these CDOs”, which per above may be a subset of all the CDOs Magnetar created. Moreover, our analysis suggests that Magnetar bought only a small percentage of the CDS protection created by its CDOs (we assumed a short interest 4x its long position, which would be equivalent to roughly 20% of the par value of the CDO). With this structure, Magnetar does best in the unlikely event that ONLY the bonds referenced by its CDS fail, and the rest perform. It would not only collect on its short bet, but the CDO would only be somewhat impaired rather than fail.

The purchase of credit protection for Magnetar was primarily a portfolio hedge to Magnetar’s long positions. This distinguishes Magnetar from some other market participants that purchased credit protection primarily as an expression of a fundamental view on the market and not as a hedge.

If our understanding of the Constellation program is accurate, this statement may be narrowly true, but it is highly disingenuous. The implied opposition between “portfolio hedge” and a short position on the market probably refers to the contrast between the Magnetar program that was long correlation and people like John Paulson and Steve Eisman who were simply short housing.

Magnetar’s role as an equity investor was limited and did not replace the roles of the investment bank (Dealer), the Collateral Manager or the credit rating agencies.

By design. But none of this contradicts any of the things that are alleged about Magnetar’s role as an equity investor.

Collateral Managers and Dealers were independent from Magnetar and negotiated at arm’s length against Magnetar with respect to transaction terms, such as the amount of certain types of compensation that the Collateral Manager and the Dealer would receive from the CDO. Magnetar did not select the underlying assets of the CDO at any time prior to or subsequent to transaction issuance.

Doesn’t follow that they were not successful in influencing the deals’ parameters.

When Magnetar was an initial purchaser of the equity of a CDO, the compensation terms and structure of the transaction provided the Collateral Manager with a financial incentive to select assets they believed would perform well.

This remark implies that the system of using Collateral Managers who received incentive compensation helped create high quality CDOs. The results across the industry in fact were the polar opposite.

Before Magnetar’s participation as an equity investor, the fee arrangements generally had less emphasis on incentive-based fees.

If we assume, then, that Magnetar is suggesting that Magnetar favored compensation packages for managers that were heavy on “performance incentives” and light on direct compensation, one tempting explanation is that they figured that the performance incentives would be unlikely to be paid.

In those CDOs in which Magnetar was an initial purchaser of equity, Magnetar did not have the intent or any reasonable basis to believe that the CDOs were built to fail.

This is the hardest statement to make sense out of, particularly since it does not track grammatically. But the “built to fail” by implication refers to the action of third parties (since Magnetar is insistent that it its role in influencing the deals was very limited). So this statement could be taken to mean that Magnetar did not believe that the Collateral Manager or Dealer were designing the CDO to fail.

In addition, derivatives expert Satyajit Das, who reviewed the Magnetar letter, advised us, “Because of model differences and problems of verifying the inputs, it is possible to construct speculative positives that may superficially appear hedged. This allows traders to take any position that they really wish to.”

This means that Magnetar could muster a mathematical analysis of its portfolio that would support its claim that it was hedging, when in fact its intention was to take a short position.

Importantly, the study finds that, when the same Collateral Manager executed transactions with and without Magnetar as an equity investor, the transactions in which Magnetar was an investor performed materially better using the above key metrics.

ProPublica claims to have produced a study showing that Magnetar-sponsored CDOs performed worse than industry norms, which is consistent with our own review of the transactions. All of
the Magnetar CDOs blew up, so the point is somewhat academic.

Put simply, Magnetar’s defense, while predictable, is less than persuasive.

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  1. Kid Dynamite

    question for Tom (the former monoline executive) – and I mean this in the best possible way: in the quest to blame groups or individuals for “causing” or “perpetuating” the housing bubble, where to the MONOLINES fit in?

    1. Richard Smith

      Hi Kid,

      You are misbehaving a bit here, you know.

      First we post on Rahm/Magnetar, and you ignore the subject, going totally off-topic in the comments by requesting a post on the letter from Magnetar to Pro Publica and a line on another blog post by someone else. OK, we had that in the pipeline anyway, so we can oblige, eventually (it is a horrifically contorted letter).

      But after we labour mightily in low gear through a load of lawyerese to provide exactly what you asked for, you ignore that post too, and go off topic in the comments again. In fact, to my perhaps weary eye (and please excuse me, do come back at me if I am misinterpreting), not only do you brush that post *that you requested* aside, you mischaracterise it as an exercise in blame deflection by a former manager of a failed monoline. That seems rather mean of you.

      Now, Tom is a more patient fellow than I am, so he may well pipe up with his usual honest explanation of his view of the monolines and his own bit part in the debacle. But please don’t then ignore it, and request a response about the rating agencies, or Greenspan, or some other damn thing, because you will begin to be suspected, with some cause, of trolling. I know misdirection is a good equity salesman’s stock in trade, and you are a virtuoso, but could you tone it down a smidge?

      1. Kid Dynamite

        I didn’t realize my comment yesterday was off topic – the first comment pointed out a direct quote from the article that seemed to be at conflict with a matter of public record from Magnetar. The second comment yesterday offered a good explanation apart from evil intents why Magnetar might actually want the riskiest assets in their equity tranches, which was also mentioned in the post.

        this comment today was a simple honest question, since the first author on the byline is labeled as a monoline exec, and the NC crowd seems intent on repeated trying to smear Mangetar as the guilty party, I thought he could shed some light, as it’s 100% clear in my mind that the monolines are infinitely more at fault than the Magnetars of the world.

        I don’t pursue issues in these comment threads, Richard, because they are met with one of three stock replies: 1) that’s a straw man argument 2) with all due respect, you have no idea what you’re talking about or 3) not to be trite, but you are incorrect.

        I did indeed appreciate the fact that this post seemed to be a direct response to my question from yesterday – thank you very much. I didn’t think that I needed to comment to tell you how good a job you guys did quibbling over semantics and speculating as to the potential thoughts in Magnetar’s head at the time of their trades.

        if you’d simply said “we think magnetar is full of it,” I would have understood your position and respected it.

        fyi, i am not and never have been an equity salesperson, and the staff at NC would do well do understand that not everyone who disagrees with them is a troll.

        1. Richard Smith

          Nicely put, Kid. And you are right in the sense that the your first comment was perfectly germane – at least it seemed that way until I saw your response to it here. Because your take on what we are up to:

          “the NC crowd seems intent on repeated trying to smear Magnetar as the guilty party, I thought he could shed some light, as it’s 100% clear in my mind that the monolines are infinitely more at fault than the Magnetars of the world.”

          …isn’t right at all. It would take some level of drooling idiocy to ascribe almost the entire guilt for the 2008 meltdown to the machinations of one hedge fund. Idiots we may be, but we don’t drool, not all the time anyway.

          More to the point, it’s less a matter of attributing blame than trying to understand the mechanisms that got us to Q4 ’08. And (alongside economic ideology, perverse incentives, suicidally rapacious IBs, non-regulation, regulation, pathologically low interest rates, the hypertrophy of repo, duff ratings agencies, goofy gearing, dubious accounting and dopey monolines and whatever else I have missed) one of those mechanisms, and IMO an underreported one, was certainly the Magnetar Trade.

          “I don’t pursue issues in these comment threads, Richard, because they are met with one of three stock replies: 1) that’s a straw man argument 2) with all due respect, you have no idea what you’re talking about or 3) not to be trite, but you are incorrect.”

          Weeell yes, that does happen rather a lot. But what’s a fellow to do? If it’s not a straw man argument, or you can prove you do have an idea, or show that you are right, then you can counterattack. Just don’t expect to bowl people over with your first assault.

          “i am not and never have been an equity salesperson,”

          Oh well, I will have to guess again. I never did figure out who EoC actually was, so the detail of your CV is probably safe from my prying eyes.

          “and the staff at NC would do well do understand that not everyone who disagrees with them is a troll.”

          Staff?? Oh well, fair enough I suppose. We do disagree vigorously with trolls and non-trolls alike. But when you get the whole idea of where we are coming from flat wrong, and then impugn the motives of my friend the arguably too-pure-in-heart Tom Adams, you are straying close to the line.

          Read ECONned yet? I suppose that will soon be another of our stock responses. But you really would have a better chance of getting what we are burbling on about with this Magnetar stuff, if you did.

          1. Kid Dynamite

            richard – thanks for the reply, i appreciate the legit discussion instead of the snarky bombs lobbed at me.

            re: Magnetar trade, my point is simply this: even WITHIN the “Magnetar Trade” they are a teeny tiny component of the trade. if Magnetar’s tiny equity contribution of roughly 10% or less somehow confused/conned/relaxed/complacen-tified (to create a word) the senior tranche investors (be they the issuing BANKS themselves, or someone else) into committing the other NINETY PERCENT OF THE CAPITAL (!!!!) then we should be looking at the 90% party, not the 10% party.

            and forgive me if i misconstrued the message here, but I’ve read posts nearly every day this week here at NC talking about the damage done by Magnetar, when they are at the very least the least to blame of all blamable parties (which again was the only point of my question to Tom), and at the very most: brilliant players of the capital markets game.


            ps – if you want to know my background, you can email me.

            pps – i had/have no intention of impugning the motives of your friend Tom – i don’t know who he worked for or what he did. But I am pretty sure that you’d have a tough time convincing me that the CEO of Ambak was less culpable in the perpetuation of the bubble than Magnetar. again, this was my only point, and I thought that a “former monoline exec” might be able to enlighten me.

          2. anon

            “More to the point, it’s less a matter of attributing blame than trying to understand the mechanisms that got us to Q4 ‘08. And (alongside economic ideology, perverse incentives, suicidally rapacious IBs, non-regulation, regulation, pathologically low interest rates, the hypertrophy of repo, duff ratings agencies, goofy gearing, dubious accounting and dopey monolines and whatever else I have missed) one of those mechanisms, and IMO an underreported one, was certainly the Magnetar Trade.”


            That summarizes the goals of everyone interested in stopping the madness.
            At a miniumum it should be the goal of any serious legislator who has any influence in designing a reg/govt solution to reduce the chances of it happening again.

            Thanks to Kid for triggering a substantive rebuttal (and thanks to Tom and Richard for supplying it) to the intellectually lazy conclusions he (Kid as mouthpiece for that MSM/WS bias) reminds us need to be addressed forcefully and publicly. Why has no one else debunked the disingenuous response from Magnetar?

            Tom’s debunking is clear and refutable. Refute with a substantial counterargument and I’ll listen. Absent that, vague conclusions that the NC/ProPublica/WSJ Magnetar story is not important is bunk.

            There was no debate/followup to the original WSJ story re Magnetar/Norma till Yves book came out. She put that story in perspective. Apparently the folks at ProPublica agreed, separately, and persued their investigation while Yves was finalizing her book (about 4Q09).

            To her credit,their(Ng/Mollenkampf WSJ)efforts were given prominant billing in the book.

  2. Bruce Krasting

    In September of 2007 I was short both Fannie and Freddie. I was pretty certain that they were going to blow up. To me it was that obvious. But one can never be sure of the future so I hedged this bet with out of the money calls against the short.

    So I made money on this strategy. I was, sort of, market neutral but had a big downside bias. What could possibly be wrong with that? Nothing.

    Our system allows one to make a bet, You can bet on an upside or a downside. Change those rules and you will have very little left.

    1. Skippy

      Mr. Krasting

      How many peoples life savings {401k etc} did as well, as required by law, too whom many have not a clue.

      Skippy…Did they even have a chance to look in the dealers eye and draw conclusions before making that BET.

    2. Yves Smith Post author

      With all due respect, your argument is a straw man. While the economic bet achieved by Magnetar resembled a butterfly, the mechanism was completely different than that of taking a position via instruments traded on regulated exchanges. Moreover, the approach used by Magnetar had the effect of both extending the life of the subprime mania and greatly increasing demand for the worst mortgages.

      The exchanges on which you took your position have rules both to assure fair treatment of investors and solvency of the exchanges. Similar rules are notably absent in the OTC markets, and the absence of the needed rules to make markets work well played a direct role in the crisis.

      The FDIC has proposed banning CDOs that are resecuritizations (which have spectacular leverage, making them systemically dangerous) and having the various parties to a deal make their intent clear in the offering documents. Those simple investor protections would have made a Magnetar-type trade impossible.

      I suggest you read ECONNED to get a better appreciation of why this trade was so destructive.

      1. sgt_doom

        Not only should he read Ms. Smith’s outstanding book, he should MEMORIZE pp. 201, 209, 244-245 and p. 252.

        Thank you.

    3. sgt_doom

      There’s an EXTREME difference between making a bet and rigging the system.

      These markets have been so utterly rigged, manipulated and rigged-speculated upon, it should no longer be a topic of conversion.


      Whether it’s the precious metals markets, bear runs utilizing unlimited number of CDSes on the target, or the usual high frequency trading.

      It is all rigged: Corporate America shipping the jobs to China, China – which should be too poor to buy US Treasuries, purchases US Treasuries in return. It’s all one big interlocking Ponzi-Tontine scheme.

      And it’s the non-super-rich who are always the last man standing!

  3. Merrill Guy

    Remember too that Magnetar could have been short MBS or CDOs into the very deals they were the equity for! So the notional of shorts they had on the CDOs for which they were the “initial equity” investor may have CONTAINED their shorts as underlying collateral!

    1. Yves Smith Post author

      Thanks, and we are well aware of that issue, which is why we think the language is pretty disingenuous. In ECONNED, we show how sponsoring CDOs as Magnetar and (in much smaller scale) John Paulson did would also give the sponsor a preferred standing in bidding on the protection created by the CDO. Magnetar is trying to give the impression that they were not effectively net short the CDOs they created (long CDO equity, short more than the value of the equity via the subprime credit default swaps created to provide most of the collateral for the CDO). But as we and you indicate, their rather tortured language is not inconsistent with what we believe was Magnetar’s strategy.

  4. jake chase

    So this Magnetar (whatever it is) created CDOs out of mortgage drek (as opposed to mortgage gold?), and some idiots sold insurance on these CDOs which Magnetar bought?

    Why are we permitting custodians of Other People’s Money to write credit insurance on bonds they clearly did not understand? Why are we still permitting this? Because the ISDA owns our National Legislature.

    Throughout the history of Wall Street, sheep have been shorn. It may sell books to identify as villains the guys who wielded the shears, but the crime in all this is the idiocy of banking and securities regulation. Send the tumbrils for Barney Frank and his pals. Magnetar did the only sensible thing in the circumstances. It capitalized on the prevailing stupidity.

    1. Yves Smith Post author

      It’s a bit more complicated.

      These CDOs were “managed” CDOs. Because the equity tranche was normally very hard to place, a dealer would find the equity investor before moving forward. The equity investor also at a minimum had veto power over the assets to go into the CDO. The idea was that the equity investor, by protecting his interests (presumably rejecting bad assets) would protect all the other investors.

      Magnetar’s CDOs consisted mainly of credit default swaps on subprime mortgage bonds. These CDS were newly created for the CDO via a bid process (the collateral manager would identify which bonds would have the CDS written on them, and various investors would bid on them).

      As recounted in Greg Zuckerman’s book, The Greatest Trade Ever, John Paulson figured out that creating a CDO was a great way to be able to obtain a lot of subprime CDS cheaply (as in he took down all the CDS used to create his synthetic CDOs). Magnetar preferred to have some real bonds in its deals, and unlike Paulson, did not buy all the protection created by their CDOs, but they had some ideas in common, that a CDO provided a good way to obtain a lot of subprime protection relatively cheaply.

      1. jake chase

        Any way you slice and dice it, the whole thing worked only because idiots were chasing yield with other people’s money and wrote insurance on bonds they did not understand. The idea that they ‘relied’ on the work of the ‘equity investor’ is absurd. The equity investor was protecting himself with insurance. The idea was to pass along the bad penny to any fool who would take it.

        You can fill the air with jargon about this and make it seem like a brand new evil, but nothing has changed about Wall Street except the names of the instruments and the complexity of the self justifying prattle. It’s the people who are just a little bit greedy who get reamed every single time.

        1. jake chase

          Let me try to make myself a little clearer:

          Imagine a Glass Steagall world in which dopey investors (banks, insurance companies, money market funds, state governments, municipalities, etc.) holding public money, investor money, in trust, cannot sell protection in the CDS market. You would then have investment banks dealing with hedge funds on these esoteric instruments. When they blow up, who cares? It would be like the MadeOff victims, regretable but systemically trivial. You can thank Phil Gramm, Barney Frank and other political shysters that we do not inhabit such a world. Their dismantling of GS and INACTION in the face of obvious danger on CDS is what enabled the crisis.

          When you scapegoat the short sellers you let those truly responsible off the hook.

      2. Gerald Muller

        I just want to add that, having finished reading ECONNED, the explanation regarding the Magnetar deal is first very clearly explained, even though the strategy is quite complex and second hair raising regarding the absolute lack of added value to mankind that such conduct shows.
        In other times, these guys would have finished burned at the stake.

        1. sgt_doom

          Quite well spoken, Mr. Muller!

          Along with many well described events in Ms. Smith’s outstanding book (ECONNED), Ms. Smith further explains Brooksley Born’s background (unraveling the problems wrought by the Hunt brohers illegal attempt at cornering the silver market when she was a derivatives attorney still at Arnold Porter).

          Previously, I had thought Ms. Born to be mysteriously brilliant and, while that still may be the case, I know realize her experience with the Hunt brothers perfity allowed her to recognize that it would be as a single grain in the sand on a large beach in comparison to the troubles to come from unregulated credit derivatives.

      3. rootless_e

        Why do you want to blame Magnetar for what is clearly the failure of (1) investment banks (2) ratings agencies (3) monoline insurers and (4)regulators ? It’s not as if banks were required to create crap CDOs and stuff them full of crap mortgages that they then intended to foist off on their customers who were unfortunate enough or greedy enough to trust the representations of low risk. For example, banks were not required to agree to the triggerless provisions and certainly should have been under an obligation to point these out to their customers and to consider the result on potential sales. The bank risk management was not required to allow all that crap to be assembled on the bank books. The ratings agencies were not required to fail on the barest elements of diligence in evaluating the deals and the underlying bonds. And so on.

        Why is this all Magnetar’s fault?

        1. Richard Smith

          Straw man: none of the incompetence, nonfeasance and possible malfeasance you mention is Magnetar’s fault; all of it facilitated Magnetar’s strategy; and none of it obliged Magnetar to execute the Magnetar Trade.

          Might I suggest a little investment in Yves Smith’s “ECONned”? It would definitely help you understand what happened rather better than you do now.

          1. rootless_e

            How is that a strawman? I’m asking for identification of the malfeasance on the part of Magnetar. Of course they were not required to make such a trade, but I have yet to see an explanation of why they were required not to make such a trade. What did they do wrong? Are you claiming that it is the ethical responsibility of investors to only make money losing deals with investment banks?

          2. AK

            rootless_e says:
            >> I’m asking for identification of the malfeasance on the part of Magnetar.

            Insider trading in my view since they participated in assembling the CDOs.

          3. rootless_e

            There is so much unethical behavior in the system that I can’t figure out why you think Magnetar’s bet is a scandal at all. For example, CALPERs put money for pensions into a Tishman/BlackRock insanely risky bubble investment in Suyvesant Village in NYC, on the theory that displacing thousands of people from their homes to create more luxury housing would make bundles of money. And they lost everything. To me, these kinds of investments are the real ethical failure and Magnetar taking advantage of the stupidity and greed of investment banks is just business.

          4. Richard Smith

            “I’m asking for identification of the malfeasance on the part of Magnetar.”

            No, if you reread your own comment, you’ll discover that what you said was

            “Why do you want to blame Magnetar for what is clearly the failure of (1) investment banks (2) ratings agencies (3) monoline insurers and (4)regulators ?…The bank risk management was not required to allow all that crap to be assembled on the bank books. The ratings agencies were not required to fail on the barest elements of diligence in evaluating the deals and the underlying bonds. And so on.

            Why is this all Magnetar’s fault?”

            You falsely attribute the claim that “this (is) all Magnetar’s fault” to some post here on Naked Capitalism. That’s the straw man you haven’t spotted.

            And then you follow up with a second straw man “Are you claiming that it is the ethical responsibility of investors to only make money losing deals with investment banks?” To which the very obvious answer is “no”.

            At this rate it looks as if it will be quite some time before you manage to engage with any of the content of the posts made on this blog about Magnetar. Have a read and a think!

          5. rootless_e

            Oh please. There’s no “straw man”, just evasive argumentation on your part. After a number of articles on this trade, all of which strongly imply Magnetar’s behavior was at least unethical and possibly illegal, you can’t identify the actual problem with what they did. What did they do wrong? If there’s nothing that they did that was wrong, why all the breathless scandal reports? They induced banks to, eyes wide open, make risky investments and possibly failed to explain to the banks that Magnetar was hedging – which they were certainly entitled to do. The banks could have hedged too.

          6. rootless_e

            Just to make it clearer, what I’m asking for is a refutation of what Janet Tavakoli wrote in the comments to the Huffingtonpost story.

            “The key architects of the subprime debacle were the investment banks that underwrote the securities that provided the funding to mortgage lenders. If you cut off that funding, the process would have died. Investment banks are obliged to perform due diligence on the portfolios and the structures, in fact they are chiefly responsible for the structure of the CDOs.

            Magnetar was a cog in the wheel, and many hedge funds were involved. For each CDO, there were multiple drivers including new special purpose vehicles, bond insurers, CDO managers, rating agencies, and many more. There were dozens of ways to pull off bad deals.”

            I’m concluding from your responses that you have no actual argument other than “buy the book”.

          7. john c. halasz


            The gist is that the Magnetar type deals resulted in “macro” terms in narrowing spreads on RMBSs and CDOs via the connections between the structured bond and CDS markets and by providing “equity” stakes for the creation of CDOs that otherwise would not have been created, at precisely the time when spreads on RMBSs would have blown out and shut down the subprime lending market, thus they prolonged the bubble and profited by increasing the over-all aggregate damage inflicted by the housing/credit bubble. Of course, none of what they did was illegal in a deregulated financial environment.

          8. Richard Smith

            “Just to make it clearer, what I’m asking for is a refutation of what Janet Tavakoli wrote in the comments to the Huffingtonpost story.”

            What john c. halasz said. The size of the deals matters, and so does the collateral selection. And also we & Pro Publica contend, contra Tavakoli, that Magnetar had a lot of influence on the structure and underlyings of the CDOs they sponsored: they are pretty distinctive.

            And whether you believe us or not, none of this would exculpate the IBs, monolines, agencies etc etc etc.

          9. Thomasina Jefferson

            Well, I think the strawman is more the continued reliance on incompetence, malfeasance, etc as an explanation.
            The whole system is geared towards a small group defrauding everyone else. It was well compartementalised, with every compartement playing its role and being legally isolated from the other so as to allow plausible deniability of any knowledge.
            This is excactly a type of organisational form you would find in organised crime.

        2. rootless_e

          How can it be insider trading? They did not act as manager or sell shares. It’s not unexpected for investors to hedge or even over-hedge. If I buy ATT shares and then buy options that pay only if ATT drops in value am I engaged in insider trading?

          1. AK

            They were participating in creating the CDOs though they didn’t have the main vote. So, they had influence and have inside knowledge.

            In your example they were ATT’s supplier with inside knowledge.

          2. rootless_e

            Wasn’t it the responsibility of the Manager and the bank to ensure that the CDO was structured correctly and to divulge all pertinent information to purchasers? Obviously, some banks refused to accept Magnetar’s advice and backed away from the deals. Certainly the banks who seem to have been the biggest losers on this had all the same information about the asset choice as Magnetar did.

            To me it looks like the whole ProPublica story, particularly, is influence by banks trying to find someone else to blame for their failures of diligence and fiduciary duty.

          3. AK

            Do you know what is insider trading? It’s ban on trading for people who has so-called ‘inside knowledge.’ Please learn something before arguing.

          4. rootless_e

            No. That’s not what it means.

            “Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.”

          5. AK

            It’s the same thing — formally ‘material non-public information’ or informally as I said ‘inside knowledge.’ I studied this subject.

          6. AK

            Don’t know for sure. This is why I said below that technically they performed inside trading but was it done from a legal point of view I don’t know.

            Btw, if you hear some talk in the elevator it’s still considered as ‘material non-public information’ and you are not allowed to trade on it. Which trust is violated here?

            So, I believe that ‘trust’ is understood pretty broadly here.

  5. Siggy

    Did Magnetar perpetrate a fraud? Possibly, but it is very important to know precisely what was said about the composition of the CDO’s it assembled and sold. Also, in those sales of the CDOs what specific representations were made as to the composition of the CDO in the offering memoranda?

    I have never understood the purchase of CDOs in that they constituted a concentration of risk by their reliance on cash flows attributable to instruments that were so deeply subordinated as to have expected values of zero. That’s what is befuddling; however, if you use the CDO as an instrument of prima facia standing for insurance, now you have something very interesting. You have two contracts enforceable at law with each being positive in potential outcome. Moreover, the CDS was typically grossely underpriced.

    Thus: Buy the CDO and a CDS against it and you have a real winner. CDO performs, you get a little income. CDO fails you get a little profit based on the price paid for the CDO and the settlement of the CDS at face of the CDO. Can’t beat that with a stick.

    As to forked tongue, what other response is rational?

    Now the CDO/CDS gambit is a trade in recognition of an asset price bubble that cannot be directly shorted. You need a proxy instrument, hence the CDO and a companion instrument that activates when the CDO fails.

    Now comes the ugly part. CDO and CDS are contracts whose motivation is speculative with respect to pricing inaccuracies. The CDO/CDS gambit is just a little bit of price arbitrage applied to a massive asset price bubble.

    The rub that develops here is that regulatory agencies have permitted the execution of contract fraud. Contingent contracts were executed wherein one party, possibly both, was incapable of honoring the contract.

    1. fresno dan

      “Thus: Buy the CDO and a CDS against it and you have a real winner. CDO performs, you get a little income. CDO fails you get a little profit based on the price paid for the CDO and the settlement of the CDS at face of the CDO. Can’t beat that with a stick.”
      No matter how much of this I read I can never grasp this – it smacks of a perpetual motion machine.

    2. jake chase

      I think you have it exactly right. Now who is the idiot selling you protection on the CDS? Ultimately, it is probably some school district in Minneapolis which is attracted by an extra 50 basis points and thinks it is getting interest on a bond.

      1. Thomasina Jefferson

        CDSs, it seems to me, were written by someone who knew or should have known that the housing market would go down and did nevertheless write CDSs at a price based on the erroneous assumption that the housing market would go up.

        It was the job of the CDS writers to know what they were insuring, i.e. what the risk was.
        Did they not care, as long as their bonuses were paid, did they collude with the counterparty to misrepresent risks to their own employer?
        I don’t buy the everyone-was-incompetent response. Everthing fits together to neatly for that.

        1. Yves Smith Post author

          The protection seller (the long side of the trade) was the CDO. The protection buyer (short seller) was the party who agreed to make payments on the CDS.

          Remember the mechanics. The CDO is managed. The dealer (usually a Eurobank or investment bank) at a minimum, needs to find a collateral manager and an equity investor. Many will want to use a monoline (to lay off the AAA risk); some like Citi plan to put the AAA tranches into their own or third party SIVs; some like Merrill were kinda indifferent to the danger of being left with the AAA tranches.

          So the dealer organizes a bidding process for the CDS (exposures picked by the collateral manager and acceptable to the equity tranche investor). The payments on those CDS (think of them as insurance premiums) are the cash flow that is divided among the CDO investors.

          So it isn’t that you have a protection buyer and seler both agreeing on a price fo BBB subprime risk, which is what you’d have if the contracts had been arranged individually. You instead have CDS protection priced individually, but the payments are co-mingled and the payment risk has been structured, with the equity tranche investor on the hook first, then the BBB CDO tranche investor, and so forth.

          So CDOs consisting almost entirely of BBB subprime risk were rated 80% AAA. This was the means by which the distortion occurred. The parties involved, for the most part, believed what the models told them: that with a diversified pool of subprime (remember in the past real estate downturns in the US had been regional) and a 20%ish loss cushion, the AAA tranches were well protected.

          And remember who the main takers of the AAA risks were: the dealers (either directly or via affiliated SIVs) and insurers (monolines and AIG). Yes, there were some other investors too (independent SIVs, German Landesbanken, etc). but a significant percentage stayed with the dealers themselves, because retaining the AAA tranche looked very attractive to the traders, particularly if it ws hedged, from a bonus standpoint.

  6. AK

    Here is my view.

    1. Magnetar took advantage of system’s imperfection.

    2. It’s unethical.

    3. Whether it is legal on not is based on the basic functioning of a legal system. In a legal system based on ‘principles’ it is probably illegal (since transactions of creating CDO and taking a bet on it were on at the arm’s length). In a legal system based on ‘rules’ (as the US legal system) it is legal (since there is no law prohibiting that).

    4. Can we say that legal system based on ‘principles’ is better than legal system based on ‘rules’? I don’t know. One has to investigate this WRT financial market and its ‘innovations.’

    1. sgt_doom


      Or, if I know I can steal something without getting caught, am I still ethically wrong!

      Frigging A!!!!!!

      (That’s YES to the unsophisticated types out there.)

    2. BenF

      On #3, I think the issue is not only that they were betting on failure(or as they would probably claim “hedging”) it’s that they were stuffing their CDOs with very risky things, therefore increasing the likelihood of failure so that they could profit. And because of the managed nature of the CDO, any fiduciary duty basically relied with the manager, not with Magentar. IMHO, it’s a very similar issue to that which was brought up by the FCIC w/r/t Goldman and subprime. It is kind of crazy that they were allowed control over the CDO contents but held no responsibility if clients eventually suffered.

  7. Hugh

    Magnetar’s strategy was an obvious example of an application of Frazzlehorn’s theorem to a standard Rubian model controlling for confabulatory fluctuations, i.e. changes in sign of the the second derivative of the underlying Ball curve. This is all clearly explained in Urmonirus’ monograph on the subject.

  8. AK

    Want to add smth.

    Technically speaking actions of Magnestar constituted ‘insider trading.’ Was it so from the legal point of view it’s difficult for me to judge. If they did, then it’s illegal and people should go to jail.

  9. VenusVictrix

    Yves, I’ve looked at your discussion of Magnetar in ECONned, and I am wondering who Magnetar went to for CDS protection on the synthetic securities in their CDOs.

    In your book you explain the following:

    - “Historically, the CDS protection writers on CDOs were AIG and the monoclines, who provided guarantees only on AAA tranches”

    - “When a CDO consists largely or entirely of synthetic assets, the investors in the CDO are effectively protection sellers, or guarantors”

    So doesn’t this mean that Magnetar should have been the CDS guarantor, by virtue of their acquisition of the synthetic securities (as stated in the email)?

    And if that’s the case, then the only way they could have made money off these deals was to offload the CDS guaranty to some other entity – as Goldman Sachs seems to claim they did with all their Cayman Islands deals. (Correct me if I’m wrong on that count – but I’ve read the circulars retrieved from, and each one clearly states that GS was the initial synthetic security counterparty.)

    Who took on those CDSs for Magnetar?

    Thanks for any info. you can offer.

    Sorry you’re temporarily grounded, but there’s worse places to be stuck than in London!)

  10. LAS

    Chapter 9 in Econned is indeed very hair-raising as GM states. The economy could not hold together because mortgage debt more than doubled in less than 10 years while GDP per person did no such thing. While it is fascinating how Magnetar and others use that information (and compound the losses), the horror is that we have no regulator with the wit and will to stop the predation then or now. What are they getting? Wall Street pay outs?

    1. sgt_doom

      When a select group of thieves have ripped off countries to the tune of trillions of dollars, that’s a lot of vig….

  11. CTM

    Hi all, I’ve followed this blog for a long time and feel it is one of the most thoughtful and revealing financial blogs on the web. With that being said I have a quick question for Yves or someone else with extensive knowledge on the subject.

    I feel that I have a fairly strong understanding of the subject (CDS, CDO, Magnetar trade etc.) but would like to understand what sort of ‘investment’ would be made in order to acquire the top tranches of a synthetic CDO. If my understanding is correct, these tranches consisted mostly of the sell-side of CDS on various subprime MBS. In other words, investors would receive the insurance premiums from CDS buyers but would be on the hook should those securities reach a default event.

    Given that the liability associated with this transaction is contingent what sort of cash investment was necessary in order to acquire these top-rated tranches? My understanding is that these were not normal bonds so they weren’t necessarily buying a note with principal and associated interest but rather a stream of insurance premiums. Thus, it would seem that minimal cash would be needed provided the investor had sufficient liquidity to cover the default event–opening the door for even greater leverage. Secondly, to what extent did investors in the top-rated tranches (I know its been stated here that banks retained a large share of them) actually understand that they were actually providing insurance protection on these MBS and not merely purchasing a plain vanilla bond?

    If this is incoherent I apologize. Thanks in advance.

  12. bandarlogician

    If the SEC is suing Goldman for not disclosing precisely the controversial aspects of ABACUS 2007 discussed on NC (Paulson was the equity, picked the portfolio, was short the seniors and paid Goldman to put the whole thing together), should we not expect similar actions against the banks who arranged Magnetar’s deals (i.e., 35-60% of the 2006-post subprime CDO market)? Or is a symbolic pound of flesh for ABACUS all they’re after?

    From the SEC website:

    Washington, D.C., April 16, 2010 — The Securities and Exchange Commission today charged Goldman, Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.


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