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SEC Investigating Magnetar, JP Morgan Dealings on Subprime CDO

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ProPublica reports that the SEC has taken interest in Magnetar’s role in a JP Morgan underwritten CDO.

We discussed Magntar at length in our book ECONNED, which broke that story six weeks before ProPublica launched its report, and remains the definitive account of how those transactions were structured. (Our continuing beef with the ProPublica account is that it missed what we discussed at length in ECONNED: the systemic impact of the Magnetar trade. It isn’t simply that Magnetar was a bad actor; its Constellation CDO program played a direct and substantial role in increasing the severity and damage of the toxic phase of the subprime bubble).

Per ProPublica’s update:

The Securities and Exchange Commission is investigating whether JPMorgan Chase allowed a hedge fund to improperly select assets for a $1.1 billion deal backed by subprime mortgages, according to people familiar with the probe.

Called “Squared” and completed in May 2007, the deal was a collateralized debt obligation, or CDO, made up of pieces of other CDOs. The hedge fund, Magnetar Capital, based in Evanston, Ill., purchased the riskiest slice of Squared as part of a strategy to bet against the mortgage market.

The issue is similar to the one that came up in the SEC suit against Goldman in April over a 2007 Abacus trade (this was one deal in a much larger Goldman program called Abacus): did subprime short John Paulson, who did take a short position in that trade, act as a Trojan horse long for a small percentage of the deal (the equity tranche) so as to gain influence over what bonds went into the deal? With the Paulson involvement, it was harder to argue impropriety, since he had made the fact that he was shorting subprime public, and the CDO manager, ACA, (who was nominally responsible for picking the exposures and clearly was negotiating with Paulson what was in and out of the deal) was part of one of the major investors in the long side of the deal (in other words, if one hand didn’t know what the other at ACA was doing, you could hardly blame the failure to communicate on Paulson and Goldman).

The trick was that firms like Magnetar and Paulson were sponsors of synthetic or heavily synthetic CDOs (note in the Abacus trade, weirdly, Paulson merely acted as if he was legitimately at the table negotiating the exposures;, remarkably, he didn’t act as the deal sponsor). The equity tranche was normally the most difficult to place, and in return for taking that risk, the sponsor typically got the right to influence the deal, in theory to reduce the risk for all investors. The minimum right was being able to nix particular exposures, but as the Paulson/Abacus example indicates, some investors went further and actually presented lists of desired assets (previous reports on Magnetar in the Wall Street Journal also indicate that Magnetar selected particular bonds). But the equity position was a sham; both Paulson and Magnetar took short positions well in excess of their equity tranche position, making them net short..

As we noted in ECONNED:

Anyone involved in these transactions probably understood the implicit logic, even if no one acknowledged it. But there is a remarkable absence of anyone who could be pinned with liability. Magnetar officially had no legal relationship to these deals. The investment bank packager/structurer was off the hook as long as he made reasonable disclosure (and remember, the standards are much lower here than for instruments that fall in the SEC’s purview). The rating agencies get off scot-free, thanks to their First Amendment exemption (discussed in chapter 6). The lawyers involved in the deal are responsible only to their clients, meaning the structurer/packager, and cannot be sued by unhappy investors. The only party on whom liability could be pinned is the CDO manager, who does have a fiduciary responsibility to all investors, not just the sponsor. But the fact that the party who in theory had the most to lose, Magnetar, approved their investments, would seem to exculpate the CDO manager.

The ruse of diffusing responsibility, and of having the party most clearly liable, the CDO manager, be an economically weak party (CDO managers typically were very small shops, sometimes with as few as a couple of professional staff), means these cases are hard to prove, even if the nature of the chicanery seems obvious now.

The JP Morgan transaction was called “Squared” because it was a CDO squared, meaning a CDO made from (typically) the riskier tranches of unsold CDOs, with a bit of other types of credit exposures thrown into the mix to make it look slightly less unsavory. The rather peculiar thing about Squared is it consisted heavily of exposures from other Magnetar CDOs, which strongly suggests Magnetar had a hand in this deal (as in dealers were choking on the unsold exposures, and Magnetar needed them placed to launch new first gen CDOs).

But Mr. Market does seem to be taking this announcement seriously; the averages started moving down when this story broke today, and Bloomberg attributes the decline to this suit. Although JP Morgan was much less heavily involved in synthetic and heavily synthetic CDOs than Goldman, if the SEC makes a case that sticks against a Magnetar trade, every major firm in the subprime business will be at risk. This could get interesting, in a good way for a change.

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9 comments

  1. john

    Bubble verse

    Back in the first round foreclosures,

    T’was the bankers that made themselves hosers:

    With Patsys for debtors their MBS bettors

    Were buggered by shorts from their brokers.

    Well-hung bankers in trading floor branches,

    Of banks built of dud bb tranches,

    Were shocked to discover their positions uncovered

    When Hypo Dutch shunned their advances.

    With mountains of dreck on their books,

    The best and the brightest and crooks,

    And Freddy and Fanny all ran to their nanny:

    It’s free money whenever she cooks!

    Now bankers, they really can’t stand her,

    That nanny, she could make them pander,

    But loves them so much that whenever they touch

    If they don’t pick her pocket they rob her.

    The lady, she makes them so jealous,

    Only bankers are worthy, they tell us,

    To indulge in her pleasures, all national treasures

    Would corrupt lesser mortals among us.

    Her own children she tends to neglect.

    She lets them all get by on debt.

    But for bankers suffices to look past their vices

    And backstop their every bet.

    When the economy finally tanked,

    From her children employment was yanked,

    But instead of their succor she embarked like a fucker

    On a high horse of moral complaint!

    It wasn’t bank’s loose lending standards,

    But the low lives, those big spending bastards,

    That created this mess and she had to confess

    They deserved all their little disasters.

    Having given all that they had asked,

    She was shocked when her bankers then tasked

    P R flaks with attacking all her efforts at backing

    Rationales for the big bucks they’d sacked.

    Now it’s nanny who’s going to get hosed

    By those big spending bankers who posed

    As the hope for the future she really felt suits her,

    But now they’ve run off with here clothes!

    Money speaks now with the voice of the state

    It tells the people to fish or cut bait

    Give your money to bankers who’s businesses are cankers

    Corruption, it insists, is our fate!

    For the moment the people are left

    To select between robbery and theft

    As preferred means to fund corporate citizens fun

    While forsaking their own lives bereft.

    It’s nice to see the SEC develop a pulse!

  2. readerOfTeaLeaves

    if the SEC makes a case that sticks against a Magnetar trade, every major firm in the subprime business will be at risk. This could get interesting, in a good way for a change.

    I’m hoping for a whole constellations of ‘interesting’; a veritable galaxy of ‘interesting’ would be even better.

    Yves, thanks for helping some of us wake up to the layers of complexity that hid layers and layers of fraud.
    Forget tv dramas; the story of our era is right here, and it’s called The Economic Meltdown, with Magnetar approximating its galactic center.

    1. Paul Repstock

      My guess would be probably not. If the Securities Commision cannot construct a white wash, they will in the eleventh hour decide that they don’t have jurisdiction.??

      1. readerOfTeaLeaves

        I’ve learned never to underestimate political ambition.

        Where’s the political payoff in turning a blind eye to this nonsense at this pont? There’s far more payoff in cleaning up the mess.

        1. alex

          “Where’s the political payoff in turning a blind eye to this nonsense at this pont? There’s far more payoff in cleaning up the mess.”

          You’d think so, wouldn’t you? And yet where are the ambitious politicians taking this route? Why they aren’t I’ll leave as as exercise for readers who are more awake than me.

  3. Conscience of a Conservative

    As has been discussed earlier, there was information the underwriters had from firms such as Clayton holdings which the purchasers of Magnatar did not have access to.

    If JP Morgan did what Goldman was accused of and helped one firm more than the other then they should be held accountable.

    Not everything is on the loan tapes.

  4. Doug Terpstra

    Could it be that someone at the SEC has finally read ECONNED? Must’ve been that mention of Yves in the Payboy article.

    I suppose they’ll arrange another nice little settlement like the GS deal.

  5. Random Blowhard

    There’s a sucker born every minute. You can shear a sheep many times, you can only skin it once. Hopefully the skinning of investors by the systemic fraud of Wall Street will result in them taking thier money else where. Until that happens, there will be no change.

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