naked capitalism

As longstanding readers of this blog presumably know, we broke the story of Magnetar, a Chicago-based hedge fund. Magnetar was arguably the biggest player in driving toxic subprime demand through its program of creating hybrid CDOs (largely consisting of credit default swaps, but also including cash bonds by design).

Magnetar constructed a strategy that was a trader’s wet dream, enabling it to show a thin profit even as it amassed ever larger short bets (the cost of maintaining the position was a vexing problem for all the other shorts, from John Paulson on down) and profit impressively when the market finally imploded. Both market participant estimates and repeated, conservative analyses indicate that Magnetar’s CDO program drove the demand for between 35% and 60% of toxic subprime bond demand. And this trade was lauded and copied by proprietary trading desks in 2006.

As a source who worked in the structured credit area of a firm that did Magnetar trades explained in ECONNED:

At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their “Constellation” program was the most amazing thing I’ve seen in my entire career. . . .

Magnetar’s idea was that CDOs were destined for long term failure—that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.

The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions—i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.

Magnetar made A TON of money . . . I’d expect every bit as much as Paulson

The important part of this arrangement was that the equity funder put up 4-5% of the deal in a cash or hybrid CDO. Because this was the scarce part of the equation, and the riskiest exposure, this investor was the sponsor of the deal and gained control over its parameters. At a minimum, the equity investor had veto rights over the bond exposures chosen, and reports from various Magnetar deals indicate that in some cases it presented lists of bonds to go into the deal and/or set criteria (as in the bonds be particularly “spready” which also meant drecky). Since Magnetar was using its equity stake to make sure it would be able to establish a short position that was a multiple of its equity position, making it net short, its interest lay in using its influence to make sure the CDO had particularly bad exposures.

Even JP Morgan, which was less active in the CDO game than other major dealers, wound up working with Magnetar. The Financial Times discusses that the SEC is negotiating a settlement with JPM on a Magnetar CDO called Squared that lost 80% of its value. Note that Magnetar piously insists it did not select the bonds in this deal. Technically, that role fell to the CDO manager, but they were very responsive to the desires of equity sponsors, thus providing useful legal cover. But

From the Financial Times:

The SEC probe into JPMorgan is focused on whether the bank told investors that Magnetar, a hedge fund that bet against certain parts of the deal, helped select the portfolio.

JPMorgan ultimately lost $880m on the CDO, known as Squared, after the housing market collapsed.

Magnetar has not been accused of any wrongdoing.

Previously, a spokesman for Magnetar said the firm “did not select the assets for the Squared transaction or require that any specific assets be put into that transaction. Further, it did not originate the Squared transaction”. The firm also said it had been “transparent in its dealings with market participants”.

Note that CDOs were sold as exempt transactions without any SEC registration or involvement, which meant it provided even less protection to investors than mortgage-backed securities investors had. Before 1995 these offerings, which were private placements had to comply with Section 12 of the 1933 Securities Act:

Any person who…offers or sells a security …by means of a prospectus or oral communication, which includes an untrue statement of a material fact or omits to state a material fact necessary in order to make the statements, in the light of the circumstances under which they were made, not misleading (the purchaser not knowing of such untruth or omission), and who shall not sustain the burden of proof that he did not know, and in the exercise of reasonable care could not have known, of such untruth or omission,…shall be liable … to the person purchasing such security from him, who may sue either at law or in equity in any court of competent jurisdiction, to recover the consideration paid for such security with interest thereon, less the amount of any income received thereon, upon the tender of such security, or for damages if he no longer owns the security.

This section would appear to impose liability for false and misleading statements and omissions in private placements just as in the case for public offerings. That was the view of securities lawyers up to the landmark 1995 Supreme Court decision, Gustaffson v. Alloyd. In Gustaffson, however, the Court ruled that offering documents in private placements were not prospectuses as defined under the 1933 Act which mean there was no liability attached under Section 12.

As a result, investors in a private placement could rely only on Rule 10b-5 to protect them from false and misleading statements or omissions. But the problem is that Rule 10b-5 is that investors not only have to prove that the disclosure was deficient, but also that the seller had the intent to defraud.

Proving intent is a much higher bar for prospective plaintiffs. The Gustaffson made it much more difficult for fleeced CDO investors to prevail.

And now you see why Magnetar continues to insist it was clean. Intent is hard to prove, and the hedge fund appears to have been particularly careful about its communications. But our contacts on dealer desks understood full well that the objective was to create deals that would crater.