More than four years after Serena Ng and Carrick Mollencamp of the Wall Street Journal first took notice of the highly destructive ways of the Chicago hedge fund Magnetar, which created a series of toxic CDOs, the SEC finally appears to be taking a serious look at some of their deals. More accurately, it seems to be dusting off and perhaps expanding a probe that it started last June (hhm, wonder if this flurry of activity has anything to do with polls showing how independents in swing states are giving Obama thumbs down for his complacency on Big Finance?) The SEC is also reportedly looking at the deceptive role played by collateral managers, something we discussed in ECONNED and that Tom Adams has written about extensively on this blog.
The short version of the story is that Magnetar constructed the perfect trade. It would fund the equity tranche of CDOs, usually 4-5% of their total value. Deal sponsors like Magnetar got significant influence over the deal, at a minimum veto rights over the assets chosen to go into the CDO. Magnetar took a much bigger short bet on these same CDOs (either by buying the CDS that were the majority of the assets in these deals) or by buying CDS on the CDO itself. The equity paid a very high interest rate (15% to 20%) until the deal started to fail. The interest on the equity funded the CDS premiums on the short bet. But these deals paid big money only if they failed, which they did with impressive speed. (For more background, see this post).
Key points from the Wall Street Journal article:
U.S. securities regulators are investigating hedge-fund firm Magnetar Capital LLC, which bet on several mortgage-bond deals that wound up imploding during the financial crisis, according to people familiar with the matter….
If the SEC were to file civil charges, it would be its first enforcement action against hedge funds related to CDOs. No decision has been made on whether to file charges, the people said…
Investigators are looking at whether Magnetar had such a strong influence in designing any of the deals that in effect it took over the role of collateral manager, a person familiar with the probe said.
The article then discusses at some length a lawsuit filed by Rabobank against Merrill Lynch on a Magnetar-sponsored CDO called Norma. That suit was settled but the SEC is apparently looking into that deal.
It is also possible that a suit by Intesa over another Magnetar deal, Pyxis, got the SEC’s attention. Here is the guts of the argument, per Bloomberg:
Intesa claims Calyon told investors that the CDO — known as Pyxis ABS CDO 2006-1 — was based on residential mortgage- backed securities that had been chosen by an independent investment firm, Putnam Advisory Co., when the underlying securities were really selected by Magnetar.
Putnam was also named as a defendant in the case.
“The scheme was designed by Magnetar,” Intesa alleged. “Calyon collected fees on the deal and, through the Pyxis swap, shifted losses on the CDO which it would have otherwise borne itself.”
The Intesa filing is a road map for SEC action. It is detailed and solid on the tradecraft:
It would be nice to see the SEC get serious on this front. But it’s been poking around Magnetar for a while (it looked into its behavior on a JP Morgan CDO, Squared, and decided not to pursue Magnetar) and has not gone forward. Some of this hesitancy is no doubt due to the fact that disclosure requirements are lower in CDO-land than for SEC-registered offerings. But a lot also appears to be due to a reluctance to try financial complex cases. And until it is willing to do so, the perps will retain the upper hand.