Revisiting the Magnetar Trade

In the wake of the SEC charges against Goldman Sachs (GS), 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 (DB) 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 yesterday:

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.