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It’s A Bird, It’s a Plane, It’s Magnetar!

by Ouida on April 25, 2010


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I swear to goodness gracious, where do they get these names? In Goldman Sachs and the Three Bears I talked about the fraud charges against Goldman Sachs and I said at the end:  I doubt Goldman Sachs is the only investment bank who has done this.  Holy, Moly, I hadn’t even heard of Magnetar when I wrote this!  Basically, upstart Hedge Fund manager creates CDOs(collateralized debt obligations) then bets against them earning hundreds of millions for his share holders and costing the US taxpayer billions in bank bail outs.  Yes, the banks lost some money, but collected more in fees and individuals at the banks made tens of millions in bonuses.  Wow.  The crazy thing about Magnetar is that this hedge fund got started after the peak of the real estate market in 2005 when CDO officers at the banks began to sense an unwinding in real-estate markets and softening in home prices.  These CDO officers were beginning to see increasing mortgage defaults among subprime mortgages and they were thinking they weren’t going to be able to sell anymore CDOs.  Along comes Magnetar offering to buy CDOs.  They offered to buy the riskiest CDOs.  It goes something like this:

Joe buys a house and his mortgage, along with a hundred others, goes to create a Mortgage Backed Security, an income investment similar to a bond that pays interest to the investors who buy it as long as Joe and the others in the pool of mortgages who make up the Mortgage Backed Security make their payments as scheduled.

A very large pool of Mortgage Backed Securities is used to create a CDO.  Now the CDO is divided into slices or tranches, we’ll call them A, B, C, D.  Tranche A is considered the “safest” and tranche D is considered “toxic waste”.  Tranche A offers the least return for each dollar invested and tranche D offers the greatest return for dollar invested.  As you can imagine it is easy to sell the safer stuff to investors and hard to sell the unsafe stuff, the toxic waste to investors.

In 2005 as the mortgages began to default, CDO officers felt that the CDO market would come to a close because they would not be able to sell the toxic waste.  Here is the deal, if you create a CDO and you are forced to hold onto a portion of it because you cannot sell it to another investor, wouldn’t you rather be forced to hold onto tranche A?  That is what the creators of CDOs felt if they couldn’t sell the toxic waste there was no point in creating the CDO.

Folks if the CDO market had been allowed to collapse in 2005 as it was supposed to, we would have had a recession, but it wouldn’t have been as severe and millions of homeowners would now not be facing foreclosure.  They never would have been able to qualify for the mortgages they got in the first place.

Alas, it was not to be.  In steps Magnetar, offering to buy toxic waste.  Because the toxic waste was essentially pre-sold to Magnetar, the CDO industry got revived.  Now CDOs were assembled by a CDO manager and Magnetar would call individual managers and make suggestions about the securities that should be included in the CDO. Hmmmm.  Then they would go out in secret and take out insurance to reimburse themselves in the event the CDO failed.  Now no one would bug out if all Magnetar did was buy insurance to protect themselves in the event that the toxic waste failed, but that is not what happened.  They had a hand in the selection of “assets” or “securities” that ultimately went into the CDOs and, wouldn’t you know it, they had a tendency to select the riskiest assets to be included in the CDO.  Then they took out insurance, not to cover the toxic waste or the D tranche, they took out insurance to cover the B or C tranches.  These were much larger tranches than D and the insurance would pay out considerably more if an A,B or C tranche failed.  The insurance that they took out is called a Credit Default Swap (CDS) and the market for them is completely unregulated.  Who owns them is one big fat secret, a secret that is until an insured investment goes belly up and the firm who issues the CDS has to pay up.

So here is the deal laid bare.  Magnetar promises to buy CDO toxic waste for $10 million dollars.  The CDO is created.  The A, B and C tranches are sold to investors, but unbeknownst to them Magnetar has pressured the CDO manager to include “likely-to-fail” assets in the CDO.  Magnetar then takes out insurance on tranche B or C and makes a killing when the CDO fails.  Their success formula?  Rinse and repeat.  Magnetar sponsors the creation of 26 CDOs all but one, the first CDO they created, Orion, has failed.

Honestly these are suspenseful stories and they are fun to read and comment on.  If these were a bunch of guys in suits ripping each other off, I got no problem, but over the last two decades, average investors have been pulled into the markets, mutual funds, endowments, trusts and pension funds fell victim to the Magnetar trade.  Some have sued and have regained a meager portion of their losses but most have been stunned into silence.  The problem is that the 401K is at the center of the majority of American’s retirement plans and mainstream financial medial is pushing the average person to invest heavily in stocks.

We need financial regulation because it is not just guys in suits stealing from each other.  The American public is caught in the crossfire.

Resources:

This American Life Episode 405 explains the Magnetar Trade.

Propublica.org Investigative journalism that explains the Magnetar Trade.

Finally, I just picked this up. If is written by a member of the Virginia Fed.

Please comment.

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