The Magnetar Trade: Trojan Horse from a Hedge Fund

What happens when it’s insanely profitable to lose money?

Huh?

Last Friday, ProPublica described how one hedge fund—Magnetar—invested in the toxic waste from sub-prime mortgages no one wanted. And it made wads of money. The story is long but well worth your time. The Magnetar Trade illustrates how: the capital markets are a new-age war; deception is a tactic; and the old Trojan Horse play is still in vogue. Here’s how the trade works in three easy steps.

Bet Against the American Dream from Alexander Hotz on Vimeo.

1. Buy the garbage nobody wants.

Wonder how a CDO works? Check out this video from the “tools tab” for a detailed explanation. The primer is easy to follow, and it only takes six minutes.

According to ProPublica, Magnetar bought the “equity” in a pool of sub-prime mortgages. In a $100 pool, for example, senior investors might ante up $80 to Magnetar’s $20. Until the senior investors received all their payments, Magnetar didn’t receive a dime.

2. Wait for other investors to pile into the deal.

Magnetar appeared to be a buffer against losses.  By taking the $20 junior position in my example, the hedge fund attracted $80 of senior capital from investors who thought they were buying safer securities. (This example simplifies a more complex structure. Complexity, however, is immaterial to the big picture.)

3. Bet against the whole mess.

What happens if the $100 pool of sub-prime assets is entirely worthless? Nobody wins. The senior investors lose. So do the equity investors. Magnetar, in this example, loses its $20.

Nobody wins—except investors who hold credit default swaps. With credit default swaps, it’s possible to bet the entire $100 pool will go bad. So a hedge fund, in theory, could lose $20 in one investment while making $100 in another. The net gain is $80.

Look, I have no idea if ProPublica has the story right entirely right. (The Wall Street Journal told a similar story in January 2008.) Hedge funds are notorious for their secrecy, and there may be details that cast the Magnetar Trade in a different light. Magnetar asserts, according to ProPublica’s article, that it was “net long” on the CDOs it kick-started with equity.

Whatever.

Indicting Magnetar is not the issue. Although, you know there’s a problem when a hedge fund is named after a black hole. The issue is uneven regulation.

This Trojan Horse trade shows the need to regulate hedge funds with the same intensity Congress regulates big banks. One hedge fund with a billion dollars in capital can wreak havoc with 4:1 leverage (80/20). And the old rationale—hedge funds don’t require much oversight because they have a limited number of investors, all of whom are sophisticated—is a joke.

What do you think?

Norb Vonnegut

2 Comments

  • Joe says:

    That a black hole and a neutron star are quite different things, although both virtually impossible for an entity with non-zero mass to escape.

    About the general thesis? That non-regulated financial entities are invitations for the unscrupulous and unethical to cheat and steal. Why else do they seem to gravitate to these firms? (Not saying that everyone at financial institutions fall in these categories; but how many blew whistles when obviously ill-fated investments were being made?)

    At the same time, I have noticed a pronounced aversion to risk in everything, these days. Everyone wants it guaranteed that they will never be hurt and always be taken care of, even when investing in ridiculous matters (financial and otherwise). So people become less cautious and, paradoxically, more outraged when they are not protected from a risky investment, whether risky because of inherent reasonable risk, or risky because it’s a scam.

    But I am innocent of economic knowledge, and so these are mere ignorant opinions.

  • Yikes, Joe. Thanks for cluing me in on the difference between the black hole and the neutron star. That non-zero mass gets me every time.

    Unscrupulous and unethical—you’re right to qualify your comments. There are plenty of great people who work on Wall Street. But the capital markets are a form of war, and I think this is one example where the combatants went too far.

    Risk aversion—no such thing as a free ride. To make money you have to take risks. If Magnetar’s thesis about subprime were wrong, they could have lost a boatload of money.

    Thanks for visiting Acrimoney.

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