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