Magnetar Hedge Fund: Did It Hasten the Housing Fall?

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magnetar hedge fund; CDOs; CDSsIs it possible that the biggest institutions on Wall Street shorted the U.S. housing market, causing it and the global economy to melt down in orders of magnitude larger than what could have been? It appears to be so....

A magnetar, by definition, sucks everything in and spits even more out. The Chicago-based hedge fund Magnetar Capital did the same thing with the financial instruments that powered the housing/refi boom -- Collateralized Debt Obligations (CDO) and Credit Default Swaps (CDS) -- to a rather sinister degree, creating an investment strategy called the Magnetar Trade.

Late in 2005, it appeared the appetite for subprime mortgages had ceased, as defaults rolled in and the crap subsequently trickled downstream into investor portfolios. In the same year a hedge fund by the name of Magnetar opened its doors with a huge appetite for these mortgages (and the securities they were traded within) that most institutions already considered extremely toxic. And Magnetar was willing to take the worst positions in the security, agreeing to be paid last in the profit stream.

Why?

The participants were subsequently betting on the fact that these mortgages would default so they could pocket huge insurance policy payouts. A CDO would go into default if the mortgages with the security are not performing -- i.e., people didn't, couldn't, or wouldn't pay their mortgages.

How was this done? First, by creating CDOs that bought (toxic) mortgages the participants effectively created the credit that enabled banks to lend and consumers to borrow. The Magnetar participants offered high yields to investors which further incentivized banks, bankers and brokers to sell these adjustable-rate, low-FICO, no-income, no-job, no-asset (NINJA) loans to willing, and sometimes unwitting, consumers. They paid everyone down the chain very well in the form of commissions and Yield Spread Premiums to push their product.

Second, participants in a Magnetar Trade bought CDSes, which are essentially insurance policies in case their investment in a certain CDO defaults. These insurance policies paid out far in excess of what the monetary loss was if the CDO defaulted.

Recap: The Magnetar Trade effectively created mercurial liquidity that fueled demand for toxic mortgages with ridiculous underwriting guidelines, then bet heavily on the fact they would fail and profited immensely when they did.

Oh yeah, this was completely legal. Ethical? No, but since when did ethics invade Wall Street. Greed makes money on The Street, not ethics.

There was a black hole at the very end of the supernova formerly known as the U.S. housing market--Magnetar. The firm quite brilliantly enabled and incentivized some of the largest and most respected Wall Street institutions to short the U.S. housing market, a strategy that culminated with an epic economic implosion felt the world over.

Many will (rightfully) say that an investment strategy which was based on the demise (or shorting) of the housing market shouldn't have been legal in the first place. But this is Wall Street -- good, bad or otherwise.

Many will (rightfully) say that any investment firm that participated in this type of transaction knew exactly what it was doing and should be penalized, slapped, put in "time out" ... or something.

The SEC quite suddenly grew some teeth and is alleging fraud on the part of Goldman Sachs for participating in such transactions. Goldman was hardly the only player in this sophisticated game of hedge-fund-o-nomics, just as Tiger Woods isn't the only pro athlete to have made transgressions. Will the allegations stick? Probably not, but it makes for good ratings.
For an in-depth read regarding the Magnetar Trade, the series on Pro Publica is a must....

Jeff Corbett is a former mortgage and real estate broker, executive entrepreneur and Partner at 7DS Associates.
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