SEC Investigates Magnetar - CDO Program Sponsor That Pumped Up Subprime Bubble, Xe's Prince Moves to UAE, Gold Galore In Saudi Arabia & Rahm Quits?

(EXTRA: If anyone could make a contribution to my PayPal account (or otherwise - contact me for further info), it would be sincerely appreciated as I've just gone off the cliff financially. I really appreciate everything that my kind readers have done for me in the past financially and otherwise. Now . . . back to your regular viewing.) Wish I could be clearer about this than Yves Smith (my idol) in Naked Capitalism is, but that would be impossible (and you thought everything was fair in love, war and rip-off capitalism?).

I've written about the financial schemes that have currently devastated our economy many times before, and outed Magnetar from several other sources, but this is just about the best explanation of its specifics you will read. (Bet you thought our largely toothless regulators today would never get around to this.)

Take a few minutes. You won't regret it. (Emphasis marks added - Ed.)

(Also see Naomi Klein's Gulf Oil Spill:A Hole in the World where she reports that "This Gulf coast crisis is about many things - corruption, deregulation, the addiction to fossil fuels. But underneath it all, it's about this: our culture's excruciatingly dangerous claim to have such complete understanding and command over nature that we can radically manipulate and re-engineer it with minimal risk to the natural systems that sustain us.")

Oh, and did you see the latest on our buddies, the Saudis? Never forget their empowerment by the CIA and the Bushes (and Reagan in his own time too). Everything we've gotten since on the financial and terrorism fronts flows from this foreign policy decision that enriched the upper class at the expense of the lower class, and began the trend back to the pre-Great Depression Crash times of 1929 (now there's some golden "trickle down!").

Saudi Gold Reserves Over Twice Previous Estimate

You might think they wouldn't need any further energy riches. NOT!

And, of course, our bestest bloodied warmonger, Eric Prince of Blackwater and Xe fame, is moving to the United Arab Emirates. ASAP with the law right behind him? Doubtful as he still pays the highest as the best employer out there. (And CBS, without turning a hair, reports that Blackwater Firm Gets $120M U.S. Gov't Contract.) Business as usual you see (no matter what you heard about the official actions to expel from them from Iraq and stop them from running the terror overseas).

And have our prayers been answered and Rahm Emanuel is departing (sometime in the distant future, of course, after he milks the last bit of influence dry)? Only for something more lucrative you can be sure. And the future lucrativity is not anything that will benefit the public, I'm betting, if you normally bet on future events based on those in the recent past (except the stock market, of course).

Saturday, June 19, 2010

SEC Investigates Magnetar, Sponsor of CDO Program That Pumped Up the Subprime Bubble

Readers of this blog may know that we broke story in our book ECONNED of the role that the hedge fund Magnetar played in increasing the severity of the subprime bubble through its program of hybrid CDOs (meaning composed of actual tranches of subprime bonds plus credit default swaps).

To recap: Magnetar embarked on an unheard-of program of CDO creation to enable it to take a no-lose bet. It sponsored CDOs by funding the equity tranche, the riskiest layer that received high interest payments, typically 18-20%. It used the cash flow from the equity to sponsor an even larger short position, using the instruments in the CDO. It balanced its exposures so it would show a thin profit as long as the CDO performed, and a much larger return when it failed. Sponsorship of the equity tranc(h)e most importantly gave Magnetar influence over the parameters of the deals (such as the ability to reject certain exposures). As an industry source said:

At their peak, Magnetar was *THE* driver of RMBS [residential mortgage backed security] CDO issuance. The size of their "Constellation” program was the most amazing thing I’ve seen in my entire career. . . .

Magnetar’s idea was that CDOs were destined for long term failure — that the leverage on leverage based on cr*p assets made the BBB tranches long-term zeros. And, they realized that while most other hedge funds were content shorting the BBB tranches from subprime RMBS, shorting BBB tranches from RMBS CDOs was a much more slam dunk of a trade. The commentary is right . . . without someone willing to fund the equity of a CDO, there was no way to get one done. So, Magnetar made the logical leap . . . they’d fund the equity necessary to create the structures and then short a multiple of the bonds their equity money had allowed to be created.

The gravy was that the equity was typically good for one or two VERY HEFTY cashflow distributions — i.e., these structures went terrifically bad, but it usually took a little while from a timing perspective for that to happen. So, their carry cost of the shorts was offset by the one or two equity payments. After that, their upfront costs were covered and they would own the 100 point options for free.

Magnetar made A TON of money . . . I’d expect every bit as much as Paulson [a hedge fund manager who earned $15 billion shorting subprime mortgages in 2007].

The discussion of the Magnetar program in ECONNED includes:

• How a seemingly small amount of BBB tranches from subprime bonds used in Magnetar’s CDOs, had a devastating impact on the subprime market. Consistently conservative analyses indicate that in the peak years of 2006 and early 2007, Magnetar’s program drove the demand for roughly 35% of subprime bonds. Industry sources have estimated that the number to be as high as 50% to 75%.

• Magnetar’s trade was imitated by other hedge funds and dealers, further increasing the systemic impact.

• The deals were mostly hybrids, typically with 20% cash bonds and 80% credit default swaps; why this structure was advantageous for Magnetar.

• The links between the demand for CDOs and the “negative basis trade” that was arguably a widespread form of bonus fraud. (When a AAA instrument was insured by an AAA guarantor, internal reports typically treated it as if all the expected income in future years was discounted to the present. As we know now, in the overwhelming majority of cases, bonuses were paid on income that was never earned. This mechanism was THE reason many banks would up holding so much AAA CDO inventory – it was more lucrative for the traders to retain and “hedge” it than sell it.)

• The masquerade of almost entirely BBB subprime risk as AAA suppressed CDS spreads on BBB subprime bonds, the most actively traded tranche of the original bonds. Via arbitrage, this also influenced subprime bond pricing, which in turn lowered the yield on the loans themselves. In this manner, the mezzanine CDO market directly influenced spreads in the subprime housing market.

The Wall Street Journal tonight reports that the SEC is investigating Magnetar:

Investigators carrying out the SEC’s broad examination into these securities, known as collateralized-debt obligations, are holding face-to-face meetings with Wall Street executives about deals involving hedge fund Magnetar Capital, according to people familiar with the matter….

Critics have said that the actions of players such as Magnetar helped fuel the boom in mortgage-linked securities after cracks had begun to show in the subprime housing market. That subsequently worsened the financial crisis when Wall Street banks incurred heavy losses from CDOs they bought or were unable to sell.

Magnetar offset its risk by betting against the default of these securities using instruments called credit default swaps. Magnetar ended up making big profits when these CDOs collapsed, while the investors in the supposedly safer parts of the security suffered big losses. . . .

Yves here. Note that the subsequent expose on Magnetar by ProPublica disclosed that many of Magnetar’s deals were “triggerless”, a particularly bad feature for the AAA investors. Normally, CDOs had “triggers” built in to change how the cash flows in a CDO were distributed if the deal started to suffer credit losses. They were analogous to the way the body responds to hypothermia, by restricting blood flow to the extremities to preserve the brain and vital organs. In CDOs, the triggers would restrict payments to the equity and lower-rated tranches. Eliminating them worked to the advantage of Magnetar, since it would keep getting good payouts even as the deal was starting to crater.

Back to the Journal:

People familiar with Magnetar’s deals say the firm actually played a role in how the securities were put together, encouraging these independent managers to pick mortgage assets with certain characteristics to put in them.

Magnetar told its investors in April that it “did not control asset selection in CDOs in which it participated” but said it “often communicated” with the bank and asset managers when the deals were being put together.

Yves here. Magnetar’s defense is technically accurate but spurious. Yes, an asset manager picked the assets that went into the deal, but those choices had to be satisfactory to Magnetar. Everyone knew that if the equity sponsor didn’t like the assets chosen, it would withdraw, and that would kill the deal. To the Journal again:

Magnetar rejected the characterization of its deals as bets on a collapse of the mortgage market. “It was not a ‘bet’ that any CDO, any group of CDOs, or the housing or mortgage markets as a whole would fail either in the short term or long term,” the firm said in its letter.

Yves here. Again legalistic. No, Magnetar was not betting on the housing market, it was betting on certain highly correlated BBB subprime exposures. And it can claim it wasn’t betting “against” the CDO, since it had a long as well as a short position in them. I hope the SEC is able to see through Magnetar’s dubious claims. It’s time that the role of the sponsors of toxic CDOs were brought to justice.

Please hit the button for Naked Capitalism and do yourself a favor for the long term. It will open your eyes (and may even change your investing ideas)! Suzan _______________