The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going
propublica.org
propublica.org
Sounds like they were acting as market makers to me. Taking up risky long positions and hedging with short positions to protect the downside. Sounds like whoever took the risk of the short position misjudged the cost of that risk.
The argument behind hedging is that it's like taking out insurance: it allows you to take a position that you'd like to be in (invest in a home, for instance) but that you would otherwise find too risky.
What they were doing, essentially, was buying a house and insisting that it be built on an unstable foundation, in a tornado zone, with substandard wiring and a garage piled with oily rags, in the hope that it'll get destroyed and they can collect the insurance.
Magnetar basically said "Okay, the risk is probably not as high as the equity guys think. And not as low as the debt guys think. Why don't we buy from the equity-holding pessimists, sell to the debt-holding optimists, and pocket the difference?" And they bought, sold, and pocketed.
If you're going to be outraged, pick one:
Did they profit from the misery of others by selling short? Then they had to be net sellers, which decreased prices and made the bubble smaller. Or did they needlessly fuel a speculative bubble? In that case, they had to be net buyers, which would make them net losers.
Since Magnetar was long volatility (returns will either be way better or way worse than investors expect), this complicates things. But they basically made money from being right, while their counterparties lost money for being wrong. As long as everyone goes into these transactions with the same information, that's the only way fools and their money are parted.
They can't prove that Magnetar was net short, because that information isn't pubically available. But their evidence was that Magentar was pressuring the banks who were creating the CDOs into building them out of unusually risky assets. They have emails from a deal that fell apart because the bank refused to bundle in the assets that Magnetar wanted.
> Did they profit from the misery of others by selling short? Then they had to be net sellers, which decreased prices and made the bubble smaller. Or did they needlessly fuel a speculative bubble? In that case, they had to be net buyers, which would make them net losers.
The thing is, Magnetar was only buying the equity position of the CDO. They were then buying insurance against the higher tranches failing.
They were sponsoring billion-dollar CDOs with a few million dollar investments in the lowest tranche. They were then buying insurance against the failure of the much larger upper tranches. Without them buying the equity, the CDO wouldn't have been created.
The argument is that without Magenatar, the CDOs wouldn't have come into existence (because they wouldn't have had a sponsor willing to buy the equity tranche). Magnetar wanted the CDO to fail as evidenced by its pressure of the banks to include rotten assets. So my analogy stands, they insisted on the construction of a dangerous house so they could collect the insurance.
Not as described by the parent. His problem was that they were creating the financial instruments and the hedges. This is exceedingly common.
I'll leave the moral outrage portion of your post alone with hopes that you already know how you vastly oversimplified simply by ignoring counterparties.