Who's afraid of the big black hole?

While we are all being told that the role as the main villain in the financial crisis, is played by Goldman Sachs, along comes the story about Magnetar! The hedge fund Magnetar, created by 41 year old Alec Litowitz, formerly trader for Citadel, practically industrialised CDO trading. Magnetar was behind 2 out of every 3 dollars of CDOs toxic mortgage backed investments sent on suicide missions, this way Magnetar could win more than their value using Credit Default Swaps.

Bond credit rating defined:  "In investment, the bond credit rating assesses the credit worthiness of a corporation's debt issues. It is analogous to credit ratings for individuals and countries. The credit rating is a financial indicator to potential investors of debt securities such as bonds. These are assigned by credit rating agencies such as Moody's, Standard & Poor's, and Fitch Ratings to have letter designations (such as AAA, B, CC) which represent the quality of a bond. Bond ratings below BBB/Baa are called junk bonds"

In short... AAA = Easy and low yield. BBB = Complex and high yield. Click to see the tables.

CDO defined: Collateralized Debt obligations - A packages of asset-backed securities and derivatives bundled together and sold off in slices (tranches) to investors worldwide, also called “mezz” or mezzanine. 

 CDS defined: Credit Default Swaps - A swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and,in exchange, receives a pay-off if a credit instrument goes into default, i.e. if the payment has stopped.

Derivatives defined: A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.

Alec Litowitz, 41, and brain behind Magnetar

In the beginning

 The heart of Magnetars transactions was creating sub-prime CDO´s by investing in the riskiest layer, the so-called equity tranche. This kind of CDO consisted almost entirely of not just any sub-prime risk, but that of the dodgiest layer that could be sold short, the BBB tranches, via a combination of actual bonds and CDS.

Before the burst.

More inflation to the bubble means more deflation when it bursts, and that's exactly what Magnetar did, it inflated the bubble to astronomically heights. How Magnetar pulled this off is one of the untold stories of the meltdown. Only a small group of Wall Street insiders was privy to what became known as the Magnetar Trade. Thousands of pages of documents and details about the securities that until now have not been publicly disclosed shed light on an arcane, secretive corner of Wall Street. According to bankers and others involved, the Magnetar Trade worked like this: Magnetar bought the riskiest portion of CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what the Godzilla of hedge funds are after. Magnetar wanted out-sized gains, the sooner the better and it placed bets that portions of its own deals would fail.

Magnetar set itself up for a huge win/win situation.

Magnetar purchased insurance against higher-rated CDO tranches (that they did not own); they purchased the lowest rated tranches paying 20%+ interest. Magnetar knew that the implied volatility in the insurance that they purchased was extremely understated. The theory was that if the party continued, they would collect high interest payments and if things faltered, they would collect high insurance payments on policies with low premiums. While Magnetar paid roughly 5% of the total deal value for its equity stake, it took a much bigger short position by acting as a protection buyer on some of the CDSs created by these same CDOs. This insurance in turn was artificially cheap because over 80% of the deal was rated AAA. Magnetar recognized that this concentrated exposure to the very riskiest type of bond associated with risky mortgage borrowers, was a binary bet. It would either work out, in which case Magnetar would still show a thin profit, or it would fail completely, giving Magnetar an enormous profit and wiping out even the AAA investors who mistakenly believed they were protected by having other investors sit below them and take losses first. Thus the AAA investors were only earning AAA returns for BBB risk.

Gaining influence

As the equity investor, Magnetar could further stack the deck in its favour through the influence it gained over the deals’ parameters. It was able to ensure that the CDOs held particularly dubious BBB exposures, and pushed for, and often got, “trigger-less” structures, which stripped away another protection most deals had. When CDOs start to show significant losses, the payments to the lower-tier investors, including the equity tranche, are cut or halted to defend the AAA layer. Trigger-less deals, even as they started to fail, kept paying the lower tranche holders, including, in this case, Magnetar itself. These transactions sound similar to the widely decried Goldman synthetic CDO program, Abacus, by which the firm went short various real estate exposures, effectively dumping the risk on the customers, but the Magnetar program was not only much larger, it also produced far more devastating consequences to the system, thanks to the structure of its CDOs.

What happened to logic?

Before the world was turned upside down, it made perfect sense that if two investments offer the same return, with one investment being riskier than the other, then all rational investors should choose the safer investment. Furthermore if two fixed-income investments have the same risk profile and were issued at or around the same time, the investments should offer close to identical returns, and if two fixed income investments issued at or around the same time have the same credit rating, but one has a higher yield than the other, rational investors will buy the investment with the higher yield. It violates fundamental principles of economics for two AAA investments to produce different returns for an extended period. And yet, during the housing bubble era, AAA rated mortgage-backed securities and AAA-rated CDOs consistently promised and produced higher returns than AAA rated U.S. Treasuries.

How was this possible?

Unless these AAA credit ratings for mortgage-backed securities were rigged. The issuers of CDOs filled with mortgage-backed securities, aka the mighty investment banks, understood that the AAA rating to mortgage bonds meant something different that the AAA rating given to, lets say, impregnable U.S. Treasuries. The point was that most investors wouldn't think twice once they saw the AAA rating. Investors simply looked at a AAA rated mortgage security and assumed a mortgage bond was in fact as safe as a bond issued by the United States Treasury.

Jesse Eisinger and Jake Bernsteins lengthy expose of Magnetar trade at ProPublica.org

Eisinger and Bernstein allege Magnetar pressed CDO issuers to include riskier assets in their CDOs that would make the investments more vulnerable to failure. They report that dozens of Wall Street professionals saw the Magnetar program as an effort to profit by betting against the sub-prime securities market. They support their claims by citing an independent study that concluded 96 percent of the Magnetar deals were in default by the end of 2008, compared with 68 percent for comparable CDOs. There is, of course, an alternative interpretation of the above facts. This may not have been fraud but simply incompetence.

Denial by Magnetar
Magnetar has responded to the Eisinger and Bernstein report with a letter that states:

1. Denial that the firm entered into transactions where default was calculated to be a significant risk.
2. Denial that they were net short on any of their transactions and securities involved.
3. Short positions were used for selective shorting in situations designed to be market neutral.
4. When there were net imbalances, the firm was net long securities with which they had exposure.
5. It is a false allegation that Magnetar designed any CDOs to fail.

Hidden in plain view
The apparent arrogance involved in this situation is evident in the name, Magnetar. This is the noun describing a dying star with intense magnetic field emanations after a supernova collapses. One of the parallel outcomes of such a collapse is a black hole, a point of extremely high mass with gravity sufficient to suck in matter from the surrounding space. The lifetime of a Magnetar is extremely short in terms of galactic time, and after that brief lifetime the residue is at best worthless. At the worst, the residue is a black hole, sucking all related activity (read "financial system") into destruction. The name Magnetar implies that the promulgators understood the opportunistic and destructive nature of their venture and had the arrogance to announce that understanding to the world. It seems the world had no understanding of astrophysics so the arrogant "warning" went unrecognized.

Written in the stars

The investments came with names like Orion, Aquarius, Scorpius, Carina and Sagittarius. One CDO, called Cetus ABS CDO 2006-3, is an example. The $1.2 billion CDO, which owned subprime-mortgage bonds and CDO securities as well as derivatives tied to them, was set up in November 2006 and underwritten by Calyon Securities. Magnetar made an investment in the Cetus CDO. Cetus was named after a mythical and monstrous sea creature with a constellation of stars attached to it. Within months of its creation, the CDO was hit with a slew of downgrades and suffered an "event of default," which means key investors can demand that the vehicle be unwound or liquidated. At least five other CDOs have declared events of default, according to data from Standard & Poor's. These include Carina CDO Ltd., named after a constellation in the southern sky, Orion 2006-2 Ltd., for a constellation named after a hunter, and Octans III CDO Ltd., named after another southern constellation. At least one investment, called Sagittarius, is the center of a legal dispute between some of its investors over how interest and principal payouts should be made.

It should be no surprise

The Sagittarius CDO is involved in a legal dispute, as Sagittarius rules the law and legal issues. The symbolism of Magnetar’s CDOs becoming toxic to investors became a reality. Pluto rules nuclear energy and anything that is toxic. Financially, Pluto rules debt. It represents extremes, from wealth and power to bankruptcy. Things reached a crescendo when Jupiter and Pluto conjoined in Sagittarius. This represented the loss of massive amounts of money through investing in risky asset-backed securities that have become toxic nuclear fallout spread worldwide.

Luck or Genius

Magnetar's trading strategy wasn't all luck, it would have benefited whether the sub-prime market held up or collapsed. That hasn't been the case for many of the investment banks that sold the CDOs, or held pieces of them. Many investment banks who took on what they believed were the safest slices of the Magnetar-linked CDOs suffered losses, in part because their hedging strategies were flawed. Morgan Stanley and UBS AG were among the banks that owned the top pieces of these CDOs, including Octans. Citigroup could report up $15 billion in mortgage-related losses. UBS has announced more than $10 billion in write-downs. Merrill has announced a $7.9 billion hit and has more coming. The amount that each bank may have retained from those CDOs isn't known. Magnetar or no Magnetar, things are bound to end up the same way, just not at the same rate. 

 A personal opinion  

It would be a good thing for rating agencies if they suffered some consequences for bad opinions. It is a problem when you have an institution who is allowed to write opinions that have enormous market impact, but no economic – they have an exemption for free speech, it can create some problems. Rating agencies acted effectively as underwriters, during the crisis since the deals could not get done without their primatur.

The President

Barrack Obama raised more money from financial services players than any previous presidential candidate, so it can hardly be a surprise that he and his minions are happy to give the industry a free pass. Key policy figures maintain that no one was to blame for the crisis, only a pervasive lack of regulation, and there are therefore no bad actors. This is the destructive behaviour of unregulated corporations, which will remain unquestioned, unexamined,uncorrected, and unpunished.

From Russia Today: The Keiser Report №35: Markets! Finance! Scandal!

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