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How One Hedge Fund Made Losses and Profited Off of Them

Next week, Congress is back in session, and financial regulation will occupy much of the legislative calendar in and mental capacity of Washington for the next month or two. The proposed legislation imposes stronger capital requirements and creates a Consumer Financial Protection Agency, among other provisions. But it cannot stop the innovation of newer, more interconnected and frankly weirder financial products — and a brilliant new investigative report by Jesse Eisinger and Jake Bernstein at ProPublica shows just how new, interconnected and weird some of those products were.

The report shows how one hedge fund, Magnetar, originated mortgage-based investment instruments, backed them with the riskiest possible assets and then made massive bets against its own products. Every part of it was perfectly legal, and very little of it came under regulatory oversight.

According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations — CDOs. If housing prices kept rising, this would provide a solid return for many years. But that’s not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.

The whole thing is worth a read.

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