The blame game continues

A small US hedge fund stands accused of prolonging the subprime crisis in order to trade against mortgage securities it helped issue. But did the fund really do anything wrong?

Two years after the subprime mortgage lending bubble started to pop with the collapse of Bear Stearns, politicians still want to know who to blame. They are making slow progress.

Last week, the Financial Crisis Inquiry Commission was told by Chuck Prince, former chief executive of Citigroup, that "everyone” from banks to rating agencies and regulators thought that triple-A tranches of collateralised debt obligations were safe investments, and that all were flabbergasted when the values collapsed.

This week, a Senate committee grilled Kerry Killinger, the former chief executive of Washington Mutual, one of the biggest mortgage lenders before regulators seized and sold it to JPMorgan Chase in September 2008. He insisted that WaMu’s foray into subprime, spurred by Wall Street and by government-backed entities such as Fannie Mae, was an anomaly.

Faced by this, perhaps politicians will shift their attention to another possible culprit, an Illinois-based hedge fund whose founder, Alec Litowitz, made $280 million for himself in 2007 after it executed one of the most notorious trades of the meltdown.

Magnetar, the fund in question, did not pretend to be engaged in something socially useful by trading subprime securities. It was simply making money for its partners and investors by examining closely the shaky foundations of the mortgage mania, and undermining them.

In that sense, it was like Michael Burry, the investor who realised that many CDOs were over-rated and over-valued, and whose fund Scion Capital was one of the first to short them. Burry is the central figure in – and hero of – Michael Lewis’s book about the crisis, The Big Short.

Magnetar has not been getting as good a press as Burry. ProPublica, the non-profit news group, last week published a long investigation into the fund, and accused it of prolonging the subprime boom in order to trade against mortgage securities it assisted banks to issue.

The inquiry is worth reading for the light it shines on one of Wall Street’s murkiest businesses in the late stages of the mortgage boom – the issuance and trading of synthetic subprime CDOs. Many investment banks became involved and most would prefer to forget the episode.

I am not sure, however, that it proves Magnetar was doing something wrong. The fact that the fund had noticed that the subprime emperor had no clothes, and was taking advantage of the fact, does not make its behaviour worse than those who looked the other way.

The Magnetar controversy centres on how it financed its bet against the triple-A tranches of CDOs that Citi trusted. Magnetar became the "sponsor” of 30 subprime CDOs during 2006 and 2007 by buying the riskiest slice of equity in them – the "toxic waste” from which others shied away. That enabled the underwriting banks to sell the "low-risk” parts to others.

The catch is that Magnetar was simultaneously going short of not only subprime securities in general, but the higher-rated slices in the deals that it had helped to launch. Like Magnetar, all of the deals were given astronomical titles, such as Orion, Libra and Norma.

ProPublica and Magnetar disagree about its intentions. ProPublica accuses the fund of trying to stuff the deals with risky assets so they were more likely to collapse. Magnetar says it was arbitraging between the different layers of securities and was "net long”, rather than engineering a short.

What is indisputable is that the Magnetar deals proved star-crossed, with almost all of them defaulting by the end of 2008. It is also indisputable that Magnetar profited from it in 2007 (although it lost money in 2008), with its main fund growing by 26 per cent.

So should we blame Magnetar, rather than everyone who was blindly long subprime, from credit agencies to mortgage lenders to investment banks that made large fees by underwriting deals? ProPublica estimates that JPMorgan was paid $20 million to create one deal, but lost $880 million after it kept hold of the senior tranches.

There are two reasons we might do so. One is that Magnetar lobbied the supposedly independent agencies that assembled the deals on behalf of banks to increase the yield, implying a reduction in asset quality. There is, however, no evidence that it crossed the line by dictating terms.

The question is whether the banks disclosed everything they should have to other investors, putting them on equal terms. ProPublica notes that the CDO deal prospectuses did not disclose Magnetar’s equity role, or detail its other positions.

The second reason is that ProPublica says Magnetar helped to keep the CDO machine humming despite, at the least, having a cynical view of housing. It was acting differently from Burry, or John Paulson of Paulson & Co, who were simply going short.

Magnetar, however, was operating in an arcane part of the CDO market and the forces driving the housing boom were far bigger than a wily Chicago hedge fund. Had Magnetar not existed, things would probably have ended up as they did.

The problem of the US mortgage market was that too many people, particularly on Wall Street, had financial incentives to ignore the warning signs and pile up risk. They were encouraged by politicians and left to it by regulators. If Magnetar saw through it, and exploited lax rules to make money from the madness of the crowd, there we are.

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