After reading Michael Lewis’ The Big Short this weekend, it’s clear that some people saw the collapse of the residential mortgage market coming.
This American Life had a story this weekend about another investor who also saw it coming: Magnetar Capital.
(A magnetar is a neutron star with a magnetic field 100-1000 times stronger than that of an ordinary neutron star.)
The story paints the picture of Magnetar buying the most risky tranche of subprime CDOs while at the same time buying credit default swaps against less risky tranches of the same subprime CDOs.
The equity tranche is the last to get paid, the riskiest portion of the CDO and the hardest to sell. Without someone to buy the equity a CDO was less likely to be put together in the first place. Also keep in mind that CDOs were often composed of the equity and junkier pieces of mortgage backed securities as a well as a kitchen soup of mortgage securities.
Pro Publica and This American Life interpret Magentar’s trade as one to sustain the volume of subprime CDOs, which sustained the volume of subprime mortgage backed securities, which sustained the origination of subprime mortgage loans, which sustained the bubble in housing prices. They claim that Magnetar’s trades made the bubble worse. By buying the equity tranche, they enabled the creation of the entire subprime CDO and had more to bet against.
Magnetar denies that was their intent. They were merely combining long positions with short positions.
I assume they saw a weakness in the pricing of CDOs and CDO CDSs and made trades to exploit the weakness. Others, like the people in The Big Short saw weaknesses in CDOs and took bets on their downfall. I doubt any of them realized that the collapse of the CDOs would result in something as catastrophic as the Great Panic.
That didn’t stop This American Life from comparing the Magnetar trades to the plot of The Producers. In the movie, a theatrical producer and his accountant attempt to cheat their investors by deliberately producing a flop show on Broadway. They realize they can oversell the shares in the production and make more money if it the show flops than if it becomes successful.