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"The Magnetar Trade"


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Propublica has a very interesting article about a hedge fund, Magnetar, which allegedly purchased equity positions in synthetic CDOs to influence the composition of the assets. Magnetar received cash flow from the CDOs and channeled the funds into long CDS positions.


Magnetar further increased its odds by insisting that the CDOs it helped create had an unusual construction. Typically, cash flowing to the last-in-line equity buyers is cut off at the first signs of trouble -- such as a rise in mortgage delinquencies. Those at the top of the CDO -- who accepted lower returns for less risk -- received that cash, leaving none for the high-risk holders.


Magnetar wanted its deals to be "triggerless," meaning lacking these cash-flow dams. When the market turned shaky and homeowners began to default, money kept flowing down to the risky slices that Magnetar owned.





The story isn't complete without some technical answers, such as whether they hedge out the underlying assets or simply the characteristics of the assets, or were they largely unhedged? Also, why did Moody's refuse to rate the CDO squared Magnetar sold to Moody's? And how could they reliably obtain CDS without counterparty risk, or without tracking error on the hedge? Unfortunately, only the government can pursue the answers.




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