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A hedge fund isn't supposed to hedge away all returns. The hedged part means that they buy and sell similar assets whose prices reveal discrepancies. In this ca

A hedge fund isn't supposed to hedge away all returns. The hedged part means that they buy and sell similar assets whose prices reveal discrepancies. In this case, there was a discrepancy between the return of the equity slice of CDOs (very high, implying a high default risk) and the cost of insuring the debt portions of CDOs (very low, implying a low default risk). Magnetar basically said "Okay, the risk is probably not as high as the equity guys think. And not as low as the debt guys think. Why don't we buy from the equity-holding pessimists, sell to the debt-holding optimists, and pocket the difference?" And they bought, sold, and pocketed. If you're going to be outraged, pick one: Did they profit from the misery of others by selling short? Then they had to be net sellers, which decreased prices and made the bubble smaller. Or did they needlessly fuel a speculative bubble? In that case, they had to be net buyers, which would make them net losers. Since Magnetar was long volatility (returns will either be way better or way worse than investors expect), this complicates things. But they basically made money from being right, while their counterparties lost money for being wrong. As long as everyone goes into these transactions with the same information, that's the only way fools and their money are parted.

jordanb 17y ago
The article asserts that Magnetar was net short on the CDOs, although the This American Life episode makes that more clear than the linked article does. They can't prove that Magnetar was net short, because that information isn't pubically available. But their evidence was that Magentar was pressuring the banks who were creating the CDOs into building them out of unusually risky assets. They have emails from a deal that fell apart because the bank refused to bundle in the assets that Magnetar wanted. > Did they profit from the misery of others by selling short? Then they had to be net sellers, which decreased prices and made the bubble smaller. Or did they needlessly fuel a speculative bubble? In that case, they had to be net buyers, which would make them net losers. The thing is, Magnetar was only buying the equity position of the CDO. They were then buying insurance against the higher tranches failing. They were sponsoring billion-dollar CDOs with a few million dollar investments in the lowest tranche. They were then buying insurance against the failure of the much larger upper tranches. Without them buying the equity, the CDO wouldn't have been created. The argument is that without Magenatar, the CDOs wouldn't have come into existence (because they wouldn't have had a sponsor willing to buy the equity tranche). Magnetar wanted the CDO to fail as evidenced by its pressure of the banks to include rotten assets. So my analogy stands, they insisted on the construction of a dangerous house so they could collect the insurance.

jordanb 17y ago

The article asserts that Magnetar was net short on the CDOs, although the This American Life episode makes that more clear than the linked article does. They can't prove that Magnetar was net short, because that information isn't pubically available. But their evidence was that Magentar was pressuring the banks who were creating the CDOs into building them out of unusually risky assets. They have emails from a deal that fell apart because the bank refused to bundle in the assets that Magnetar wanted. > Did they profit from the misery of others by selling short? Then they had to be net sellers, which decreased prices and made the bubble smaller. Or did they needlessly fuel a speculative bubble? In that case, they had to be net buyers, which would make them net losers. The thing is, Magnetar was only buying the equity position of the CDO. They were then buying insurance against the higher tranches failing. They were sponsoring billion-dollar CDOs with a few million dollar investments in the lowest tranche. They were then buying insurance against the failure of the much larger upper tranches. Without them buying the equity, the CDO wouldn't have been created. The argument is that without Magenatar, the CDOs wouldn't have come into existence (because they wouldn't have had a sponsor willing to buy the equity tranche). Magnetar wanted the CDO to fail as evidenced by its pressure of the banks to include rotten assets. So my analogy stands, they insisted on the construction of a dangerous house so they could collect the insurance.