How can you sponsor a business while betting against it?
Goldman Sachs has taken plenty of heat for doing just that, even though they owned subprime and alt-A mortgage lenders, which gave them cover for their purchase of credit insurance, since they had a constant level of exposure.
On the other hand, if you’re really a hedge fund, and not a Primary Dealer acting like one, you don’t need to waste any time or energy on having the business (and the headaches) that you’re buying insurance against.
In late 2005, when the ABS CDO engine was already coughing and acting like it was going to run out of gas, a new player showed up.
That player, was Magnetar, named after a high-energy state dying stars enter just before becoming black holes.
For those who want to see how cynical the big money boys can be when no one is looking, this article describing the Magnetar trade just about takes the cake. Magnetar was a son-of-Citadel hedge fund set up to specifically invest in CDO equity while simultaneously buying CDO credit protection.
The managers at Magnetar pushed Wall Street to bring its CDO managers to the table with an offer those managers almost couldn’t refuse: Magnetar would put up the cash to buy the “toxic waste” first-loss equity portion of new CDO’s, and they kept making the offer well after it was obvious the game was over.
Well, the boys at Magnetar were setting themselves up to make a small profit if the CDO deals didn’t blow up, since they took the 15% to 20% yield from the equity investment and used most of the cash to buy credit insurance (CDS). As the key to doing new deals, they were in the drivers’ seat with their managers, free to push the managers to stretch for more yield (and take more risk by doing so).
On the other hand, Magnetar would make a fortune if the CDO deals did blow up, because the insurance payoff would be many times the size of their investment in equity.
All legal, and nicely hidden from sight due to the rules laid out in the Commodity Futures Modernization Act of 2000.