Magnetar Redux

Reuters blogger Felix Salmon just nails it today with his post explaining (again) the Magnetar trade.

I thought I would add a little market color around it, and put numbers in place so you can see just how huge an influence this previously completely hidden trade had.

First, as noted, the Magnetar strategy of investing long in CDO equity drove $40 billion in issuance.

That’s a big number for a single market participant to drive in a single market segment.  But the effect was multiplied far more than you might think, enough to drive the core of the US economy (housing and finance) off the cliff at maximum speed.

Here’s how the multiplier came into being.

Magnetar deals only bought the BBB slice of those subprime MBS deals.  That was typically the lowest-priority publicly offered tranche in an entire “capital stack” of bonds.  That BBB slice only consisted of about 5% of the deal.  To get the true size of the demand for mortgages, we need to multiply by a factor of 20.

If they had all been cash deals (instead of some synthetics), they required roughly $800 billion in subprime mortgages to create.

Also, since the BBB was so much in demand, its yield was pushed down and its price went up.  That meant any investor who wanted more safety by buying AAA, AA or A-rated bonds had to take an even lower yield (pay a higher price).

In turn, that meant the mortgage loans were worth even more in 2007 than they were in 2005.  If there was ever an open invitation to insane optimism or outright fraud on the part of borrowers and mortgage brokers, homebuilders, real estate agents and economists, that was it.

Some would say that it wasn’t as bad as all that, since so many of the deals were synthetic.  My answer is that the losses weren’t synthetic, just hidden until the taxpayer was handed the bill by the bookies.

It might be worth noting that in 2006, peak year for subprime originations, there were approximately $600 billion of subprime loans closed.  Of those, about $400 billion were bought and securitized by Wall Street firms principal trading desks.

That should give you a clue just how huge the Magnetar trade really was, and lead you to the conclusion that maybe, just maybe, having insurance written that far exceeds the value of the insured property might “cause” fires.

I’ll be watching carefully to see whether any reform package that comes through the political sausage machine has provisions that bring structured finance CDS into the light of day.



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