Today's WSJ featured a column titled "A Fund Behind Astronomical Losses" which is worthy of close study. Magnetar Capital is a $9 billion hedge fund established in 2005 by a 41-year old trader Alec Litowitz who had been a trader for Citadel Investment Group.
Magnetar facilitated the creation of $30 billion of CDOs named after various constellations. These CDOs starred Magnetar as the anchoring investor which would provide the all-important critical highest risk tranche of funding. Knowing this and recent history, one might guess that Magnetar had become a black hole. Not so.
In a version of "head I win, tails you lose," Magnetar lived up to the name "hedge" fund, profiting whether the subprime market held up or collapsed. Magnetar did this by purchasing credit default swaps, which essentially insure against the AAA tranches - possibly in the same CDO as it bought the riskiest tranches. Because investors were so bullish about the highest tranches (and risk in general), the highest tranches were overpriced. The resulting losses in these tranches provided Magnetar more return than total losses in the riskiest tranches.
A resulting question is who sold Magnetar these credit default swaps. Certainly these five year swaps are continuing to be held be Magnetor and "marked to market" for investment results for Magnetar investments. Are the swaps, which are less than liquid, being marked equally on the other side? Me thinks not.
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