The Strange But True Story of the Magnetar Debacle
Magnetar's back in the news. I'm giddy.
First, the story that opened up the local hedge fund to the public, a ProPublica investigation done in collaboration with WBEZ's This American Life and NPR's Planet Money, won a well-deserved Pulitzer; it was the most fascinating investigative article I read last year, even if it took me several tries to understand it, and the episode of This American Life based on it, Inside Job, is one of the best half-hours of radio I've ever heard.
Second, JP Morgan is in talks with the Securities and Exchange Commission to settle a lawsuit over investments created with the input of hedge funds--among them, Magnetar:
The allegations the SEC is weighing include claims that banks failed to tell investors who bought slices in a CDO that the investment had been created with input from hedge funds that were betting on the fall of the housing market—an event that would damage the value of the investments.
Meanwhile, new details are emerging thanks to a Senate investigation that's reliant on the ProPublica reporting. What happened is complicated--ProPublica's investigation took months--but it's a look into the powerful forces at work behind the scenes of the housing bubble. And it all happened in our backyard. Here's a thumbnail sketch; it's not a substitute for the amazing original, but it might help you understand it:
Magnetar is a local hedge fund run by Alec Litowitz, a young veteran of Citadel. (A magnetar is a type of neutron star, i.e. it's sometimes left after the collapse of a massive star. The name is not without irony.)
The hedge fund started buying pieces of collateralized debt obligations (CDOs) in 2006, which basically take debt obligations (mortgages, credit cards), package them, and resell them to different buyers. If you think visually, see the video below, but don't think "debt obligations"; think "Cubs games."
Imagine that you're trying to make money betting on the Cubs. I'll be your bookie. Betting on each game is risky and time-consuming. They're probably not going to win every game against even a terrible team. So what I'll do for you is look at the matchups, and put your money on the games they're probably going to win. Since they're probably going to win, I can't give you very good returns--the odds will lower your profits--but you will get consistent returns, and you don't have to look at the lineups every day.
That leaves me with the less-good matchups, which I also want to sell. So I'll sell those to people who are willing to deal with longer odds in order to get a bigger return. Between over-hopeful Cubs fans and gambling addicts, I know I can get them if I offer really high returns.
Great: so now you've got your investment in the Cubs. But I want more money, and I've sold all the Cubs games for the season.
Here's what ProPublica says Magnetar did: they offer to bet on a bunch of Astros games, especially the ones they're going to lose, like when their worst pitcher is starting. The worst team in the league with their worst pitcher--who'd bet on that?
Well, imagine if your friend Magnetar knew you were doing lots of gambling. And they started betting on you. It's just like betting on a game--they're betting on gamblers to lose, instead of the Cubs. So they want people doing irresponsible things like betting on the Houston Astros.
They're going to lose their bets on the crappy games, but they're going to win much bigger on all the gamblers who go bust. It's a weird bet to make--one I've heard described as like taking out homeowner's insurance on houses you don't own--but it's legal.
And ProPublica reporters Jesse Eisinger and Jake Bernstein spent months putting together evidence that Magnetar encouraged investment banks to keep bundling massive CDOs, offering to bet on the crappiest parts of it and pushing the banks to make the CDOs even crappier... and then betting against the CDOs.
Why should you care? People have argued that Magnetar, on the whole, is a small part (even if the numbers are big) of the collapse, and if Magnetar hadn't done it, someone else would have.
And maybe that's true. And if it is true... it's probably scarier, and more resonant. What makes Magnetar a really, really important story, complicated and arcane as it sounds, is that it reveals the perverse--and entirely legal--incentives that combined to destabilize the market.
A lot of debt obligations were created--credit cards printed, houses built--that might not have been, shouldn't have been, if it weren't for the fact that there were incentives to do so. Magnetar may only be one story of the housing crisis, but through Eisinger and Bernstein's reporting, it resonates for the whole.