GO
Loading...

How Did Those Magnetar Bets Against the Housing Market Work?

Martin Poole | Stockbyte | Getty Images

The “Norma” deal that the Securities and Exchange Commission is investigating was one of several complex transactions that became known under one name, “The Magnetar Trade.” To many in finance, it is still considered one of the most elegant trades in recent memory.

What made the trades so special is that they simultaneously solved two of the challenges that made putting together collateralized debt obligations (CDOs) and betting against the housing market so difficult—negative carry and the need to find someone to take the risky equity tranche.

The classic problem with shorting mortgages was that it was a negative carry trade. People who went long mortgages would pay for a piece of mortgage bond and immediately begin receiving revenue from the bond.

As long as your cost of financing was less than the revenue from the bond, you made money.

Buying a credit default swap, however, not only required an initial purchase, but almost always also required on-going payments. Unless the insured bonds defaulted, there was no revenue whatsoever to balance out the costs. You were “losing” money right from the start.

Loathing of negative carry is one of the reasons that so few investors were short the mortgage market. It just seemed too damn expensive.

Only a few traders, such as John Paulson, could convince investors to go along on the naked, negative carry trade of buying protection on mortgages.

Magnetar solved this problem by buying the highest-yielding slice of the CDOs, the very risky and relatively unpopular equity tranches.

These were at the bottom of the payment waterfall for a structured finance vehicle, the first to lose money if mortgagees stopped paying.

Magnetar wanted the equity tranche for a very peculiar reason—to finance its short positions, bets it made that the senior portions of the CDOs would default.

What Magnetar did was use the income stream from the equity tranche to finance the payments on the insurance. The income from the equity tranches was so high that it could pay Magnetar’s entire cost of shorting the more senior positions in the CDOs. In fact, it probably paid even more than that—allowing Magnetar to make money. It became a postive carry trade.

______________________________________________

Questions? Comments? Email us atNetNet@cnbc.com

Follow John on Twitter @ twitter.com/Carney

Follow NetNet on Twitter @ twitter.com/CNBCnetnet

Facebook us @ www.facebook.com/NetNetCNBC

NetNet TV

Wall Street