Magnetar Invested in CDO Deal Under SEC Scrutiny

The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.
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The U.S. Securities and Exchange Commission seal hangs on the facade of its building in Washington, DC.

The hedge fundMagnetar may find itself embroiled in the U.S. Securities and Exchange Commission's investigation into how Standard and Poor's rated a 2007 mortgage bond.

On Monday, S&P's parent company, McGraw-Hill Cos., said that it had received a so-called Well's notice informing the company that the SEC was considering bringing a civil case alleging securities violations in connection with the rating of a collateralized debt obligation known as Delphinus CDO 2007-1.

Delphinus was arranged by the U.S. subsidiary of the Japanese investment bank Mizuho. The collateral manager was Delaware Asset Advisors.

But Magnetar was an investor in the CDO, according to an investigation conducted by Pro Publica.

Magnetar was not a passive investor in many of its CDO deals, and it often helped to create the CDOs, Pro Publica found.

The hedge fund would allegedly push for riskier assets to be included in the deals, which it would then bet against, according to Pro Publica.

Emails uncovered by a U.S. Senate panel revealed that S&P had rated Delphinus with placeholder or “dummy” bonds, with the expectation that when genuine bonds were put in place they would have the characteristics of the dummies. Instead, the bonds that were actually put into the portfolio were far riskier. S&P analysts noted that the bonds were backed with mortgages that had less principal and worse ratings, and passed the information on to S&P managers, according to the emails. But the rating on the CDO went unchanged.

The deal, which closed in July 2007, was one of the last CDOs Magnetar invested in. It's triple-A trache was downgraded just six months after the deal closed.

Mizuho was a latecomer to the CDO market and wound up being one of its biggest losers. By summer of 2007, many banks were getting out of the CDO business. The Japanese bank, however, had hired Alex Rekeda, a young Ukrainian immigrant who had worked on Magnetar's first deal when he was at the French bank Calyon.

Here's how Pro Publica describes how Magnetar deals worked:

The hedge fund bought the riskiest portion of a kind of securities, known as collateralized debt obligations—CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.

Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure. The hedge fund acknowledges it bet against its own deals, but says the majority of its short positions, as they are known on Wall Street, involved similar CDOs that it did not own. Magnetar says it never selected the assets that went into its CDOs.

As Pro Publica notes, Magnetar denies that it was betting against the housing market and that it selected the assets that went into CDOs it bet against.

It's not clear exactly what position Magnetar had in the Delphinus CDO 2007-1.

There is no indication that Magnetar itself is being investigated by the SEC in connection with the deal. John Paulson was never drawn into the SEC's case against Goldman Sachs despite his involvement with the Abacus CDO.

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