The Chicago Hedge Fund That Foxed All of Wall Street

Drawing the line between legal and illegal is fairly objective and straightforward; however, deciding what is ethical and unethical? Not so much.

Magnetar Capital is a hedge fund based in Evanston, Illinois. The firm was founded in 2005 and invests in fixed income, energy, quantitative and event-driven strategies. Today, Magnetar Capital claims to be focused on “delivering positive outcomes for their investors, generating tomorrow's diversifying return streams by challenging today's investment norms.” However, about a decade ago, one could question this immaculate ethos.

In late 2005, the booming U.S. housing market seemed to be slowing. The Federal Reserve had begun raising interest rates, and subprime mortgage company shares were falling. The housing bubble, which had propelled an unprecedented growth in home prices, seemed poised to deflate. At just that moment, a few financial engineers at a Chicago hedge fund changed the course of the near future. Magnetar, the hedge fund, helped revive the Wall Street money machine by spawning billions of dollars off Collateralized Debt Obligations (CDOs).

CDOs were created in 1987 by bankers at Drexel Burnham Lambert Inc. Within 10 years, the CDO had become a major force in the derivatives market, wherein the value of a derivative is ‘derived’ from the value of other assets. In a CDO, an investment bank collected a series of assets, often high-yield junk bonds, mortgage-backed securities, credit-default swaps, and other high-risk, high-yield products from the fixed-income market. The investment bank then created a corporate structure, the CDO, that would distribute the cash flows from those assets to the investors.

CDOs were marketed as investments with defined risk and reward. If you bought one, you would know how much of a return you could expect in exchange for your capital. The investment banks that were creating the CDOs presented them as investments in which the key factors were not the underlying assets but the calculations and algorithms of quant traders. However, this was the very web of deception and misdirection that Magnetar, along with other investment banks at the time, used to lure investors in and maintain the bubble that sent out the first invitations to the 2008 financial crisis.

Magnetar bought the riskiest parts of these CDOs. If housing prices kept rising, they would provide a solid return for many years. However, if the housing market failed, the losses would be even larger. Magnetar was not chasing these solid returns though; they wanted outsized gains, and soon. Magnetar set itself up for a tremendous win: it placed bets that portions of its own deals would fail. That is, Magnetar invested in high-risk assets and bet that these very assets would fail, and the bubble of the housing market would eventually burst. The hedge fund pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure.

When the market finally crashed, nearly all of these CDOs became worthless. There was a loss of an estimated $40 billion incurred by investors, the investment banks who helped bring them into the world, and, eventually, American taxpayers. Yet, when the financial crisis began and the CDOs became virtually worthless due to the defaults, Magnetar earned outsized returns. The Magnetar Constellation Fund, the firm's fund that had the most exposure to the CDO trades, was up 76 per cent in 2007 while main fund, Magnetar Capital Fund, was up 26 per cent that year. By the end of 2007, Magnetar had $7.6 billion under management, up from the $1.7 billion it began with two years earlier.

Legal bodies did not raise any red flags over the trade; Magnetar’s trades were within the law. Had the mortgages not defaulted, the payoff for the investors who had taken a long position (expecting that the value of the CDOs will increase over time) on the CDOs would have been tremendous. It was the investors’ responsibility to have known the risk they were taking on. However, they did not, in part because the rating agencies were over-relied upon and also because lots of players were wildly ignorant. There is nothing to say that if Magnetar had not created these mortgage CDOs, they would never have existed. They very well may have been created by someone else, sold, and become worthless just the same.

However, legal or not, many people would agree that the Magnetar trade was not among the list of ethical and responsible hedge fund trades. The very purpose of a hedge fund, or for that matter any investment fund, is to maximise their investors’ returns while minimising their risk. Magnetar, by contrast, operated in a duplicitous manner; it offered risky debt obligations to its investors knowing that they were risky and, according to their predictions, bound to fail. In fact, they themselves took a position against the rise in the value of the CDOs that they were recommending as a hedge fund. They claim to have been market neutral, but most professionals and experts agree that Magnetar had, in essence, bet against the subprime mortgage securities market. The trades may not have been illegal, and they may have made the fund a fortune, but all this came at the cost of Magnetar’s reputation and credibility.

In 2013, the Securities and Exchange Commission (SEC) decided not to file civil charges against Magnetar over its role in helping create mortgage securities that lost value during the financial crisis. At present, Magnetar works in alternative asset management and offers consultancy to private investors and businesses. Wall Street still talks about the Magnetar trade; some are yet in awe while others abominate the very concept. Magnetar must indeed be appreciated for its foresight; moreover, it did not break the law to make the returns. However, for many, this cannot justify their intentions. Magnetar did operate unethically and for self-serving reasons. It can either be considered one of the most prescient funds in Wall Street history or just another fund wrapped up with itself.