The Magnetar Trade according to ProPublica’s recent article is a long-short strategy that worked due to the perverse incentives operating in the CDO market during the boom. According to Jesse Eisinger and Jake Bernstein, Magnetar went long the equity tranche and short the senior tranches and used their position as the buyer of the equity tranche to ensure that the asset quality of the CDO was poorer than it would otherwise be. If ProPublica’s account is true, then this is a moral hazard trade i.e. Magnetar buys insurance against the burning down of a house and uses its influence as an equity buyer to significantly improve the odds of the house burning.
However, there are some hints in Magnetar’s response to the story that cast significant doubt on the accuracy of ProPublica’s narrative. To understand why this is the case, we need to understand what exactly the Magnetar trade as described in the story would look like. Magnetar’s portfolio was most likely a “close to carry neutral” portfolio consisting of long equity tranche positions and short senior/mezzanine tranche positions. In order to be carry-neutral, the notional value of senior tranches that are shorted needs to be an order of magnitude higher than the notional value of equity tranches purchased. In option parlance, this is equivalent to a zero-premium strategy consisting of short ATM options and long OTM options.
There are two reasons to execute such a strategy – one, simply to fund a “short options” strategy and the second, to execute a market-neutral “arbitrage” strategy. The significant advantage that such a long-short strategy has over a “naked short” strategy a la John Paulson is the absence of negative carry. As Taleb explains: “A butterfly position allows you to wait a lot longer for the wings to become profitable. In other words, a strategy that involves a butterfly allows you to be far more aggressive [when buying out-of-the-money options]. When you short near-the-money options, they bring in a lot of cash, so you can afford to spend more on out-of-the-money options. You can do a lot better as a spread trader.”
However, Magnetar describe their portfolio as market-neutral and “designed to have a positive return whether housing performed well or did poorly”.This implies that the portfolio was carry-positive i.e. the coupons on the long-equity positions exceeded the running-premium cost of buying protection on the senior tranches. This ensures that the portfolio will be profitable in the event that there are no defaults in the portfolio.
If the Magnetar Trade was based upon moral hazard, then it would have to short the senior tranches of the same CDO that it bought equity in and the notional of this short position would have to be multiples of the notional value of the equity position. However, Magnetar in their response to ProPublica explicitly deny this and state: “focusing solely on the group of CDOs in which Magnetar was the initial purchaser of the equity, Magnetar had a net long notional position. To put this into perspective, Magnetar would earn materially more money if these CDOs in aggregate performed well than if these CDOs performed poorly.” The operative term here is “net long notional position” as opposed to “net long position”. A net long position measured in delta terms could easily imply a net short notional position in which case the portfolio would outperform if all the tranches in the CDO were wiped out. But Magnetar seem to make it clear in their response that in the deals where they were the initial purchaser of equity, the notional of the equity positions exceeded the notional of the senior positions that they were short. They also assert that “the majority of the notional value of Magnetar’s hedges referenced CDOs in which Magnetar had no long investment” i.e. of course the notional value of their short positions exceeded that of their long positions, but these short positions were in other CDOs in which they did not have a long position.
But what about the fact that Magnetar seemed to be influencing the portfolio composition of these CDOs to include riskier assets in them? Surely this proves conclusively that Magnetar would profit if the CDOs collapsed? To understand why this may not necessarily be true, we need to examine the payoff profile of the Magnetar trade.
As with most market-neutral “arbitrage” trades, it is unlikely that the trade would deliver a positive return in every conceivable scenario. Rather, it would deliver a positive return in every scenario that Magnetar deemed probable. The Magnetar trade would pay off in two scenarios – if there were no defaults in any of their CDOs, or if there were so many defaults that the tranches that they were short also defaulted alongwith the equity tranche. The trade would likely lose money if there were limited defaults in all the CDOs and the senior tranches did not default. Essentially, the trade was attractive if one believed that this intermediate scenario was improbable.
A distribution where intermediate scenarios are improbable can arise from many underlying processes but there is one narrative that is particularly relevant to complex adaptive systems such as financial markets. Intermediate scenarios are unlikely when the system is characterised by multiple stable states and “catastrophic” transitions between these states. In adaptive systems such as ecosystems or macroeconomies, such transitions are most likely when the system is fragile and in a state of low resilience. The system tends to be dominated by positive feedback processes that amplify the impact of small perturbations, with no negative feedback processes present that can arrest this snowballing effect.
It turns out that such a framework was extremely well-suited to describing the housing market before the crash. Once house prices started falling and refinancing was no longer an option, the initial wave of defaults triggered a vicious cycle of house price declines and further defaults. Similarly, collateral requirements on leveraged investors, mark-to-market pressures and other positive feedback processes in the market created a vicious cycle of price declines in the market for mortage-backed securities and CDOs.
So what does all this have to do with Magnetar’s desire to include riskier assets in their long equity portfolios? If one believes that only a small perturbation is required to tip the market over into a state of collapse, then the long position should be weighted towards the riskiest possible asset portfolio. Essentially, the above framework implies that there is no benefit to having “safer” long positions in the long-short portfolio. The fragility of the system means that either there is no perturbation and all assets perform no matter how low-quality they are, or there is a perturbation and even “high quality” assets default.
The above framework of catastrophic shifts between multiple stable states is not uncommon, especially in fixed income markets. In fact, the Greek funding situation is a perfect example. If one had to sketch out a distribution of the yield on Greek debt, it is likely that intermediate levels are the least likely scenarios. In other words, either Greece funds at low sustainable rates or it moves rapidly to a state of default – it is unlikely that Greece raises say 50 billion Euros at an interest rate of 10%. The situation is of course made even more stark by Greece’s inability to inflate away its debt via the printing press. Of course, the bifurcation exists in fiat currency issuing countries as well, but at the point when hyperinflation kicks in.
Bank incentives are the real problem
Even if my arguments are valid, it is nevertheless obvious that even if Magnetar may not have executed the moral hazard trade, someone else could quite easily have done so. But the moral hazard trade was only possible because there was sufficient investor demand for the rated tranches of the CDO and even more crucially, because the originating bank was willing to hold onto the super-senior tranche. As I have discussed many times earlier in detail, bank demand for super-senior tranches is a logical consequence of the cheap leverage that they are afforded via the moral hazard subsidy of the TBTF doctrine. If banks were less levered, many of these deals would not have been issued at all.
In fact, two of the hedging strategies that we know were implemented in banks – UBS’ “AMPS” strategy and Howie Hubler’s trade in Morgan Stanley – were mirror images of the Magnetar trade. It is not a coincidence that bank traders chose the negatively skewed payoff distribution and Magnetar chose the positively skewed one.
Disclaimer: The above note is just my analysis of the facts and assertions in ProPublica’s article. I have no additional knowledge of the facts of the case and it is entirely possible that Magnetar are being less than fully forthright in their responses to the story. The above analysis is more useful as an illustration of how the facts as described in the article can be reconciled to a narrative that does not imply moral hazard.