Just about everywhere you look, you see how the US mortgage meltdown is negatively affecting everything connected to it. Even in this market though, people are killing it. The Wall Street Journal has a fascinating article about Magnetar and the handsome profits it made betting against the mortgage market. WSJ Online (Reg Required): A Fund Behind Astronomical Losses by Serena Ng and Carrick Mollenkamp
In this case, Magnetar swooped in on securities that it believed could become troubled but were paying big returns. CDOs are sliced based on risk, with the riskiest pieces having the highest yield but the greatest chance of losing value. Less-risky pieces have lower yields and some pieces were once considered so safe that they paid only a bit more than a U.S. Treasury bond. 
 
Magnetar helped to spawn CDOs by buying the riskiest slices of the instruments, which paid returns of around 20% during good times, according to people familiar with its strategy. Back in 2006, when Magnetar began investing, these were the slices Wall Street found hardest to sell because they would be the first to lose money if subprime defaults rose. For the Wall Street firms underwriting the deals, selling the riskiest pieces was “critical to getting the deals done because they were designed to act as a cushion for other investors,” says Eileen Murphy, principal at Excelsior CDO Advisors LLC, a structured-finance consultancy.
 
Magnetar then hedged its holdings by betting against the less-risky slices of some of these same securities as well as other CDOs, according to people familiar with its strategy. While it lost money on many of the risky slices it bought, it made far more when its hedges paid off as the market collapsed in the second half of last year.
 
Wall Street, on the other hand, is reeling. Investment banks made big fees by underwriting Magnetar-linked CDOs, but several banks made the costly mistake of holding some of the higher-rated and supposedly less risky pieces of these investments. 
 
¬†As the article points out, Magnetar’s strategy would have worked whichever way the mortgage market went. They had downside protection and then some in the case of a downturn, but if the market held up, they owned the slices of the market with the best returns. Very impressive.It also highlights the information advantage that insiders have. There’s no way individual investors could have this sort of insight and then act on it. One lesson here, if you’re not intimately familiar with a market, be wary of easy money.
