Jesse Eisinger and Jake Bernstein come very close to accusing Alec Litowitz of the Magnetar hedge fund of being a financial arsonist. I have been speculating about financial arson for a year and a half now.
The hypothesis is that Magnetar deliberately set up especially low quality CDOs and bought CDS insurance on them. Magnetar bought the equity tranches of the CDOs and so had a voice in the selection of underlying assets. Many anonymous sources claim that Magnetar pressed for risky assets to be included in the CDOs.
Magnetar clearly used the revenue from their equity tranches to invest massively in CDSs. They claim they were net losers when all but one of the CDOs which they sponsored defaulted. So ? Arson analogy after the jump.
First I admit that in my old posts, I didn’t discuss setting up an especially bad CDO. I think it would be legal for Magnetar to have over-insured their holding in a CDO which they sponsored. However, it seems that they didn’t insuring just enough that a default would cover the loss of all value of the equity tranche and using the rest of the cash flow to invest in CDSs of similar CDOs which they didn’t sponsor.
I think they still made money when the CDOs which they sponsored defaulted — the value of CDSs on similar CDOs surely shot up. If Eisinger and Bernstein’s suspicions are correct, this would be a trick as the apparently similar CDOs were not really all that similar, they hadn’t been deliberately engineered to fail.
The arson analogy is as follows — I buy fire insurance on my house equal to its value. I also buy fire insurance on my neighbors house. I light a fire in my house (oooops). Then I sell my neighbor the policy on his house before the fire department puts out the fire.
My house is not over-insured. His house didn’t burn down. There is no problem. Except I made money via arson.
The difference is that it appears that everything Magnetar did was legal.
Oh and also it prolonged the housing bubble and caused much more damage than any fire started in Chicago since a cow kicked over a latern.