The Wall Street Journal-20080114-A Fund Behind Astronomical Losses
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A Fund Behind Astronomical Losses
The trading strategy of a little-known hedge fund run by an astronomy buff contributed to billions in losses on Wall Street, even as the fund itself profited from the subprime-mortgage crisis.
Magnetar Capital, founded in 2005 by a former star trader of Citadel Investment Group, left its mark in another way. Many of the mortgage securities that collapsed in recent months were named for stellar constellations. Magnetar, named for a neutron star with a powerful magnetic field that is a remnant of a supernova, was their common link.
The hedge fund, run by Alec Litowitz, 41 years old, facilitated the creation of a few of the worst-performing collateralized debt obligations, or CDOs. These are giant packages of subprime-mortgage securities and derivatives that are bundled together and sold off in slices to investors around the world. The investments came with names like Orion, Aquarius, Scorpius, Carina and Sagittarius and were managed by third-party money managers. In all, roughly $30 billion of these constellation CDOs were issued from mid-2006 to mid-2007, with Magnetar as their lynchpin investor.
Even as it helped to spawn CDOs that would later wrack Wall Street with painful losses, Magnetar, which has around $9 billion in assets, itself made a tidy profit. Its funds returned 25% across a range of stock and debt strategies last year, thanks largely to the way it hedged these trades.
Its trading highlights the important role some hedge funds played in the great debt unwind that is now plaguing financial markets. Many hedge funds realized early on "that the loans and securities that went into CDOs were extremely toxic, and they designed structures to exploit that," says Janet Tavakoli, a structured-finance consultant.
Mr. Litowitz, an accomplished squash player, had been head of equity strategy at Citadel, the hedge-fund giant known for swooping in on troubled companies. At Magnetar, he recruited a former colleague, David Snyderman, who used to head credit trading at Citadel, to oversee the fund's subprime strategy.
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. This week is likely to bring another round of giant write-downs by the likes of Merrill Lynch & Co. and Citigroup Inc. as they come to grips with the magnitude of their bad mortgage investments.
Last fall, when many subprime bonds suffered steep credit-rating downgrades because of borrower defaults, some of the constellation- themed CDOs were severely hurt. Still, on average, the constellation deals are performing better than most other similar CDOs in the broader market, and many are still paying out interest.
One CDO, called Cetus ABS CDO 2006-3, is an example. The $1.2 billion CDO, which owned subprime-mortgage bonds and CDO securities as well as derivatives tied to them, was set up in November 2006 and underwritten by Calyon Securities. Magnetar made an investment in the Cetus CDO, according to people familiar with the matter. Cetus was named after a mythical and monstrous sea creature with a constellation of stars attached to it.
Within months of its creation, the CDO was hit with a slew of downgrades and suffered an "event of default," which means key investors can demand that the vehicle be unwound or liquidated.
At least five other CDOs have declared events of default, according to data from Standard & Poor's. These include Carina CDO Ltd., named after a constellation in the southern sky, Orion 2006-2 Ltd., for a constellation named after a hunter, and Octans III CDO Ltd., named after another southern constellation.
Others are facing additional rating downgrades, and the slices they sold to banks and other investors have plummeted in value. At least one, called Sagittarius, is the center of a legal dispute between some of its investors over how interest and principal payouts should be made.
Magnetar hedged itself by buying credit default swaps that act as a form of protection -- similar to an insurance policy -- against losses on the CDOs. It isn't clear which CDOs it hedged against, but these swaps broadly soared in value when the CDOs dived last year.
"There was a certain amount of luck to timing the subprime trade right," says Don Brownstein, CEO of Structured Portfolio Management, a $820 million hedge fund that began shorting subprime securities in February 2007 and made a profit of more than 180% last year.
Mortgage analysts note that Magnetar's trading strategy wasn't all luck -- it would have benefited whether the subprime market held up or collapsed.
That hasn't been the case for many of the investment banks that sold the CDOs, or held pieces of them. Many investment banks who took on what they believed were the safest slices of the Magnetar-linked CDOs suffered losses, in part because their hedging strategies were flawed. Morgan Stanley and UBS AG were among the banks that owned the top pieces of these CDOs, including Octans, according to people familiar with the situation.
Representatives for the banks declined comment or didn't return calls for comment.
Tomorrow, Citigroup could report up $15 billion in mortgage-related losses. UBS has announced more than $10 billion in write-downs. Merrill has announced a $7.9 billion hit and has more coming. The amount that each bank may have retained from those CDOs isn't known.
