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Hedge funds, CDOs and the financial crisis: An empirical investigation of the “Magnetar trade”

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  • Mählmann, Thomas
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    Abstract

    The so called Magnetar trade (a kind of capital structure arbitrage on the US housing market, using CDS and synthetic CDOs, and exploiting rating-dependent mispricing of risk) has gained a high publicity due to a Pulitzer Prize awarded media story from two journalists of ProPublica (an online news outlet). The story essentially claimed that the mortgage investment strategy of the hedge fund Magnetar during the period between 2006 and mid 2007 was based on a desire to construct CDO deals with riskier assets so that they could place bets that portions of their own deals would fail. This paper provides several pieces of evidence in line with the argument that tranches from Magnetar-sponsored CDOs present overly risky investments. However, investors and rating agencies appear to have adjusted their required spread levels and ratings to reflect this higher riskiness, at least to some extent.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 37 (2013)
    Issue (Month): 2 ()
    Pages: 537-548

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    Handle: RePEc:eee:jbfina:v:37:y:2013:i:2:p:537-548

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Arbitrage; Collateralized debt obligation; Credit default swap; Hedge funds;

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    References

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    1. Maciej Firla-Cuchra, 2005. "Explaining Launch Spreads on Structured Bonds," Economics Series Working Papers 230, University of Oxford, Department of Economics.
    2. Arnoud W A Boot & Anjan V Thakor, 1992. "Security Design," CEPR Financial Markets Paper 0020, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
    3. repec:reg:rpubli:569 is not listed on IDEAS
    4. Jan Pieter Krahnen & Christian Wilde, 2009. "CDOs and Systematic Risk: Why bond ratings are inadequate," Working Paper Series: Finance and Accounting 203, Department of Finance, Goethe University Frankfurt am Main.
    5. Hamerle, Alfred & Liebig, Thilo & Schropp, Hans-Jochen, 2009. "Systematic risk of CDOs and CDO arbitrage," Discussion Paper Series 2: Banking and Financial Studies 2009,13, Deutsche Bundesbank, Research Centre.
    6. Leslie E. Papke & Jeffrey M. Wooldridge, 1993. "Econometric Methods for Fractional Response Variables with an Application to 401(k) Plan Participation Rates," NBER Technical Working Papers 0147, National Bureau of Economic Research, Inc.
    7. Mählmann, Thomas, 2012. "Did investors outsource their risk analysis to rating agencies? Evidence from ABS-CDOs," Journal of Banking & Finance, Elsevier, vol. 36(5), pages 1478-1491.
    8. Bernstein, Jake & Eisinger, Jesse, 2010. "The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going," Working paper 569, Regulation2point0.
    9. Joshua D. Coval & Jakub W. Jurek & Erik Stafford, 2009. "Economic Catastrophe Bonds," American Economic Review, American Economic Association, vol. 99(3), pages 628-66, June.
    10. Maciej Firla-Cuchra & Tim Jenkinson, 2005. "Why are Securitization Issues Tranched?," OFRC Working Papers Series 2005fe04, Oxford Financial Research Centre.
    11. John M. Griffin & Dragon Yongjun Tang, 2012. "Did Subjectivity Play a Role in CDO Credit Ratings?," Journal of Finance, American Finance Association, vol. 67(4), pages 1293-1328, 08.
    12. Joshua Coval & Jakub Jurek & Erik Stafford, 2009. "The Economics of Structured Finance," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 3-25, Winter.
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