Must-Read Story of the Morning

I've grown a little numb to the shocking revelations of this financial crisis, but every so often, a story will drop my jaw and make me go "wow."

Today's candidate: Pro Publica's The Magnetar Trade.

One of the authors, Jesse Eisinger, you may remember from the Wall Street Journal. I admired his stuff during his tenure there. He impressed me as a smart guy who liked to dig -- and then dig some more.

The "Magnetar trade" Yves Smith apparently has written about at some length in her new book Econned. She has mentioned Magnetar a few times on her blog, without going into too much detail (I'm sure her book does, and I'm dying to read it. Where's my review copy, dammit? :))

Right now, Magnetar looks like the scariest enabler of this subprime bubble I've seen so far. Of course Michael Lewis looked at the enabling role the shorts played in his The Big Short. But the players he interviews were small. And they were only indirectly feeding the subprime lunacy.

To wit: as long as there was appetite for products packed with questionable home mortgages (the securities known as CDOs, or collateralized debt obligations), his shorts would happily take the other side of the trade. But, as far as I can tell, they weren't actively instigating the creation of these crap-congested things.

Magnetar apparently had a more clever, and dangerous, approach. It offered to buy the lousiest portions of the CDOs (the so-called "equity tranches" -- they're not technically equity, but tend to behave like equity, thus the name). For a high risk investment, the equity tranche is like the canary in the coal mine, an early-warning signal of trouble ahead. Or, to mix animal metaphors: A fish rots from the head down. A CDO rots from the equity tranche up.

So the equity tranche can be hard to place, especially for a shaky investment. And if you can't place it, then the CDO just doesn't get created. So was Magnetar crazy?

Crazy like a fox, it turns out. Because the hedge fund turned around and shorted the entire CDO.

How it made money initially puzzled me, but as far as I could tell (Eisinger keeps it sketchy, presumably because he's writing for a general readership), Magnetar's equity investment was a rather small piece of the CDO, and since the hedge fund was going short on the entire security, it stood to gain more than it would lose. The disturbing brilliance of this strategy: while the CDO is "in the clover," making money, the income thrown off by Magnetar's equity tranche funds its short bet on the CDO. So the fund solved the classic short problem of "how long can I afford to hold out if this thing doesn't blow up soon?"

Read the story. I have a feeling that "Magnetar," before this a name that's been largely under the radar, is about to start attracting a little (unwanted) attention.

Update: My further reading leads me to believe that Magnetar was buying credit-default swaps against other slices of the CDO (larger slices than what it owned certainly), though not the entire CDO.