How a Bullish Trade on Subprime CDOs Made Good Profits

From Merrill Lynch to Morgan Stanley, everybody who lost boatloads of money on subprime-backed CDOs seemed to be following the same big-picture strategy: they went short the riskiest, most junior tranches of the CDOs, and hedged their bets by buying the safe tranches.

If the short-junior long-senior trade was a money-loser, then one would expect that the long-junior short-senior trade would have been remarkably profitable. And today, the WSJ finds a fund which did just that: Magnetar Capital. Magnetar was instrumental in bringing a lot of these CDOs to market in the first place, because it was willing to buy the lowest-rated equity tranche. Counterintuitively, that bet paid off nicely:

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.

In other words, Magnetar was bullish on subprime CDOs, but still managed to make healthy returns when the market collapsed. Nice save!

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