Magnetar and J.P. Morgan's Squared CDO

Note: Black Box Casino is to be published September 30 by Praeger. In writing this account of the financial crisis, the author found that ultimately some of what he had written had to be cut from the book. Below is an excerpt that was written too late to make it into Chapter 7: "Fast Money and High Stakes."

By Robert Stowe England
July 20, 2011

The Evanston, Illinois hedge fund Magnetar Capital LLC stated in April 2010 that it engaged in trading activities that its senior management claimed were neutral towards the housing market.

That is, Magnetar claimed that they were making simultaneous shorts and longs on various pieces of collateralized debt obligations, which were backed by mostly subprime mortgage-backed securities.

The point being made with the claim of neutrality was they were not betting against the housing market and bad subprime loans and securities.

After a number of news stories surfaced in 2010 about the $50 billion or more in losses from CDOs deals in which Magnetar took positions, the claim of neutrality became a public defense against any potential claims Magnetar had influenced the selection of collateral in CDO deals in a way that would provide the hedge fund with performance bet opportunities; that is, CDO tranches against which it could place high stakes bets and reap rewards when they failed.

Slowly information is emerging, however, that on many deals, the claim of neutrality does not withstand close scrutiny.

On June 21, 2011, JPMorgan Chase settled with the Securities and Exchange Commission over charges it had committed fraud by putting together a deal -- CDO Squared in 2007 -- that lead to enormous losses for investors -- a deal that also boomeranged on the firm.

Magnetar executed a correlation trade with CDO Squared as it had with other of its investments, such as the notorious Norma CDO from Merrill Lynch.

Squared was a CDO made up of other CDOs. The SEC settlement with JPMorgan Chase just also happened to reveal that in that deal Magnetar’s long position on the equity tranche was $8.9 million and its short position on mezzanine tranches was $604 million.

There's hardly any way of looking at positions Magnetar took on the Squared CDO and not conclude it was a $604 million bet against subprime mortgages.

The question is whether or not Magnetar played a role in selecting the assets in the deal in way that would assure it reaped a bonanza.

According to the SEC, an e-mail from an employee at Magnetar on January 29, 2007, described the hedge fund’s equity or long position as “basically nothing” and explained that Magnetar was “was just doing it . . . to buy some protection.”

The SEC obtained a series of communications that showed Magnetar played a role in selecting 33 of the 65 CDOs in Squared – all the ones the hedge fund bet against.

The Squared CDO defaulted in January 2008, eight months after it closed in May 2007, costing J. P. Morgan $880 million in losses from the super senior tranches it held in the deal, according to the SEC. When the deal was arranged J. P. Morgan earned $18.6 million on the deal.

The collateral manager for Squared, an independent firm selected by J. P. Morgan to choose assets in the deal, was GSC Group of Florham Park, New Jersey. The SEC has alleged that Edward Steffelin, head of the team at GSC that selected the collateral assets, “permitted Magnetar to participate in the selection of assets knowing it planned to short those assets.”

The investors who bought the mezzanine tranches of Squared knew nothing of Magnetar’s role.

The U.S. investors included Thrivent Financial for Lutherans in Minneapolis and Security Benefit Corporation in Topeka, Kansas. In East Asia, investors in Squared included Tokyo Star Bank, Far Glory Life Insurance Company Ltd., Taiwan Life Insurance Company Ltd., and East Asia Asset Management Ltd.

The deal was a tough sale for J. P. Morgan’s world wide sales staff. The employee in charge of global distribution for the tranches in the deal wrote to the sales team on March 22, 2007, that “we are soooo pregnant with this deal, we need a wheel-barrel (sic) to move around….Let’s schedule the cesarian (sic), please!” The sales team failed to disclose that Magnetar played a role in asset selection and was betting against the deal.

Steffelin was charged with securities fraud by the SEC on June 21, 2011, for failing to disclose Magnetar’s role. Steffelin’s lawyer Alex Lipman claimed it was a “real reach” for the SEC to charge Steffelin when it was J. P. Morgan that failed to disclose Magnetar’s involvement in the deal to the investors. Even so, while the deal was being put together, Steffelin sought employment with Magnetar, further cementing the appearance of collaboration in selecting assets for Squared.

Key players in the Squared fiasco escaped any fines or punishment. Michael Llodra, who headed the asset-backed CDO team at J.P. Morgan at the time of the deal, was not charged by the SEC. Neither were any high level executives at J. P. Morgan.

J.P. Morgan, without admitting or denying any wrongdoing, paid $153.6 million to settle charges it had misled investors.


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