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Between May and December 2006, Magnetar Capital executed a massive "self-funding" bet against the housing market by sponsoring mezzanine asset-backed CDOs with a total deal balance of $26.1 billion, representing 39.0 percent of the entire mezzanine ABS-CDO market during that period. The hedge fund's strategy, which would later become known as "the Magnetar Trade," involved taking long positions in the highest-risk equity tranches of synthetic CDOs while simultaneously shorting safer mezzanine tranches through credit default swaps—effectively betting against the very securities it encouraged others to buy.
Magnetar's approach was particularly insidious: by agreeing to purchase or finance the toxic equity tranches that no one else wanted, the fund enabled banks to create new CDOs at precisely the moment when the housing market began to decline. The firm invested in approximately 30 CDOs from spring 2006 through summer 2007, with analysis showing these Magnetar-sponsored deals defaulted faster and at higher rates than comparable CDOs. By fall 2006, housing prices had already peaked, but Magnetar's assembly line continued producing CDOs it would bet against. JPMorgan alone brought in half a billion dollars in revenue in 2006 on synthetic CDOs, many involving Magnetar.
Investigations by NPR, Chicago Public Radio, and ProPublica revealed that Magnetar encouraged the creation of CDOs containing low-quality mortgages specifically so the fund could bet against them using credit default swaps, without disclosing these conflicted positions to investors purchasing the long side. The strategy required selecting the riskiest possible mortgage-backed securities to maximize returns when they failed. Despite SEC investigations into several Magnetar deals, no enforcement action was ever taken against the firm. This represents a clear case of Wall Street engineering systemic risk for private profit while regulators stood by—Magnetar made billions while expanding exposure to losses that devastated pension funds, insurance companies, and institutional investors who took the other side of their bets.