Classic Arbitrage or Theft?

The Wall Street Journal reports, you decide.

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.

So, if you say "this is all a sham that will fall apart as a piece," then this is a pretty obvious strategy. Buy the piece that everyone says will fail -- so you get the high returns when the music's playing -- and bet against the rest, so you make out when it stops.

It's so cynical and obvious, that you have to be inclined to believe there was real criminal intent behind it. We're sort of married to the narrative that employment in the financial sector makes you blind to economics truths, but this story rather belies that.

The interesting part is the statement that the deals couldn't get done without this action.

• We securitize mortgages
• Buying them is obviously a bad idea
• We 'put the risky bits aside'
• The badness of the idea of buying them is now obfuscated
• Hedge funds buy the risky bits and bet against the safe bits

All of the bits are based on infinitely inflating housing prices, so they're all bad bits.

• Hedge funds do well while the prices inflate
• Hedge funds do well when the prices collapse

Nice work if you can get it, which I guess is why getting it involves years of 16 hour days, advanced degrees from elite institutions -- Magnetar's founder Alec Litowitz apparently only has a Bachelor's, but it is from MIT -- and wealthy parents.