A Tale of Two Hedge

Funds:
Magnetar and Peloton

Case summary

Magnetars success
Pelotons failure
Housing boom & burst- Low interest rate, CDOs, rating agencies
Cov-lite corporate bank debt

Financial Crisis

Lowest Interest rate in forty years

Loose Lending Practices

Home loans were sold to major investment banks

Investment banks Securitized into CDOs and sold to investors.

Collateralized Debt Obligation

Securities backed by a pool of fixed income assets

Consists of CLOs, CBOs and RMBS

Provide liquidity as traded daily on secondary market

Pay slightly higher interest rate than corporate bonds

CDO is complex and costly process

Enables a bank to design loans to homeowners to make more loans as bank can sell
loan to third party principle agent problem

Bank can originate more loans and fees

Many CDOs became liquid due to size, investor breadth and rating agency coverage

Securitizatio
n process
took time

Reason of
Holding CDOs

Kept a
small
holdback
amount

Trading
divisions
made
markets in
the
security

LBO (Leveraged Buyout)

The acquisition of another company using a significant amount of borrowed

money (bonds or loans) to meet the cost of acquisition. Often, the assets of the
company being acquired are used as collateral for the loans in addition to the
assets of the acquiring company

The purpose of leveraged buyouts is to allow companies to make large

acquisitions without having to commit a lot of capital
Performed its own calculation of Risk for each tranche and compared that with
the return that the tranche offered

Role of credit rating agencies

Used historical data.

Believed that a nationwide housing downturn was unprecedented
CDOs were not present in significant numbers to scientifically analyse.
This cycle was different from previous cycles therefore historical data could
not be relied upon
Rating agencies allocated risk to different tranches based on collaterals
correlation with each other.
Uncorrelated- defaults will happen evenly asset diversification can solve the
problem
High correlation- non diversifiable risk reasonable likelihood of senior
tranche impairment.

Magnetar strategy

Equity and Mezzanine tranches of ABS CDOs had same risk but
very different yields

Both were related. Either both get paid or both not.

Magnetar capitalized on this by going long on Equity tranche and

taking short positions in Mezzanine tranche.

Trades were constructed in such a way that the cash inflow from
long positions in equity tranche were much higher than the cash
outflow due to short positions in Mezzanine tranche.

At the same time in case of a high default, the principal balance on

Mezzanine shorts would be much more than equity longs meaning
high payoffs even if the underlying collateral went south.

Their strategy would only lose money if the equity got wiped out
while the Mezzanine tranche stayed intact, the probability of which
was very less.

Peloton

Founded in 2005

Top performer in hedge funds in 2007

Became bankrupt after one month of getting two prestigious awards-at Black tie
euro hedge ceremony

Peloton Fall Strategy

Shorted the US housing market before subprime crisis and was profited

Misunderstood the subprime crisis

Went long for AAA-rated securities backed by Alt-A mortgage loans
UBS downgraded its Alt-A backed securities
Market went down leading to margin calls
No support from investors and banks due to conflicts in views

Leveraged Profit

The investors purchased the senior tranche of CDO yielding LIBOR +50 bps

By leveraging by 25x earned a return commensurate with equity tranche or

LIBOR +1250bps.

Bank Debt & Cov-lite Loans

Fueled by leveraged buyout boom

Corporate bank debt allowed companies to operate with no maintained leverage

or interest coverage ratio

LBO firms demanded loose terms

Lenders passed on the weak cov-lite loans

Investors analyzed at summary level

Bank Debt & Cov-lite Loans

Rating agencies gave false sense of security

Bank loan and leveraged securities prices fell

Investors believed that the default rates would hit higher level that in 1930s
and would stay there till maturity

Covenant - lite Loans

The current cov-lite loans were traded heavily

Was thought to have limited near term default as companies ran until cashless

The Cov-Lite were traded heavily as compared to Cov-heavy loans

The nominal coupons were less on cov-lite as compared to cov-heavy loans

Arbitrage Bank loans and Bonds

Yield on secured cov-lit bank loans and compare it with unsecured bonds of same
company

If yields are close, trading opportunity exist

More risk the company wider spread gets

Difference of recovery rate on various securities

Default rates were identical because issued by same company

Bank debt had pressure of selling as held in large by investors. Whereas, bonds did not

Thank You
Amrita Das
Ankit
Chokhani
Shreyansh Jain
Vivek S Nath