I’m a regular listener of This American Life, a weekly radio show hosted by Ira Glass from Public Radio International. Each week they offer incredibly interesting stories about…well…pretty much anything. The thing that ties all their stories together is their uncanny ability to draw you into the situation and make you understand what’s happening; even when it comes to complicated topics.
Last week they featured a story about a hedge fund called Magnatar, who they claim not only saw the mortgage meltdown coming, but were able to figure out a way to profit from it on a pretty incredible scale. It’s worth mentioning that Magnatar denies the claim in this story that they intentionally set out to profit from the subprime mortgage collapse.
According to the story, Act One of the show entitled “Inside Job,” Magnatar sponsored the creation of complicated and, ultimately, toxic financial securities backed by low quality mortgages, which they then bought insurance against so that when those securities became worthless, the insurance would pay out big.
At first glance, this is a fairly typical investment strategy called “hedging,” in which a company purchases one set of securities as a primary investment and then purchases a second set of securities that will pay out if that first set drops in value. In this way, the second set of securities essentially becomes insurance against a drop in value of the first set.
The interesting aspect of this story, and the reason it posits that Magnatar was actually betting on the collapse of the subprime mortgage market is that Magnatar was able to work out deals in which the insurance would actually pay out significantly more if the primary investment failed than the primary investment cost to begin with. Not only that, but the reporters suggest that Magnatar intentionally pushed for low quality assets to be bundled into the primary set of securities, expecting them to fail so that they could collect on the much larger insurance payout.
To better understand the concept of hedging, consider this example. Let’s say you thought Gold prices were going to go up over the next year and so you decide to invest in Gold. However, just in case some event occurs that causes Gold prices to crash, you decide to also invest in the U.S. Dollar, knowing that when Gold prices go down, the value of the U.S. Dollar tends to go up. This way, if Gold prices do go up as you expected, you’ll reap the rewards of your investment in Gold, but if Gold prices fall catastrophically, your investment in the U.S. Dollar will likely increase in value, preventing you from losing all your money.
You can listen to Act 1 of the radio show online at This American Life’s website.
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