Magnetar Hedge Fund Strategy

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Risk: Counterparty Risk where CDS seller are unable to finance the CDS buyer in an event of default.

Hedge Fund Strategy 2: Directional Bet

This strategy aims to take a bet on the market direction by taking a position. If the bet is correct, they will earn more profits. If the bet is wrong, lose more money.

Risk: Highly dependent on the market as compared to relative bet.

Financial Crisis 2007 to 2008: Subprime Mortgage crisis

- The subprime crisis occurs due to the innovation of CDOs. Compensation for banks originating the loans are now based on the number of deals done, not how the loans will perform over time. Hence, lending from banks become loose as they are able to securitize their loans and transfer most of the risk to someone else.

- CDOs investors do not understand what they are buying, given that a CDO can be made up of thousands of loans, hence they are largely dependent on rating agencies.

- Rating agency do not have enough history model to rate such new and complicated history models.

- Low interest rates encourage more borrowing for housing.

Similar to housing bubble, the corporate bank debt market has spawned lending practices that are similar to CDOs, called Collateralized Loans Obligations (CLO). Loose lending terms from Cov-lite bonds occur (allowed companies to borrow with less covenants) as they can be sold to third parties.

Hedge fund take opportunity by using relative bet, by betting on the difference in recovery rates among various securities. E.g compare the yields of cov-lite bank loans and unsecured loans of the company, if yields are similar, long debt/short bonds are bank debt will typically recover more than bonds in bankruptcy.