Yves Smith has a piece at naked capitalism related to the extended Pro Publica (http://www.propublica.org/special/the-timeline-of-magnetars-deals) report by Jake Bernstein, Jesse Eisinger, and Krista Kjellman Schmidt that describes how hedgies manipulated subprime CDOs:

“Magnetar

1) A neutron star with an intense magnetic field, capable of emitting toxic radiation across galaxies
2) A hedge fund, the single market player most responsible for the severity of the 2008 financial crisis, through the toxic instruments it created

(Lila: Yes, People simply don’t get this. Fundamentally the subprime bubble was destined to deflate, but the way it collapsed was NOT endogenous. It was abrupt, savage, and bore all the earmarks of having been orchestrated as a “take-down” of the kind that anyone watching the gold market would immediately recognize)

Rahm Emanuel

1) White House Chief of Staff
2) Politician selected by Magnetar’s CEO to be sole recipient of his political donations, 2006-2008

Strange as it may seem, nearly three years after the onset of the global financial crisis, its greatest, most destructive, and most profitable “it ought to have been a crime” has gone almost entirely unnoticed.

Most people believe that they understand the broad outlines of the financial crisis, and that a central element was an explosion in mortgages made to people who could not afford them.

But how did such destructive behavior occur on such a large scale? The conventional view is that the subprime mortgage blowup resulted from bank executives being short-sighted, greedy, or both.

But that simple story deters inquiry into how and why this disaster came to pass. Some recognize that the appetite for subprime mortgages seemed to come from investors. In fact, it resulted in a large degree from the way traders at certain large banks used subprime mortgages in a strategy to make their profits seem much larger than they actually were. The effect of this “negative basis trade” strategy was to overpay employees of those banks and consequently eviscerate the banks’ abilities to withstand future economic uncertainty.

The appetite for subprime mortgages was also inflated by people who were betting that the housing market would fail.

Moreover, the devastation wrought by this strategy remains virtually a secret. The fact that it has been almost invisible and appears to have been entirely legal, demonstrates a set of vexing problems. First, that investigations of the crisis have not delved deeply enough, and second, that the deregulation so keenly sought by the financial services industry has made activities legal that by any common-sense standard should be criminal.

But the sponsors of this toxic trade did bother to make sure they had a powerful friend. The head of the firm in question gave substantial amounts of money by political contribution standards to Rahm Emanuel’s PACs, and only his PACs, over the period when these transactions were in play.

The moving force behind a brilliant and devastating subprime short strategy was a heretofore unknown Chicago hedge fund, Magnetar, headed by Alec Litowitz, formerly of the hedge fund behemoth Citadel. Our studies indicate that Magnetar alone accounted for between 35% and 60% of demand for subprime mortgages in the year 2006.

This is how their strategy worked in detail.

The ruse at the heart of their transactions was creating subprime (so called “mezz” or mezzanine) collateralized debt obligations by investing in the riskiest layer, the so-called equity tranche. This kind of CDO consisted almost entirely of not just any subprime risk, but that of the dodgiest layer that could be sold short, the BBB tranches, via a combination of actual bonds and credit default swaps.

But Magnetar’s true objective was not to invest in this toxic waste, which its role as funder of the CDO would lead most to believe. While Magnetar paid roughly 5% of the total deal value for its equity stake, it took a much bigger short position by acting as a protection buyer on some of the credit default swaps created by these same CDOs. This insurance in turn was artificially cheap because over 80% of the deal was rated AAA. Most investors did not understand what Magnetar recognized: this concentrated exposure to the very riskiest type of bond associated with risky mortgage borrowers, each of these CDOs was a binary bet. It would either work out (in which case Magnetar would still show a thin profit) or it would fail completely, giving Magnetar an enormous profit and wiping out even the AAA investors who mistakenly believed they were protected by having other investors sit below them and take losses first. Thus the AAA investors were only earning AAA returns for BBB risk.

As the equity investor, Magnetar could further stack the deck in its favor through the influence it gained over the deals’ parameters. It was able to ensure that the CDOs held particularly dubious BBB exposures, and pushed for, and often got, “triggerless” structures, which stripped away another protection most deals had. When CDOs start to show significant losses, the payments to the lower-tier investors, including the equity tranche, are cut or halted to defend the AAA layer, much the way the human body, when exposed to severe cold, will restrict blood flow from the extremities to save the brain and organs. But triggerless deals, even as they started to fail, kept paying the lower tranche holders, including, in this case, Magnetar itself.”