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Magnetar Says It Didn’t Help Banks With CDOs ‘Built to Fail’

Magnetar Capital LLC, the $7 billion hedge-fund firm that profited in 2007 from wagers that subprime-housing debt would tumble, told investors it didn’t help banks create mortgage-linked investments “built to fail.”

The firm offered limited input on the selection of securities in the deals and made bets that would pay off if they soured, as part of a “market neutral” portfolio designed to profit no matter what happened, according to a letter to clients yesterday from Evanston, Illinois-based Magnetar.

“There was no embedded view regarding the direction of housing prices, the rate of mortgage defaults or the subprime-mortgage market generally,” the firm said in the letter.

Bank of America Corp.’s Merrill Lynch unit, Citigroup Inc. and UBS AG are among at least nine banks that underwrote more than 20 collateralized debt obligations whose riskiest slices were bought by Magnetar, according to data compiled by Bloomberg. Those CDOs, named for constellations, totaled at least $32 billion.

Magnetar’s 11-page letter came in response to an April 9 article on the Web site of ProPublica, an independent, nonprofit investigative journalism project based in New York. The article suggested its CDOs were “built to fail,” according to Magnetar’s letter.

“The facts in our story should allow readers to reach their own conclusions,” ProPublica said in a statement to Bloomberg News. “We see nothing in the story to correct.”

Goldman Sachs Sued

The SEC sued Goldman Sachs Group Inc. for fraud on April 16, saying the bank improperly failed to disclose that New York-based Paulson & Co., a hedge-fund firm betting that subprime defaults would climb, had helped choose risky mortgage-based securities to be linked to a so-called synthetic CDO. Paulson then wagered the investment would collapse.

Paulson, which wasn’t accused by the SEC of any wrongdoing, said in a statement that ACA Management LLC chose the assets for Abacus 2007-AC1, as Goldman Sachs disclosed to investors. Paulson suggested some individual holdings, according to the SEC’s complaint. Goldman Sachs, based in New York, has said the SEC’s allegations are unfounded.

Magnetar said in its letter that it didn’t select specific securities to be included in its CDOs. Collateral managers for the firm’s CDOs included State Street Corp., Marsh & McLennan Cos.’s Putnam Investment Management LLC, GSC Partners and Harding Advisory LLC, Bloomberg data show.

John Nester, an SEC spokesman in Washington, and Steve Lipin, a spokesman for Magnetar, declined to comment.

Magnetar said in the letter it bought the riskiest piece of CDOs, known as the equity, which it expected to return 20 percent annually over six to eight years if mortgage defaults remained low. It also hedged those positions with bets against its CDOs and others at a cost of less than 6 percent annually, the firm said.

Use of Swaps

The credit-default swaps that the company used to make those bets represented on average no more than 7 percent of the collateral of its CDO, the letter said. The banks serving as underwriters would know whether its CDOs included those bets, the firm said.

The purchase of a CDO’s equity class is usually taken as “an expression of confidence in the structure,” said Thomas Adams, a partner at New York-based law firm Paykin Krieg & Adams LLP who worked in the CDO groups for two bond insurers. “It would definitively have been relevant” to other investors that Magnetar wasn’t simply making a bullish bet, Adams said in a telephone interview.

Although Magnetar said its portfolio was designed to make money no matter what happened to the value of subprime mortgages, its executives have expressed views on the market.

“Magnetar has been concerned about the excesses in the subprime-housing market since early 2006,” David Snyderman, Magnetar’s head of global fixed income, said in an interview with Bloomberg News in March 2007. “As a result, we have positioned our structured-credit portfolio such that we are profiting from the recent volatility.”

Magnetar was started in late 2005 by Alec Litowitz, who previously worked at Ken Griffin’s Citadel Investment Group LLC. He specialized in trading the stocks of merging companies. Snyderman also worked at Citadel before joining Magnetar.

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