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FINANCIAL CRISIS INQUIRY COMMISSION REPORT
they could make some money as long as the CDOs performed, but they stood to
make more money if the entire market crashed. An FCIC survey of more than
hedge funds encompassing over . trillion in assets as of early found this to
be a common strategy among medium-size hedge funds: of all the CDOs issued in
the second half of , more than half of the equity tranches were purchased by
hedge funds that also shorted other tranches. The same approach was being used in
the mortgage-backed securities market as well. The FCIC’s survey found that by June
, the largest hedge funds held billion in equity and other lower-rated
tranches of mortgage-backed securities. These were more than offset by billion
in short positions.
These types of trades changed the structured finance market. Investors in the equity
and most junior tranches of CDOs and mortgage-backed securities traditionally had
the greatest incentive to monitor the credit risk of an underlying portfolio. With the ad-
vent of credit default swaps, it was no longer clear who—if anyone—had that incentive.
For one example, consider Merrill Lynch’s . billion Norma CDO, issued in
. The equity investor, Magnetar Capital, a hedge fund, was executing a common
strategy known as the correlation trade—it bought the equity tranche while shorting
other tranches in Norma and other CDOs. According to court documents, Magnetar
was also involved in selecting assets for Norma. Magnetar received . million re-
lated to this transaction and NIR Capital Management, the CDO manager, was paid a
fee of , plus additional fees. Magnetar’s counsel told the FCIC that the .
million was a discount in the form of a rebate on the price of the equity tranche and
other long positions purchased by Magnetar and not a payment received in return for
good or services. Court documents indicate that Magnetar was involved in select-
ing collateral, and that NIR abdicated its asset selection duties to Magnetar with Mer-
rill’s knowledge. In addition, they show that when one Merrill employee learned that
Magnetar had executed approximately million in trades for Norma without
NIR’s apparent involvement or knowledge, she emailed colleagues, “Dumb question.
Is Magnetar allowed to trade for NIR?” Merrill failed to disclose that Magnetar was
paid . million or that Magnetar was selecting collateral when it also had a short
position that would benefit from losses.
The counsel for Merrill’s new owner, Bank of America, explained to the FCIC that
it was a common industry practice for “the equity investor in a CDO, which had
the riskiest investment, to have input during the collateral selection process[;] . . .
however, the collateral manager made the ultimate decisions regarding portfolio
composition.” The letter did not specifically mention the Norma CDO. Bank of
America failed to produce documents related to this issue requested by the FCIC.
Federal regulators have identified abuses that involved short investors influencing
the choice of the instruments inside synthetic CDOs. In April , the SEC charged
Goldman Sachs with fraud for telling investors that an independent CDO manager,
ACA Management, had picked the underlying assets in a CDO when in fact a short
investor, the Paulson & Co. hedge fund, had played a “significant role” in the selec-
tion. The SEC alleged that those misrepresentations were in Goldman’s marketing
materials for Abacus -AC, one of Goldman’s Abacus deals. 
