The Assignment

The Assignment offers you the opportunity to demonstrate your mastery of certain aspects of Investment Banking. Specifically, you are invited to apply the knowledge and skills developed in class to analyse news archives of the leading financial newspapers and financial commentaries related to ‘trading'.

The focus of this Assignment is on trading strategies with the structured products such as Collateralised Debt Obligations (CDO) and Credit Default Swaps (CDS). Although the story (see Reading List below) centred on two hedge funds - Magnetar and Peloton - no in-depth knowledge of hedge funds is required to successfully complete the assignment. You only need to know, as discussed in the Lectures, that hedge funds have maximum flexibility in implementing strategies they chose to use yet can operate under minimum regulation. The trading strategies deployed by these two hedge funds led to their eventual success (for Magnetar) and demise (for Peloton).

Reading List

The Assignment requires your response to the four questions set out below under ‘Assignment Questions". Begin by reading the case study "A Tale of Two Hedge Funds: Magnetar and Peloton" in our text book by David Stowell. Details are given in [S2013] below.

To gain a wider perspective on the issues, you should also read the news archives and financial commentaries in the reading list below. Links to these are in the ‘Individual Assignment" folder on UTSOnline.

1. [S2013] "A Tale of Two Hedge Funds: Magnetar and Peloton" in "Investment Banks, Hedge Funds, and Private Equity" by David Stowell, pages. 513-530.
2. [EB2010] Eisinger, J., Bernstein, J., "The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going." ProPublica. April 9, 2010. (This article has won the 2011 Pulitzer Prize in National Reporting)
3. [NM2008] Ng, S., Mollenkamp, C., "A Fund Behind Astronomical Losses." Wall Street Journal, January 14, 2008
4. [M2013] Mahlmann, T. "Hedge Funds, CDOs, and the Financial Crisis: An Empirical Investigation of "Magnetar Trade", Journal of Banking & Finance (37), pages 537-548, 2013
(Note: You only need to use Figure 3 and the descriptions of Magnetar strategy on page 540 of this paper for the assignment)
5. [E2008] "Peloton runs out of road" Economist, Febuary 29th 2008.
6. [BMZ2008] Bryan-Low, C., Mollenkamp, C., Zuckerman, G. "Peloton Flew High, Fell Fast", Wall Street Journal, May 12th 2008
7. [Z2008] Zuckerman, G., "Trader Made Billions on Subprime", Wall Street Journal, January 15th,
2008

Assignment Questions

Question 1. In your own words, describe the process of securitization. You may use Lecture Notes and our textbook as references. The points below should be useful; the specifications in Parts (a) to
(d) are intended to help you organise your description and place your description in context.

a. What are the roles of the originator and investment banks in securitization?

b. Describe the role of the credit rating agencies in securitization.

c. In securitization, how can the originator finance via the structured products with credit ratings higher than its own?

d. Explain the "waterfall cash flow" structure of CDO. Discuss also the risk/return and liquidity aspects in this waterfall cash flow structure.

Question 2. Discuss the CDO strategy deployed by Magnetar during 2007.

a. Figure 3 in [M2013] illustrates the so-called "Magnetar trade". How did Magnetar use the Credit Default Swap (CDS) protection in the trade? In your own words, explain each scenario in Figure 3. On page 517 of our textbook [S2013], why did David Stowell say "The strategy would only lose money if the equity got wiped out while the mezzanine tranche stayed intact"?

b. In [NM2008], why did the authors say "Mortgage analysts note that Magnetar's trading strategy wasn't all luck - it would have benefited whether subprime market held up or collapsed."? Use your answer in part a) to illustrate the concept of relative trade.

c. In [EB2010], authors criticized Magnetar for "building CDOs to fail". What are their major criticisms? How did the Investment Banks get involved in the Magnetar trade? You may use your answer in part a) as illustration.

Question 3. Discuss the trading strategy of Peloton.

a. Using [E2008] and [BMZ2008], describe the directional trade deployed by Peloton. How was Peloton's directional trade in 2007 different from its strategy in early 2008?

b. In comparison with [Z2008], how was it different from John Paulson's strategy? More specifically, how did John Paulson benefit from the use of CDS protection?

c. In [BMZ2008], why did Ron Beller, the chief of Peloton say "Peloton failed not because it made the wrong investments but because his bankers didn't stick with him when the prices of those investments were temporarily out of whack"? Use your knowledge on margin call from the Lectures to explain the liquidity crisis faced by Peloton. What role did UBS play in this case?

Note: Answers to Question 2 and Question 3 should also comment on the shift in Peloton's strategy between 2007 and 2008 and analyse the difference between Peloton's and Magnetar's strategies. What were the implications of these differences?

Question 4. Answer the following questions on the global financial crisis (2007-2008):

a. How did the process of securitization play a critical part in causing the global financial crisis (2007-2008)? What led to the proliferations of these structured products?

b. Describe the principal-agent problems that existed in the mortgage securitization market that led to the global financial crisis. In particular, explain the principal-agent problems among the key players in the process of securitizations. How did the hedge funds contribute to these principle-agent problems? You may use your answers in Questions 2 and 3 for illustration.

c. Revisiting each of the divisions/business areas of an investment bank individually, describe the impact of the global financial crisis (2007-2008) on each of these divisions/business areas individually.