According to bankers and others involved, the Magnetar Trade worked this way: The hedge fund bought the riskiest portion of a kind of securities known as collateralized debt obligations -- CDOs. If housing prices kept rising, this would provide a solid return for many years. But that's not what hedge funds are after. They want outsized gains, the sooner the better, and Magnetar set itself up for a huge win: It placed bets that portions of its own deals would fail.In short, investment banks needed equity investors to create new CDOs. Magnetar volunteered and then allegedly used its clout as investor to push the CDO managers into toxifying the securities in the structure so that it would fail. Magnetar wanted it to fail, despite owning the equity, because that loss would be made up many times over by the payout on the credit-default swaps (which essentially insure against default) that it had taken out on the crappified CDOs with earnings from the equity. As long as the CDOs paid out, Magnetar could buy the swaps. When the CDO failed, the swaps would give the big payday. It was magic, nearly miraculous -- kind of like magnets themselves. ("Fucking Magnetar, how do you work?")
Along the way, it did something to enhance the chances of that happening, according to several people with direct knowledge of the deals. They say Magnetar pressed to include riskier assets in their CDOs that would make the investments more vulnerable to failure.
Along with some useful elucidation, James Kwak explains the significance of this Magnetar business in a post aptly titled "The Cover Up":
The lessons of Magnetar are the basic lessons of the financial crisis. Unregulated financial markets do not necessarily provide efficient prices or the optimal allocation of capital. The winners are not necessarily those who provide the most benefit to their clients or to society, but those who figure out how to exploit the rules of the game to their advantage. The crisis happened because the banks wanted unregulated financial markets and went out and got them -- only it turned out they were not as smart as they thought they were and blew themselves up. It was not an innocent accident.As Bernstein and Eisinger explain, "From what we've learned, there was nothing illegal in what Magnetar did; it was playing by the rules in place at the time." Obviously these "rules" are useless if they provide no safeguard against systematic abuses and unsustainable banking practices and apparently rampant rating-agency laxity. The whole point of having rules governing the financial sector, after all, is to allow it to function for the common good of the economy -- so that it can match savings with worthwhile investments like the apologists say it does. But instead we had legislation undoing Glass Steagall and forbidding regulation of derivatives, etc. -- establishing rules that made it seem as though the function of a financial system was to guarantee that bankers could make lots of money no matter what happened to the economy at large.
As for what to do about it now, Mike Konczal's useful paper (pdf) about the current state of financial reform is a start.