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Magnetar's Investor Letter Denying CDO Improprieties

Magnetar's Investor Letter Denying CDO Improprieties

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Investor letter from Magnetar Capital, denying allegations that the hedge fund helped construct mortgage securities designed to fail in order to reap massive profits.
Investor letter from Magnetar Capital, denying allegations that the hedge fund helped construct mortgage securities designed to fail in order to reap massive profits.

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Published by: DealBook on Apr 20, 2010
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Magnetar Capital LLC 1603 Orrington Avenue 13~ Floor

Evanston, Illinois 60201

847.905 A400 847.905.5868 fax

April 19, 2010

Dear Magnetar Capital Investor:

We consistently strive to maintain clear and open channels of communication with our investors. In pursuit of this goal, we wanted to address the recent publicity regarding our Mortgage COO investment strategy, At the center of these stories is a blatantly false and misleading story written by Pro Publica, an online news outlet, regarding our Mortgage CDO investment strategy that was active from 2006 through 2007, Despite our best efforts to educate ProPublica's reporters about the specifics of Magnetar's Mortgage COO investment strategy as well as the general process and market circumstances regarding th~)structuring and issuance of COOs, Pro Publica simply got the story wrong,"'\

This letter is intended to address several of their inaccuracies,. provide you with a recap of the pertinent facts regarding 0 strategy. To that end, we have detailed herein much of th discussed with these reporters prior to publication of

ue~~;no rtg~ge \;:, Investment nform;:1tl1Jn that we had

Assuming that the reporters understood th rma.'iwe relayed, they chose to

disregard the key fundamental facts tha . fired r~k,our discussions and supporting

documentation, Pro Publica claims t .' \ inve§ted in COOs that were built to fail .


(and preferably to fail as quickl so"'as to maximize returns) in order to

capitalize on a fundamental. 'e,V$\ prime mortgage market was going to suffer

significant defaults. Sit"\~.e't\pu '" its article, ProPublica has been continuously

retelling its story r '11\ netarJ"s if it were fact. Ironically, there may very well be

other market par .,.e strategies are accurately described by the ProPublica

thesis. HO~jW;ifef}~l'!~2h make it true in our case,

, Ase;\';~xPIgtped tJt~he reporters, and have explained to you, our investors, consistently

sin the i;i;?'ffY'''p~"~t of 2006, our Mortgage CDO investment strategy was based on a

ma atlQ~1 statistical model. There was no embedded view regarding the direction of

housihg"p:¥Tces, the rate of mortgage defaults, or the subprime mortgage market generally, and, therefore, the strategy was designed to generate and maintain a market neutral portfolio over time, In its simplest form this strategy was a capital structure arbitrage, Our models simultaneously took into account all COO equity tranches in which Magnetar invested, together with appropriate levels of portfolio hedge positions, in a global framework and not on a deal-by-deal basis. Our portfolio construction was designed to make attractive returns over a long duration (an estimated average portfolio life of 6 to 8 years) if the housing and mortgage markets were healthy, but contained a prudent level of hedges to provide for the performance of the strategy in a continuum of scenarios in which the overall housing and mortgage markets might lose value, It was not a "bet" that any COO, any group of COOs, or the housing or mortgage markets as a whole would fail either in the short term or the long term.


We do not feel it is constructive, or in some cases even possible, to address all of the article's assertions and speculations, or the variations on ProPublica's theme that have been expressed by other media outlets. We realize that many of you are likely to get inquiries from your own investors and colleagues on this article and we wanted to ensure that you had the detailed information needed to answer these questions accurately. For many of you these points, and the graphs illustrating them, should be very familiar, as we have not varied in the description of our Mortgage COO investment strategy from its inception in early 2006.

Our Mortgage COO investment strategy was based on a market neutral statistical framework which specifically did not incorporate a fundamental view regarding the direction of the housing or subprime mortgage markets.

Magnetar's portfolio varied over time, but both the initial construction and subsequent modifications of the portfolio were at all times managed to be market neutral. The assertion that Magnetar built its investment portfolio with the hope and/or expectation that COOs would fail either in the short or long term, is simply inconsistent with the

construction of our portfolio.

As we stated earlier, Magnetar's strategy was in essence a capital tryctu. .'>This type of strategy is broadly employed in corporate credit nL .. ' s,"apd \1$ based on the

_,,;.2,:>" ~~~?.\ F.:;,_

relative value between differing components of a company,;:'s"c Jill strq~ture (in our case

the different tranches or classes of a COO), and on the)i.!-lpplY~!;le ;~g imtlalances which can be exhibited in the pricing of rated and non"rateMj~~he§},:Bt e~rly 2006 to late 2007,

there was a systematic relative value mispriq et.yv:;c'n tll~"~~quity tranches of Mortgage

COO structures, which offered approxi ,tl% et yields, and mezzanine debt

tranches of Mortgage COO structur ; tfit protection could be bought for

between 1% and 4% (depending ~.. e and COO). The facts detailed below

regarding Magnetar's exec, '511 ,,ftegy contradict Pro Publica's speculations.

Magnetar's investment s,tr 'asrtb.t ed on a desire to construct deals with "riskier

assets" so that we could!". ts thafiportions of [our] own deals would fail".


• From'ttITg',th~ strategy through to its conclusion, Magnetar believed that ,C'. tf~lio, including macro hedges, would be profitable independent of the o~{fhe housing and subprime mortgage markets. We clearly explained this

facti;:, ;"!the reasoning behind it, to Pro Publica. The graph below (Graphl)

. reptbsents the average portfolio payoff profile over time, and clearly demonstrates

ffi'£t the payoff profile in respect of COOs in which Magnetar invested was longbiased. Of particular note is the lower, darker line which represents the payoff profile of our long investments in these COOs plus only those hedges referencing tranches in these same COOs (that is, excluding the performance of hedges we purchased that related to transactions in which we had no long interest).



Magnetar's Portfolio - Mortgage COO Strategy Projected Payoff Profile

Graph 1

2.5 x

'] 2.0 x '0.

1'1:1 u '"CI

~ 1.5 x 1)1




c 1.G x 1)1




:1! 0.5 x

0.0 x

The sha(h~d area de~"tOtes !'e(i~nt fos-~ experience los of lCC6} for the tinded,.ir.g

-- Break"ven Point


50' zc




L05s Percentage on COO A5sets

Note: Due to considerable trading activity, the

is representative of the portfolio. .

• The expected retur .. ' the equity tranches of the CDOs in which

Magnetar investe'~\w stima to be approximately 20% per year if the housing

and mortgag!?!i;Jl1af~? . emained robust (and, accordingly, the underlying assets perfox:me .""~!Jj;:i~);iMSg e ar purchased hedges (out-of-the-money credit protection) on tJJ!~'se~j~:pOSWith an estimated cost of less than 3% per year. This is shown

~. "GPO He~ge Cbst" in the graph (Graph 2) below, Magnetar purchased additional hedg~s'iiiGJ;ri$'ait protection) referencing CDOs in which Magnetar had no equity . owi[ershiiJ interest, as a macro hedge to insure its overall portfolio was market '~~~'l!)ng(ftral and did not express a view on the direction of the market. The expense of

this additional hedge was again less than 3% per year. This amount is represented as "Macro Hedge Cost" in Graph 2 below.

• As you can see in the CDO Portfolio Analysis graph below (Graph 2), only a portion of the income created by our long CDO investment strategy was utilized to finance the cost of the hedges on the portfolio. Had our goal been to create a short bias in our portfolio, the hedge ratio should have been approximately 5 times greater just to arrive at a net carry of zero.



COO Portfolio Analysis

No-Loss Scenario


2 20.0%
- 17.5%
~ 15.0%
0 12.5%
to 10.0%
e 7.5%
.s 5.0%
2.5% • Long Irw;;stf"l'ent IRR Ii COO HedgE Cost,

All of this stands in stark contrast t strategy would only be profitable . scale, or that we had construpte"d a be barely sufficient to cg:ye~~tth~.,,§:ost clever self-funding mechat:11sntft

:::' ... ': ... : .....•. ':: ....• :..... '~\! .. ~~ .. ~;"., ". \~;t.

a's'set selection in CDOs in which it participated.

.",,,"c:,.,;:::-f"'."'J.iSby Pro Publica and others, that the Os 'i~ . ch Magnetar invested failed on a grand Qli():H~!"which the yield on the long positions would c'a'ltFying the hedges and was nothing more than a

Ma netar did"nots. .

g /:&":\!i0\:~lk"

~:"C'(/'-;'~", ~3~ W~!, '-.~~'

The,ci9utfiorsZ!g,[ the .. ~roPublica article have also asserted that Magnetar was in control of the

ass''': selec . "I1'(ofi'tne COOs, or at the very least pushed for the COO managers to include the

risl t a s in those deals. Magnetar at all times only acted as the equity investor, not as

the rna er of a transaction (the "Collateral Manager") or investment bank arranging the

transaction (the "Dealer"). As the equity investor, Magnetar often communicated with the Dealer and Collateral Manager during the transaction process. Magnetar, in its role as equity investor, did not select or have control over the assets that went into a COO. A closer look at the asset selection and marketing processes of a transaction highlights both the limitations of Magnetar's rights as an equity investor and the ultimate checks and balances the Collateral Manager and the Dealer had on the asset selection process.

The Dealer and a Collateral Manager would agree on the general terms of a proposed COO transaction. The Dealer and Manager would generally receive market feedback from potential investors including, most commonly, Super Senior buyers and equity investors (such as Magnetar) to assure that the general terms of the proposed deal would be marketable and, if possible, to secure "lead orders" for the transaction. Magnetar typically provided an equity purchase letter that unambiguously described the general terms upon which Magnetar would be willing to invest, including the requirement that assets would be selected and managed by the Collateral Manager. In the typical COO, over the 3-5 months following the initial agreement between the Dealer and the Collateral Manager, the



Collateral Manager would select assets and direct the Dealer to purchase and inventory the assets prior to the closing of the COO (the "warehouse" period).

The Collateral Managers relied upon their investment processes to choose the assets for the COO. The Dealer, in each case, had to affirmatively agree to each and every asset purchase during the period that the assets were warehoused prior to the closing of the COO and the issuance of securities. When the Dealer purchased an asset and put it in the warehouse, it took risk on its balance sheet. The Dealers' requirement to approve the inclusion of every asset in the portfolio prior to the closing of the COO was a protection established for the Dealer. It allowed the Dealer to review the quality of the assets to reduce the risk of including an asset that would cause a loss while it was on the Dealer's balance sheet. The process also allowed the Dealer to monitor the creation of a portfolio so that it would be attractive and acceptable to investors once the marketing phase commenced.

Once a substantial amount of assets had been purchased into the warehouse, the Dealer and the Collateral Manager started their marketing effort and presented the proposed transaction to potential qualified investors. Each potential investor (whether.a potential investor in the equity or the rated debt securities) had the opportunity tofullY~nalyze the portfolio, discuss particular assets with the Collateral Manager and chati'gl:tgej~y 9[;"the manager's selections before making an investment decision. If trrpr~!. wet~.:,~,ti·zin,iufff~ient number of qualified investors that chose to invest or subscribe):f6F deHt ort1~quit)rtranches of the COO, the Dealer would either be left with the unsold 'rlf~r~i~,ts in tfi~ CDO or all of the

underlying assets.<~) ",.


The process described above was followed c. which Magnetar was an equity investor,illt!1o might have been different. In particul t;,j'ffsH'qJ!

'h of the mortgage COOs in

he p . ss for other COOs in the market


.)11B~i{eting or distribution of CDO transactions.


• Qp ~~erage ., ....• r . s Magnetar's entire portfolio, less than 7% of the aggregate assets "6f' tli~§g CQ;~;s consisted of CDS where Magnetar held a hedge position in the same inst!3;uni~'ht. While there was significant variation among the COOs in which ". M~ghetar held equity, this number was derived from the following conservative

". 'm'~thodology:

o While Magnetar was an active purchaser of COO protection (hedge instruments), in all cases Magnetar's hedges and its long investments were transacted with a Dealer as counterparty.

o Because Magnetar's transactions were always with Dealers and never with COOs, we are unable to know with certainty how many of our protection instruments ultimately became assets of the various COOs in which Magnetar purchased equity.

o However, for purposes of the statement in the principal bullet above, we have assumed the most conservative possible outcome (that is, we assumed that all of Magnetar's protection instruments became assets of the various COO's in which we held equity, to the extent that the assets in the COOs' warehouses corresponded to the protection instruments held by Magnetar).



Magnetar's portfolio and structural preferences were expressed in a manner consistent with general market practices.

ProPublica asserted that Magnetar requested higher spread collateral in the COOs in which it purchased equity, for the purpose of increasing the likelihood that a "bet against" the deals in which Magnetar was an equity investor would become profitable due to the failure of the deal. They posted the email discussed below as support for their assertion,

However, the context of that email actually shows that Magnetar's intentions were to increase the attractiveness of a potential "long" investment in that deal, by bringing the deal in line with then-current market norms. The COOs of the type in which Magnetar purchased equity interests were specifically synthetic Subprime Mezzanine COOs. The market rate of return that was typically expected by equity purchasers of these COOs at that time was in the range of "mid teens" to "low twenties" depending on the deal. Magnetar's COO transactions were conducted within this range of expected returns - they were market

transactions. "

~} In order to achieve these market rates of return and actually close.;¥[~'~ive to potential purchasers of COO equity, the portfolio of assets ying the, 0 required a certain level of yield. As we noted above, there would I¥ihbe on:~.olhg interactions between potential investors (including Magnetar), theD'j, . and ''to,e COO Manager during the warehouse period. This was part of the pro.£§ss '.". . .".wl the 'ii1vestors would satisfy their diligence requirements and assure theI11t"··es,.th~., th~'t(ibOs assets would have the

appropriate characteristics for a transact] .. ~ !:f.Ype.·(~>.

Pro Publica has asserted that Magne..ta ' .•. she,. ecific assets to go into specific COOs, It published the email referen ,F'<3.bo·~~\ilt~.slBi¥ned that the email supported this assertion,

However, Pro Publica int~n y fa'll:l:!d'ttrpublish the accompanying attachment to that

email, which we prqvid ,y, , that'made it clear that Magnetar's sole interest was in

achieving a portfoC;:::;'Q.t n broad characteristics. The email did not mention or

suggest indi¥iHt¥alvi\~s;.,lie full email and its attachment are included as Appendix A The followij" facts'~reip;;lrticularly noteworthy:

"i"~ ,

"iFf!~lates to a transaction that was proposed but never completed.

ginally, the Collateral Manager proposed an overall portfolio weighted average spread (WAS) of between 101 and 136 basis points which was well below the typical market levels for subprime mezzanine COOs. Magnetar estimated the proposed transaction would produce returns on its equity investment of between 1 % and 7% if the portfolio suffered no losses. This transaction was, therefore, not attractive either on an absolute basis or in comparison to similar transactions in the marketplace at the time. Accordingly, Magnetar responded and requested a "higher spread" portfolio that could earn the equity holder market level returns, commensurate with the perceived risk and more comparable to other similar transactions in the marketplace.

• As you can see from the attachment at Appendix A, Magnetar's response proposed a different sector composition with wider asset spreads. Magnetar's behavior was consistent with a rational equity investor's interests and with a process which was standard not just in the COO market, but in investing generally.



• The same Collateral Manager subsequently executed a COO with Bear Stearns in December 2006 which had a minimum spread requirement of 188bps. This transaction was initiated shortly after the email discussed above was written, and was completed at spreads approximately 10% wider and with a weighted average rating factor (or WARF) 7% higher (and implying a need for commensurately "riskier" assets) than what Magnetar had proposed in its email. Magnetar was not an equity investor in that subsequent transaction.

• As has been discussed with many of you in the past, the "triggerless" equity structure that Magnetar preferred for its long investments required a significantly larger initial equity tranche investment, increasing the required long investment by at least 50 percent for a given CDO portfolio. If Magnetar had a fundamental short view, with an expectation that the equity would be written off, it would have been irrational to purchase equity in a triggerless COO instead of taking that extra 50 percent investment and using it to buy additional credit protection. Even the argument suggested by Pro Publica and others, that our longs were funding our shorts, would not require us to acquire (and risk) anywhere near the amount of CDO equity that our portfolio held relative to its hedges.'!'

We hope that the above provides you with more detail to clearly UD9~t;§tan,,)jff9.

<'!""'''\ .. ,.'"'.,,.',

actions in the marketplace. And we further hope that haVin&.rj¢,,~wedi,:~p o,~,the facts, you

will be able to state with confidence to anyone who asks, that Mag z. tar's'$trategy did not engage in the "Magnetar Trade" as coined by the medi~:h."\A1.:': nota icipate commenting

on additional media stories, as our priorities rem.e.in f(r~M~e .. anaging our investor

capital.·<DY'·' .


Magnetar has been built on "best'xg$t'itent processes and the business, operational and legal infrastru~lu·ft¢ quire ;}TIpport them. We remain committed to serving you in our capacity9.s!;~'t~w~'~I1S\&(Y:9'Ur invested capital. We truly appreciate your

continued trust in and s' agri~tar: '



Appendix A

4. ,_~r --.0 ,/ .. ,

..J.,,:: ~~')~~': ~~ ~I~.(I .

'i'~~\l ::':I;"'i f~-r-,-,~r:l 1-1.' z.n

(,~.1:~ C'1l:~l ~;'J(i (~~t~~J=~( f~~;' .. ,,:

;:\,:: :';"';-1:: : t"'~(' \-'p

Pti~Oc Mn:~ ;.,_'>dre"S:::w,

Had a !ong discuseren \~~UI D3:1(: Sr;yd.:lrmll.1I ',\'il fuel 'St!Oag~y that th;, arb \·,'{Ir't support h:9h.':)r Ices. AIE:o m:mag ... r rees are -:Nl:Lng do.m each d .. :_;;:j \\,;!'W don" has eeen st r:mg'ilSSf',,!Iy j",\,(,f lees :md ~:-'" believe tlus tro .. d \\i~1 ~Qrll:llu(l

Alllh:ll b~lng ::~Id I C::'11 do lO~p seruor 2_5bp !ll::.J and 2.o~~ 01 (!),;CB!:!l cash !II),N ::II!-Ell [1Ir.-:ut~II/i3 {).quily 1-6% lim Our gC:l.1 ss 10 P::Ir!flf'[ >\1!~ m:>:II:1gllls sue de ::c S{>Flf'S of d .. als there we 1'.'10 lII:<n3gI!I" ,11Ih. \\hom sO il.rii ~Irl!~(j~' en our llurd dEl;"t~ E.:J:,d lic-CI .... lOS~ '\!~':IH:I~ Ir~!.:<ld of these '.\':1S (10M 3; 10 scmor oll~y plus rrK(lrlllvilj. ~ U"t~r'd.:. H~.:.- C:,lmh!::Iti\'<: busmes s \',"iH be \\~"'Ith·:.hdil even If you l>:lilllh-a fle:'l d(:,,11S 100 5~Cj1r_Y

fron~: Ao("tie_'~ S!rO(l~

Sent; Ft~di;l.y. september 0(1. 2{l~·6 .q:~{) P .... ~ To: pn.Jsko, James


jI.pple(;~~~(I VO"f ccnstderatlon of our P05.IIIQIt hope we c;'tn work :;'-0111(:111100 cut nn eround uus i·,t-(o~('nd 10 .j~S~U5S

1~~g3:d!i. Jim

lhatlk!S ,,!,S

: Do !,Ol.l h:J.'11: ume 10 do a ca!l nus anemoon?

Andrew P. SbOIl"K

P( ... ssuent ('. Ctli"~ IH~il~lm~ml cm~~c l~Vtu~ C",j.ii~31'.I;~nJ~emoJn!.lLC 71:2 6th ;wC. 10111 ;CIOO'

nG"w yO'~. N~' IM19

.~II.1ch~d plu~~ find :i~.;. draft of the ~11g.3f.,mw~ .. leuer I'~rth~

: uansaction u 1\"~11 as {ii)tlu term sheet pll'\"i(lll!ly ".!l% .. ed te by )'h91~I:n

"nd 1 !~hU! and (in) the s .. ru~turinl\l~mh~ for tbe transaction ; previeuslv !h:n("..:i \·.~lh lUp311;~~. \\"e J;t"H ',',llh Jim. that this

: trans action needs to happen Ihil vear and -re loll!" (.pfl:l:lln~ [1]\ that

. .HJWllplif;ln. ! wccid 11IQPO~<! that -ve have i (-.)11 \\llh Lchus "'ml.~IJj:~,ml",1 ~ IOmort(l.t\·:m()m:ng:it 10 ...... \1 to talk duough a jccpcsed tuncline and we '.~ill : then gml"L~l~ a detailed ume and l-t!pon!ii:iliIY to-In~U1c Ih~t WI!: can meet

our ~O;l~ (l.fcoml?l~~irLg the transacucn Illll vear



~";DH ~:lr,~~-d~-:·:~,'; 1;~:~~ ! ~,.~,:,,_ .~'~d; ;::r~'i,~,l :h, ~';'il;~1 ,~;,;~ rn

I ~~,i,c~ -.:~1;,~(.!~,_.tI !n:..;~ ! ... ould ::k~' ;~::$ d2;-d w.ti. !;I~:'J'-'t

::::c'::.tc.-:j.' 10 c!H)":O:{' 11"\',,: m :. s:<·;i!I:(·~lY

,,', v ~·,r~~i;M: E:"'r~ir,t "ikll :;.~ i_(;:[:'>2 _\(;,:;~; 1101 d ,~:I ;:1 :;~I! \J.JH\"!\ 1T:;,,;~','1 C, h!:! ~;;\' i_Hl,<~li::: ::,~

From; Proske, lame-s ._. _

Sent: Friday, September 29. 2006 7:12 :p~.,

l~O~' ;~~;:=:::::;~:::=::::::::::::,~~g'H).(Jmj

cc. Andr!;w StlQok -J,·::;gc.ib,(om]; ". __ "._. '~;l)Cib,comJ~


Subjed~ RE: Oea1 status

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Of ccmse. the actual secucty eelecucn rs totally vour purvrev .. I just wante-d to make sure- the overall portfolio chataclenstics worked for our strll\"'gy l took forward ~ 0 50! (lrli~g ngll1 .%''''Y

Thanks for ~\'Oj~:1/l9 11m .. thts wnh me


from; Andrew Sho~k_""'''I1111''._ •• _ Sent: Tues-day, October 03, 20005 5:33 PN

10; iP.ru.>kii·Oii' J.aii"'jj"_._ ••• _. __

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Subject: SP:f€'?".j l;:Yt2'J5

Sony for the delav . I howe been slammed all dav t [ust rar1g and rolled Into vorce mail.

vse performec much analysts reg:1;rd~ng execuncu. We have a comfort level sunoundinq the 160 \NAS t~rg.el. ThM said. I want to make sura Wi;] aH l~l1derstal1d and are comrcrtcble with tho Resource America'lschas philosophy

Simpty put, lschus \~il! I)uy credits. nOI spreads. Relatrvc ·Jr.t~ua-7 YOS- ~"",~III w.(l tako a v~O\v? Yes Bul we ' .... ill 1101 <lssI,}mb!o a portfolio we are not proud of and tee! stronqly abcutm t~10 name 01 a spread tarqer.

11 we arc ,,-II in aqreement on this W~ should push ahead 100% If not. we should rethink the hade

We are lei\dy 10 w!l if you are.

Reqards Aps

Andrew p, Shook 1"-cJ~t"'t:.-'1~ ':0

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