It could also invest large sums of money to work while having little effect on market prices, undertaking little risk, and locking in returns that were nearly certain, a dream trade for hedge funds. Magnet observed that the equity and mezzanine trenches Of ABS Cod’s had Very different yields and therefore capitalized by buying CDC protection on the mezzanine trench and going long on the equity trench. The Cad’s acted as a form of protection- insurance- against losses on the COO’s.
It wasn’t clear which Cod’s it hedged against, but these swaps broadly soared in value when the Cod’s dived last year. Magnet only needed to realize that the aforementioned trenches were relatively priced. Trades could be structured to generate cash on an ongoing basis because the current yields flowing in from the equity long positions were so much higher than the current yields being paid on the mezzanine short positions.
In the event of high defaults, the principal balance on the Cezanne shorts would be higher than that of the equity longs, so the strategy would have a large payoff if prices of the overall underlying collateral took a turn for the worse. The only way the strategy would lose money is if the equity got wiped out while the mezzanine trench stayed intact. Magnet considered the probability of this event occurring as being remote. Magnet made over $ 1 billion in profits, noting that equity trench of Cod’s and COD- derivative financial instruments are relatively undervalued (misperceived).