According to Propublica, a hedge fund called Magnetar put together a trade back in 2005 to take advantage of a collapsing mortgage market. It worked like this:

1. notice that CDOs are broken into tranches, with lots of demand for the lower risk tranches, and significantly less demand for the riskier (equity-like) tranches
2. buy equity tranches of mortgage-backed CDOs, using buyer clout to harangue the deal operator into putting riskier mortgages into the pool
3. use buyer clout to remove triggers from the CDOs which stop payment to riskier tranches when the market deteriorates
4. use the recurring income from your equity tranche to offset purchases of credit default swaps on the temporarily less riskier tranches of the same CDO

Net, say Magnetar pays 100 M$ for the equity tranche, they receive 15-20 M$ annually in mortgage interest. They then buy 15-20 M$ of default insurance on the other tranches. As they scale up, Magnetar makes a huge bet that they will have enough money to carry them over the time period when income from the equity tranche has died and when the valuations rise on the CDSs they purchased.

Finance has an F in it for a reason....

Update on 2018-06-13:

Senior SEC officials have concluded there isn’t enough evidence to file civil enforcement charges against Magnetar, the Journal said, citing people familiar with the situation.

-- Reuters

The Securities and Exchange Commission today charged the managing partners of a Charlotte, N.C.-based investment advisory firm for compromising their independent judgment and allowing a third party with its own interests to influence the portfolio selection process of a collateralized debt obligation (CDO) being offered to investors.

The investment managers have agreed to collectively pay more than $472,000 and exit the securities industry to settle the SEC’s charges.

According to the SEC’s order instituting settled administrative proceedings, disclosures to investors indicated that NIR Capital Management LLC was solely selecting the assets for Norma CDO I Ltd. as the designated collateral manager. However, NIR’s Scott H. Shannon accepted assets chosen by hedge fund firm Magnetar Capital LLC for the Norma CDO’s portfolio, and Joseph G. Parish III allowed Magnetar to influence the selection of some other assets. Shannon himself called at least one of the residential mortgage-backed securities (RMBS) ultimately included in the portfolio a “real stinker.” Magnetar bought the equity in the CDO but also placed short bets on collateral in the CDO and therefore had an interest not necessarily aligned with potential long-term debt investors that relied on the CDO and its collateral to perform well.

The SEC also today announced charges against Merrill Lynch, which structured and marketed the Norma CDO.

“Shannon and Parish could not serve two masters,” said George S. Canellos, co-director of the SEC’s Division of Enforcement. “They allowed Magnetar to influence asset selection and abdicated their duty to pick only the assets they believed were best for their client.”

-- SEC