Earlier this year, the independent investigative newsroom ProPublica compiled the story of Magnetar, a hedge fund that helped to keep the mortgage bubble ballooning from late 2005 to 2008. Now, the SEC is investigating some of these shady deals.

But first things first
Here's what you need to know about Magnetar.

Because of the way collateralized debt obligations -- those opaque pools of subprime mortgages -- were set up, you needed to have investors willing to buy the safest, the middle, and the riskiest parts. Otherwise, the deal couldn't be structured. In late 2005, as the quality of loans deteriorated, it was becoming harder and harder to find investors who wanted to buy the riskiest parts of these deals. Financial markets began to self-correct, and the bubble might have subsided.

Magnetar stepped into this void, and began buying up deals worth anywhere from one-third to two-thirds of the monthly market for the riskiest mortgage investments. They helped to reinflate the housing bubble by purchasing some of the crummiest loans. One of the deals was so toxic, even Moody's (NYSE: MCO) refused to rate it. (S&P and Fitch, however, didn't seem to mind.)

Poor timing?
Magnetar also bought tons of credit default swaps to short its own investments, so that as the bubble burst, they made serious bank, while banks and mutual funds that bought the safer portions of the deal got crushed. This wasn't a drop in the bucket – JPMorgan Chase (NYSE: JPM) lost $880 million on one of Magnetar's deals.

Some bankers say Magnetar even selected the riskiest bets to put into its CDOs so they'd have a greater chance of failing. The Wall Street Journal uncovered a lawsuit that accused Merrill Lynch (now part of Bank of America (NYSE: BAC)) of helping to concoct a Magnetar deal designed to fail.

ProPublica found that 96% of Magnetar deals collapsed by the end of 2008, compared with just 68 percent of comparable deals. This is similar to what the SEC is accusing Goldman Sachs (NYSE: GS) of allowing one of its hedge fund clients to do. But Magnetar's deals were worth $40 billion -- nearly four times those of Goldman that drew the SEC's ire.

So what?
Magnetar was able to earn such high returns because it detected and exploited a loophole in Wall Street's business model. It may have known how crummy these mortgage-backed securities were, but the securitization and ratings process obscured their poor quality. Co-investors and counterparties got burned because they didn't realize they were being ripped off.

If you're investing in large banks, it's important to understand that, for many of them, a good chunk of their revenue comes from trading and investment banking, which can be a brutal industry. Here are some of the banks that put together Magnetar's deals:

Company

Investment Banking, Trading, and Private Equity (% of total revenue)

Deutsche Bank

61%

JPMorgan

47%

Bank of America (NYSE: BAC)*

28%

UBS (NYSE: UBS)

14%

Citigroup (NYSE: C)

13%

Wells Fargo (NYSE: WFC)*

4%

Data from Capital IQ, a division of Standard & Poor's.
*Magnetar deals were assembled by their respective predecessors, Merrill Lynch and Wachovia.

While it may not be the case that these entire divisions are involved in the sorts of tricks that Magnetar pulled, a big chunk of many of these banks' business comes from understanding deals better than their clients and counterparties. A significant amount of their business involves leveraging superior market positions to rip the faces off their customers, and, conversely, avoid having their faces ripped off.

The other fascinating takeaway from Magnetar is that unfettered finance does not automatically lead to free markets or positive outcomes. When a business model is founded on obscuring risk or prices to take advantage of unsuspecting buyers (who admittedly should have thought twice about what they were doing), it may be unregulated, but it's certainly not "free" in the sense of "competitive" or "characterized by perfectly informed parties." High finance also worked against the ability of financial markets to self-correct in a reasonable fashion, because Magnetar inflated the very bubble it was simultaneously shorting.

What's your take on Magnetar or the state of free markets on Wall Street? Sound away in the comments box below.

To find out how the future of the financial industry will look, check out The End Game for Wall Street.

Fool editor Ilan Moscovitz doesn't own shares of any company mentioned. Moody's is an Inside Value and a Stock Advisor recommendation. Motley Fool Options recommended writing puts on Moody's. The Motley Fool is investors writing for investors.