Before the Abacus synthetic CDO that led to Goldman Sachs being accused of securities fraud came the CDO deals associated with Magnetar, the Illinois-based hedge fund.

Now Magnetar has come out fighting against accusations from ProPublica, the online news group, that it helped to stoke the US housing bubble in order to short its CDOs with astronomy titles such as Libra and Norma.

Magnetar sent a letter to investors on Monday, attached at the bottom of this post, in which it attacks ProPublica’s “blatantly false and misleading story” and provides an analysis of its strategy.

The letter is a pre-emptive defence against any accusations of misconduct in the synthetic CDO market, where Magnetar was a major force in 2006 and 2007.

I wrote about Magnetar in my column last week, before the Securities and Exchange Commission accused Goldman of securities fraud, and the issues involved are similar.

Magnetar insists it “did not control asset selection in CDOs in which it participated”, although though it told collateral managers (playing the same role as ACA in the Abacus deal) what sort of yield it needed to invest in the equity.

It also asserts that it “did not participate in the marketing or distribution of CDO transactions” and “did not make representations to qualified investors who purchased CDO tranches.”

Magnetar argues that it was not shorting the subprime market but was arbitraging between different layers of CDOs, taking advantage of the fact that it could get a yield of 20 per cent on the equity and then hedge that by shorting the mezzanine layers.

The chart it provides on page three of the letter suggests that it would have made money as long as the CDO market held up with no or few losses, and also make money if there was a high percentage of losses. Its risk was that subprime losses ate through only the equity tranches.

As it turned out, almost all of the Magnetar deals defaulted, bringing it very high returns in 2007.

Magnetar Letter to Investors (PDF)