A Subprime Crisis

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					A Subprime Crisis Some Welcome
Certain hedge funds ride the credit mess to huge gains and continue to see opportunity in market turmoil
"The bottom line is everybody in this business was drinking the Kool-Aid," he says. "At that time, when 1 went around to investors to raise capital. I told them this would be the best risk reward scenario they'll see in their life." Other hedge funds who took advantage of the situation echo this sentiment and call the opportunity in 2005 and 2006 to short subprime mortgages "an historic one," according to Michael Burry. managing director of Cupertino. Calif.-based Scion Capital. "This sort of opportunity is so large and so asymmetric in its risk and reward that it is necessarily very rare." he says. investment information. They not only saw tbe tremendous appreciation of real estate over the rate of inflation in the previous five to eight years, but they were also able to identify tbe growth in origination of subprime mortgages loans. "Their fundamental research also involved deconstructing the balance sheets of a typical subprime borrower." Heinz says. "People identified it but didn't fully appreciate how unattractive that segment would become." A hedge fund manager who wanted to stay anonymous says many in tbe industry thought it wasn't realistic to think such a situation would occur. "Most didn't even give it a consideration," the manager says. "Like most people, they go on recent history: They go live years back to make decisions, and it's not the correct perspective." Another essential factor in the success of these hedge funds is tbe importance of proprietary research. "It cannot be overemphasized when trading subprime securities." says New York-based Paulson & Co. in its third quarter letter obtained by IDD. "Selecting individual securities in which to invest is highly complex and a virtual minefield for the uninitiated. Investors who rely on faulty agency 'ratings,' Street research, or off-the-shelf models will invariably get burned." Paulson is a merger arbitrage shop whose flagship fund, the Paulson Credit Opportunities fund with $8 billion in assets, was up 436% at the end of the third quarter, and is up 550% year-todate, according to an investor. The fimi


lenty has been written about the casualties of the subprime turmoil, but not everyone has come out a loser. Indeed, some hedge funds have managed to thrive, with some achieving gargantuan returns by shorting the mortgage industry. Many of these funds identified the opportunity back in the summer of 2005 or in early 2006, when they saw that rating ageneies and issuers were inappropriately rating the asset-backed issues, several hedge fund managers say. They then followed the ABX inde.x. an index created by Markit Group, that tracks subprime mortgage bond prices, and shorted it. "We had the foresight that a lot of the risk premium being charged for these bonds was mispriced." says Kyle Bass, managing partner of Hayman Capital, a Dallas-based hedge fund. "We did a lot of due diligence and we figured out who the worst issuers with the lowest standards were and we followed their loans from origination to securitization." His fund, the Hayman Capita! Partners Subprime Credit Strategies Fund, which is jointly managed with Fort Worth Texas-based Corriente Capital, has realized a 570% return year-to-date and was up 27.5% in October The fimi manages a little more than $1 billion in assets. Bass says many of his peers were leveraged and used to going long, not wanting to believe the bottom could fallout and instead pinning their hopes on home price appreciation being correlated to income and jobs growih.
14 IDD NOVEMBER 19, 2007

Capital's Bass: 'The bottom line is everybody in this business was drinking the Kool-Aid.*
Scion Capital realized an 85% retuni during the first nine months of 2007 and an investment in the fund at its inception in November 2000 and held through Sept. 50. 2007, shows a net gain of 331 %, according to an investor letter obtained by IDD. Burry says he identified the opportunity by paying attention to what lenders were doing. "Their lending apparatus structure encouraged corruption and poor moral structure," he says. Hedge funds who were able to identify the growing risk in the subprime securities grounded their observation in a eouple of premises, says Ken Heinz. president of Hedge Fund Research, a finn specializing in the aggregation, dissemination and analysis of alternative

manages $26.5 billion in overall assets across three strategics: merger arbitrage, event arbitrage and the credit vehicle which it launched in |uly 2006. Paulson declined to comment. As delinquencies rose and the credit market tightened, the lower tranches of subprime mortgage securitizations fell, resulting in large gains lor their funds, the firm explained in its report. It further says that given the current conditions, it appears likely that the vast majority of the securities they are short will be written off and that as a result of recent rating downgrades, approximately 62% of their portfolio is now rated noninvestment gi'ade.

or to the fall. Looking forward, the funds are well positioned by every fundamental metric I can analyze." He says that hedge funds for years ignored this trade because it was negative carry, and they were focused on the positive carry trades — leveraging small positive cash flows. "A lot of hedge funds have trouble doing that because their investor base is not patient enough," he says. "They don't look for these opportunities: their minds don't even go there." Going forward, new opportunities stemming from the subprime debacle are already arising for hedge funds. Hayman's Bass says he is maintaining his shorts in the mortgage market and believes things are about to get a lot worse as another actor, the monoline insurer, is arriving on the subprime scene with its own set of issues, adding to the turmoil. The capital adequacy of these insurers is going to be "problematic." he says, as many of them fail stress tests for it. Asked whether monoline insurers might soon be downgraded. Bass says

"Our strategy is to hold these securities until they trade in single digit or low double digit range or arc written off. We estimate that by doing so we can realize an additional 30% to 40% gain from our subprime positions from September month end." the firm said. Patience was also key in being successful with the strategy, as credit and real estate cycles are historically much longer than stock market cycles. Scion's Butry says some investors left late IV£ OFFER COMPLETE. PROFESSIONAL REPRINT SERVICES, INCLUDING PREMIUM PRINT AND ELECTRONIC REDISTRIBUTION. last year, thinking his bet would not pay off. "But my stomach is strong. I really think that in investment management in general you have to wait two to three years for the biggest payoff," he says. ith Investment Dealers' Digest Reprints & E-prints! In a letter to inExpand the exposure your business has received in the most vestors he wrote in the cost effective way. Increase the reach and impact of your story in first quarter of 2006, Investment Dealers' Digest by using high-quality reprints and e-prints. Burry says he guided Reprints from Investment Dealers' Digest work many ways, includingij the funds into the cred• Direct Maii Promotions it derivative positions • Public Relations with full awareness • Sales Support that speculative manias • Client Presentations • Event Handouts are taken to the 'nth' degree before they fall Contact Denise Petratos at 212-S03-6557 or into depression. He exdenise.petratos@sourcemedia.coni pected "intolerable Source pain and capitulation among the shorts pri-

that it is a political issue. T m not sure the Treasui7 and the White House are ready to have them downgraded. The markets can't handle them folding; there is a huge systemic risk if that happens." The next shoe to drop will include credit card receivables, auto loans and commercial real estate (CRE), some observers say. Nouriel Roubini. a professor of economics at New York University and chairman of Roubini Global Economics, says that many of the same excesses that were observed in subprime — poor underwriting standards, loose and excessive lending to marginal projects — are also observed in CRE, "Actually, the bubble in CRE construction — like the bubble in residential construction — will soon turn into a painful bust," he says. "Investors' worries and panic are now shifting towards CRE and its related securitized products — CMBS and CMBX — and there is room there to make a lot of money for hedge funds."

' ? B S ^ T ^ ^ I H l " "(WIerage

NOVEMBER 19, 2007 tDD 15

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