By Irwin Speizer
| Donald Brownstein: Logic is kind of dry, but it has important ramifications Photographs by Chris Clinton |
Donald Brownstein struggles to remember what life was like back when he was a shaggy-haired professor of philosophy at the University of Kansas. “Those were the days of hippie glory,” he says. “I was very young. I guess I was born to be wild.” He pauses for emphasis. “Like a true nature child.” And then he chuckles.
What are the lyrics of Steppenwolf’s 1968 rock anthem “Born to Be Wild” doing on the lips of a 67-year-old, buttoned-down Connecticut hedge fund manager? Brownstein says he can’t help himself. Old song lyrics simply pop out whenever they occur to him, which is often. This is just one of many anomalies in the quirky character and unusual life story of a man who went from lecturing college students on fine points of logic to running a hedge fund company with $2.8 billion in assets that regularly churns out eye-popping returns.
How he accomplished this unusual second act is almost as difficult to comprehend and explain as the techniques he uses to extract value from esoteric mortgage-backed securities.
Structured Portfolio Management, or SPM, specializes in residential mortgage securities, digging deep into derivatives to find anomalies it can exploit, sometimes by stripping out and trading parts of a bigger security. Under Brownstein’s guidance, SPM was among a handful of managers that racked up huge gains by shorting mortgage-backed securities in 2007. But he has made money in the field both before and after the MBS collapse, displaying a knack for uncovering profitable opportunities in those securities — with one major exception in 2008, when the financial crisis led to losses in several of his funds.
Brownstein says the firm’s long-term success is mostly the result of creative analysis and skillful execution, but he doesn’t discount the role that serendipity plays. “I really think that a lot of what we do depends upon having good ideas, exploiting the opportunities we see and being very disciplined about how we do it,” he says. “I imagine that there is a fair amount of luck involved, as there is in everything.”
The firm’s flagship fund, SPM Structured Servicing Holdings, has $1.6 billion in assets and has posted annualized returns since its launch in February 1998 to the end of September of 27.93 percent. Year-to-date through September, the fund was up 12.65 percent, while the AR Mortgage-Backed Securities Index was down 0.51 percent. Three of the firm’s funds were nominated in the AR 2011 awards competition.
Citing government restrictions on hedge fund marketing and promotion, Brownstein declines to discuss financial details of his operation, including assets under management, performance or the workings of his strategies. SPM investors, though, get the full Brownstein. “We are 100 percent transparent to our investors,” he says.
Brownstein’s second career mirrors the second act of his personal life. He has shed the bushy-haired, bearded look of a college professor — a career that lasted into his 40s — for the close-cropped silver hair, clean-shaven face and starched shirt of the distinguished older business executive he has become. At age 67, divorced and remarried, he has two young children, six and ten years old, and another who is 37.
| Brownstein: I had gotten a late start,obviously — I wanted to make some money |
Brownstein runs SPM out of offices on the fourth floor of a nine-story waterfront building in Stamford, Connecticut, with a staff of 37 that includes six Ph.D.s. Brownstein’s corner office looks out on the trading floor. He does no trading himself, preferring to concentrate on strategy development and investor relations. A majority of SPM’s assets now come from institutional investors. The firm’s funds charge 2 percent management fees and 20 percent performance fees. SPM concentrates on the U.S. residential mortgage bond market, dealing mostly in triple-A- and double-A-rated securities. Brownstein looks for trends that might influence mortgage securities, then does deep analysis to come up with a thesis for how he might profit from a situation.
At the heart of SPM’s system are pricing models developed over a dozen years that analyze hundreds of thousands of residential mortgages and then predict prepayment rates, which are especially important in interest-only (IO) strips. As their name implies, IOs are the interest part of mortgage payments stripped out to create new securities. How those models work and exactly how SPM earns its profits are closely held secrets that Brownstein declines to discuss except in the broadest sense.
“For us investing is something like an experiment,” he says. “You have a thesis about the way things work. The investing part is seeing if that thesis is right. One of the things in a firm like ours is keeping the experiments as pure as we can — not contaminating them by running multiple versions simultaneously and overlapping them.”
Those who know SPM and Brownstein say that what distinguishes the firm from others in the MBS field is not just its ability to land the occasional big payoffs — a trait it shares with other MBS investors — but its ability to weather a crisis.
A big reason for SPM’s staying power is Brownstein’s commitment to limiting leverage to help avoid getting caught by liquidity crunches. When Lehman Brothers Holdings collapsed in 2008, triggering a liquidity crisis and a market collapse, several MBS funds blew up. SPM lost money, but it survived.
“If you look back at the guys who were doing MBS in the middle of the 2000s, a lot of them were greedy and took risks they shouldn’t have,” says one Wall Street veteran familiar with Brownstein. “He didn’t.”
SPM’s various funds can post very different performance results at any given time, even though they all invest in the MBS market. One investor in SPM notes that what Brownstein does is actually not that complex, proprietary models notwithstanding. “It is not that complicated,” the investor says. “It is effectively the same trade over and over.”
The firm is hardly alone in building and maintaining computerized systems to analyze mortgage data. SPM’s secret weapon is its team of math and science Ph.D.s, led by William Mok, head of portfolio management, who holds a degree in computer science from Columbia University. The firm’s computer models have played an important role in its success over the years, particularly in IOs. One way SPM uses IOs is to express the different prepayment rates among mortgages and set up trades that profit from those differences.
The market for mortgage-backed securities is estimated at about $10 trillion. The biggest part comes through so-called agency loans, which are backed by Freddie Mac or Fannie Mae and represent some $6 trillion in mortgage loans. Another big category consists of nonagency loans, which are privately backed and represent an additional $1 trillion.
Structured Servicing Holdings concentrates on nonagency loans. When Brownstein initially noticed some anomalies in refinancing rates, it was the nonagency loans that caught his attention. He used his models to help analyze and then trade on those anomalies.
Running a hedge fund firm is an un-likely career for a Bronx-born son of a furrier.Brownstein’s first home was a fifth-floor apartment in the New York borough. He was born in 1944; World War II was still under way, and commercial television broadcasting had yet to arrive.
“It was idyllic,” Brownstein says of his childhood, with characteristic irony. “The beautiful Bronx. A blade of grass sticking out between each block of sidewalk.”
Brownstein had no idea what he would grow up to be, except that he wouldn’t be a furrier, which he saw as a “brutish” trade. His father was a tough man, a Golden Gloves boxer who had once sparred with middleweight champ Rocky Graziano. When Brownstein was eight, the family moved to Queens, and he did well enough in public school to skip the eighth grade; he enrolled in City University of New York’s Queens College at the age of 16.
“I was a terrible student,” Brownstein says. “I didn’t like doing homework. But I was highly skilled at taking aptitude tests. I was a standout. It was a good thing they were so stuck on aptitude tests.”
Brownstein started his college career with an interest in history and gradually shifted to philosophy, getting a BA in 1965. He earned his Ph.D. in philosophy from the University of Minnesota in 1969, then landed a job as a philosophy professor at the University of Kansas in Lawrence.
He specialized in metaphysics and logic. His academic pursuits had less to do with big thoughts about the human condition than they did with the process of thinking. Some of the papers he authored at the time are highly abstract and dense, often punctuated with equations to demonstrate the essence of a logical argument.
“Logic is kind of dry,” Brownstein says. “But it has very important ramifications. You sort of spend a lot of your time worrying about what appear to be trivial and picayune issues. Later on you discover many times you were right — they were trivial. But sometimes they were profound.”
If his academic pursuit was dry, his social and cultural life was anything but. It was the height of the hippie era and the movement against the war in Vietnam, and Lawrence was a midwestern crossroads for the counterculture. Brownstein grew his hair long and adopted a full beard, looking very much like activist Jerry Rubin. He joined in antiwar rallies and hung out with author William S. Burroughs, who had moved to Lawrence; that connection brought him into contact with poet Allen Ginsberg.
“He was very lively and socially active,” recalls John Bricke, a philosophy professor at the University of Kansas, who has stayed in touch with his former colleague. But there was another side to Brownstein. His students looked up to him and the example he set with his scruffy look and antiwar rhetoric, but he also liked nice things and drove a sporty yellow car that seemed out of sync with the rest of his image.
What opened the door for Brownstein’s eventual transformation from midwestern hippie to East Coast yuppie was a controversial shopping mall project proposed for Lawrence. At about that time, Brownstein had gotten divorced, and his ex-wife moved to Philadelphia with their child. Brownstein began thinking about relocating back east to be closer to his son, and he began contemplating how he might improve on his professor’s salary.
The proposed mall project stirred up a debate centering on the wisdom of putting a mall in a cornfield, but it got Brownstein thinking about the economics of the plan. He started researching real estate and then securities, and he came up with an idea for securitizing leases on the anchor tenants of a mall.
The idea went nowhere, but he turned the concept into an academic paper that got published by the University of Pennsylvania’s Wharton School. He then used that paper to introduce himself to people in finance and banking, eventually landing a consulting gig with Franklin Savings Association in Ottawa, Kansas, which led to a full-time job in which he was supposed to harness his brainpower to the cause of profit. It was the beginning of a new career in finance based on real estate and structured finance. “I was a business economist,” Brownstein says. “I was supposed to think stuff up.”
One of the projects he worked on was not his own idea, but it turned out to be very profitable. It involved buying the rights to service mortgages. The owner of the rights — a bank, for example — would collect its fees early rather than over a long period of time; Franklin would buy those rights at a price that would enable it to make a profit on servicing. (The structure was a precursor to a highly successful strategy he would use at SPM.)
“We were approached later on by someone who was interested in hiring a group of us from Franklin,” Brownstein says. “They wanted to know what kinds of returns we were generating. I remember it was around 17 percent.”
In 1993, Brownstein took a job in New York with French bank Caisse des Dépôts et Consignations, working on similar loan-servicing-rights securities. A few years into that job, Caisse tried to buy a mortgage servicing company in Texas. The owner of the company didn’t want to sell and instead wanted to buy a share of the Caisse mortgage servicing business. Caisse wasn’t interested. But Brownstein was.
“Caisse did not want outside investors,” Brownstein says. “So here I had someone interested in putting in money. It was 1996. I was already 52 years old. I was thinking about my own future. I had gotten a late start, obviously. I wanted to make some money.”
Brownstein worked up a deal to start an investment fund. The Texas company would supply the capital, Brownstein the brains and sweat equity. Brownstein quit Caisse at the end of 1996 and formed SPM in 1997. But the expected big infusion of capital from Texas never materialized. SPM limped along, finishing 1997 with just $5 million under management.
Undeterred, he kept looking for a way to distinguish his operation from others in the mortgage market. His study of mortgage securities pointed him toward an anomaly: There were differences in the refinancing rates of borrowers with agency loans and those with nonagency loans. No one seemed to have an explanation for why that was or how to predict and model it. Brownstein decided to try to find out.
“The standard view of things is that people refinanced in order to take advantage of interest rate savings. So why was it the case that some people who had this opportunity were not taking advantage of it?” he asks. “We bothered to do the work to find out. One of the oddities of finance is that while people work long hours, sometimes extraordinarily long hours, in some respects they are lazy. There is a tendency to not challenge authority. Whatever is the official explanation tends to get promulgated, and people stick to it. That is not science.”
Again, Brownstein won’t go into details on exactly what he discovered or how he used that information to inform his trades. But in February 1998 he started Structured Servicing Holdings to capture the spread between prepayment rates in the agency and nonagency markets.
Brownstein used an IO strip trade during 1998’s economic troubles, which included the Russian default, the Asian economic crisis and the collapse of Long-Term Capital Management. The trade was highly profitable but also benefited from a hedge that allowed him to hold on to the trade until IOs rallied.
One problem with IOs is that they lose the income they derive from underlying mortgages if those mortgages are refinanced. High rates of refinance, which can occur during periods of falling interest rates, can send IO strip prices tumbling. In addition, volatility tends to punish IOs. Both issues were in play in 1998, pushing IOs to as low as 10 cents on the dollar.
SPM started buying those cheap IOs through its Structured Servicing Holdings fund in early 1998. Brownstein was looking for IOs whose underlying mortgages might be less likely to experience widespread refinancing and thus were likely to see a strong rebound. SPM developed models and computer analytic tools to screen for borrowers who might be less inclined to refinance their loans even under favorable interest rates. But the trade also needed protection from the volatility in the markets that was present at the time as a result of the economic dislocations.
Brownstein chose to hedge using ten-year Treasury notes, figuring that if the global economic crisis continued and spread, it would likely lead to a flight to quality and boost his Treasury investments. In fact, Treasuries rallied, and the profits on that investment helped protect the IO play. The combination of low leverage and the Treasury hedge allowed SPM to ride the IO strip play through the difficulties of 1998 and into a 1999 rally. Structured Servicing Holdings earned 21.58 percent in 1998. In 1999 it notched a gain of 84.55 percent.
Although the 1998 IO strip play was a strong moneymaker for SPM in its early years, the firm scored an even bigger win in 2007 by shorting mortgage-¬backed securities. Like several other investors, Brownstein wondered why U.S. housing prices were rising so fast and where all the demand for new mortgages was coming from. The numbers didn’t add up: There was no population boom to support all the residential construction, and the fastest-¬growing segment of the mortgage market was highly vulnerable subprime loans.
“The people building houses weren’t keeping count of the number who were able to buy,” Brownstein says. “Eventually, they ran out of people. Like Wile E. Coyote, they went off a cliff.”
Brownstein surmised there was an opportunity in shorting mortgage-backed securities. What concerned him was timing. He could wind up stuck with losses if he jumped in with a short play too early, housing prices continued to rise and he was unable to hold on to his position long enough.
“If this was an inflationary phenomenon, then you didn’t know when it would burst,” he says. “There was no intrinsic reason why it shouldn’t go on for a long period of time. Some people who got in early had to get out.”
Brownstein and his team were looking for a trigger that would tell them the time was right for a short play. He relied on the expertise SPM had developed in mortgage servicing to guide his search.
The first part of his MBS shorting thesis revolved around the companies that were originating subprime mortgages. Brownstein figured that most of those originators were probably not well capitalized, with cash flows that depended on selling their new mortgages quickly to banks and Wall Street investors, then using that cash flow to continue operating. SPM began monitoring mortgage defaults that occurred within the first 90 days of loan closings. Brownstein assumed that if early defaults began to rise, originators of subprime loans would come under pressure and quickly start to fail as a result of cash crunches. As originators fell, the so-called mortgage warehouses run by big investment houses would start filling up with bad loans. Once that happened, the whole MBS loop would be in danger of collapsing on itself.
“We were waiting for the first card to show,” Brownstein says. “The first card was the home buyer.”
When he spotted an uptick in early loan defaults in late 2006, he immediately rushed to form a new fund, SPM Strategies Portfolio I. The fund launched in February 2007 with the narrow strategy of shorting mortgage-backed securities. On cue, subprime defaults spiked, mortgage-backed securities crashed, and the fund had returned 186.5 percent by the end of the year.
“We didn’t make as much as John Paulson,” Brownstein says of the hedge fund manager who famously made a fortune betting against the housing market. “But none of our investors had any complaints. It was a home run.”
The speed and depth of the MBS collapse surprised Brownstein, and he could see the opportunity to short MBSs vanishing as quickly as it appeared. He shuttered the fund in January 2008 and returned investor money after a highly successful run of just 11 months.
Although Brownstein will not discuss his recent performance, his strategies remain based on the ideas, models and formulas that have been at the center of his system for years. IO strips continue to be a favorite instrument for his strategies.
Despite his transformation into an investment whiz, Brownstein maintains his quirky mannerisms. He recalls one meeting with a prospective investor in which he wound up likening the investor to a flatworm. Rather than being put off, the investor was intrigued and ended up giving SPM an allocation. “He later told me I had him when I compared him to a flatworm,” Brownstein adds.
But another prospective investor who listened to Brownstein’s pitch several years ago came away unimpressed. “He was definitely kind of the mad professor,” this investor recalls. “He was not someone who I thought was institutional investor quality.”
On the other hand, an investor who did put an allocation with Brownstein says he didn’t find the character quirks at all unusual. The hedge fund business is full of oddballs, the investor says, and some of them produce the best results.
Brownstein says he is who he is, and he has no apologies for his style: “I must say some investors enjoy it. Others find it off-putting. I don’t know that I can do anything about that. It is the way I think.”
His secretive methods came close to being aired in public as a result of a lawsuit filed in Connecticut last year. Former SPM trader Jeffrey Kong sued the firm, claiming he was stiffed millions of dollars after he resigned and moved to a rival company. SPM countersued, saying Kong owed the firm money. (Brownstein declined to comment on the lawsuit, which was settled before the case went to trial.)
The case received considerable play in local newspapers, including the Stamford Advocate, which recounted an affidavit Kong entered into the record in which he described Brownstein stalking the office while slapping a baseball bat into his palm in a menacing gesture reminiscent of Robert De Niro playing Al Capone in the movie The Untouchables. Several people who know Brownstein say the incident sounds more like one of his frequent riffs on jokes and movies and that Brownstein does not physically menace people.
“Don is a very amusing guy,” says philosophy professor Bricke. “He has a New York sense of humor.”
Brownstein not only remains in contact with Bricke and other friends and colleagues from his University of Kansas years, he goes back for regular visits and has endowed two annual awards for excellence by the school’s philosophy students. Brownstein’s office is decorated with several large paintings by Roger Shimomura, a Japanese-American artist who worked with Brownstein at the university.
Lately, Brownstein has returned somewhat to his philosophical roots. Emboldened by his investment success, he has become something of an economic sage, offering up advice on national and global economic issues with his characteristic directness. He has popped up on various financial TV programs espousing his views on inflation and monetary policy.
“The biggest opportunity right now is for people who are policymakers both here and in Europe to stop acting like jackasses and start doing what is required,” Brownstein says. “There is a surfeit of caution about inflation and an underabundance of caution about a second recession or worse. If you are looking at unemployment and stagnant demand and the possibility of another crisis in the banking industry, now is not the time to worry about inflation. I am advocating fiscal and monetary stimulus, and a little bit of inflation. We should be stimulating by spending.”
Brownstein isn’t waiting to see how Washington will deal with the country’s economic problems. He continues to expand his firm, launching a new fund, SPM MVPQ, in September to pursue yet another twist in his overall strategy of investing in mortgage-backed securities. (The name derives from a formula that expresses the quantity theory of money in an economy.)
In his off time, he gets involved in social, civic and environmental issues, including a local project to develop a park in downtown Stamford. He has taken up fly fishing, although it is hard to tell exactly how serious he is about the sport.
“I like to stand in water up to my chest,” he says. “The fly rod and all that other stuff . . . if I just walked into the river and stood there, they would call the loony bin to come and get me. By having the fly rod in my hand, I get to stay there.” AR
