If the end of the world is near for the credit markets, word hasn’t reached Durham, North Carolina. The city is home to $26 billion institutional money manager Smith Breeden Associates. To the firm’s top executives, the current turmoil offers the chance of a lifetime. “This is a multigenerational opportunity,” says Daniel Dektar, Smith Breeden’s chief investment officer.
Now, says Dektar, buyers can acquire high-quality assets at fire-sale prices in the mortgage-backed-securities market. Smith Breeden is even dipping into the subprime sector, where the credit crisis first took hold. The firm, which runs about $2.3 billion in absolute-return strategies, is walking the walk: “Well over half” its alternative assets, says Dektar, are invested in mortgage-related securities.
Patrick McMahon, co-head of investment at New York–based hedge fund firm MKP Capital Management, which manages $4 billion in assets, echoes Dektar’s enthusiasm. “We look forward to one of the greatest investment opportunities of our careers,” McMahon says.
The vast deleveraging that has shaken the financial markets for more than a year hit mortgage-backed securities and derivatives like collateralized debt obligations especially hard. Commercial banks, investment banks, structured investment vehicles and other highly leveraged operations held huge portfolios they were forced to sell at any price.
Now, however, the U.S. government’s $700 billion bailout plan and other measures it is taking may well put a floor under the market — once the price the government will pay for such assets becomes apparent (see “A Swift Federal Infusion May Not Work So Swiftly”). Investors have a unique opportunity to profit at the expense of distressed institutions provided they have the expertise to separate beaten-down bonds supported by sound collateral from those that are questionable or impaired beyond hope.
It’s not a game for the faint of heart. Antonio Muñoz-Suñé, chief executive officer of EIM Management USA, the New York–based arm of EIM Group, Arpad Busson’s $15 billion, Geneva, Switzerland–based fund of hedge funds, concedes that although distressed mortgage credits may one day present “interesting opportunities,” managers who trade in corporate credit have neither the experience nor the infrastructure to analyze mortgage credit. Neither do mortgage-arbitrage players accustomed to trading highly leveraged portfolios of Fannie Mae and Freddie Mac bonds, for which credit risk was never a concern.
“It’s not just a fundamental play,” cautions Muñoz-Suñé. “It’s also a macro play, a political play, a social play, a structural play, a liquidity play and a leverage play.” He knows of few managers who can analyze distressed-mortgage credit, understand the capital structures involved and combine that understanding and analysis with sound macro-economic forecasting.
Although EIM has closed out its successful exposure to the short subprime play, Muñoz-Suñé isn’t ready to reverse the trade. “We don’t feel there is enough visibility to be long mortgage credit right now,” he says. “We are not certain that the knife has reached the floor and is solidly stuck.” He believes it’s too early for the macro bet but not for idiosyncratic opportunities in specific subprime credits. He warns, though, that that too is a treacherous arena.
A common mistake among many mortgage credit managers, says Muñoz-Suñé, is that they place too much faith in valuation models built on assumptions that apply in normal market conditions. Thus, he seeks out managers who have strict risk management controls designed to prevent disaster when models cease to work, as they inevitably do — and as they have done recently.
Models in a new market — such as subprime mortgages — are particularly vulnerable because they have not been tested in times of stress. Muñoz-Suñé notes that most mortgage credit managers have a long bias, for which risk management often means no more than buying assets at a discount. “That works as long as you can hold the positions,” he says, a point newcomers like the now-defunct Peloton Partners in London and established but struggling mortgage players like Ellington Capital Management, based in Old Greenwich, Connecticut, and Dallas-based HBK Investments ignored at their peril.
Stephen Vogt, CIO at Mesirow Advanced Strategies, a Chicago-based fund of hedge funds, agrees. Although Vogt sees good value in the sector, he will not place a big bet on mortgage-backed securities that trade infrequently in his main fund. “We have too limited a budget to go far out on the illiquidity spectrum,” he says.
To stave off forced selling, Mesirow has set up a new fund of funds that has a five-year life — a cross between the quarterly liquidity that funds of hedge funds usually offer and the ten-year commitment of a private equity fund. The initial focus will be on mortgage-backed securities, but the new fund will also tap managers of such distressed credits as defaulted corporate bonds (although Vogt says it could be a year or more before the time is ripe in that market).
“You have to stay in the game,” says Anthony Lembke, co-head of investment at MKP Capital. “That means you cannot take business risk.” The firm dodged a bullet last March when Bear Stearns Cos., one of its prime brokers, imploded: By the time the ax fell, MKP had eliminated its position exposure and moved its assets to a backup clearing agent.
At MKP a counterparty risk management team continuously pores over documents to make sure the firm knows where its assets are held, whether they are commingled or segregated, and what happens to overnight cash balances. “It’s not as sexy, but it can trump whatever expertise you have on the investing side,” says Lembke. Several money management firms, including some hedge funds, learned that lesson the hard way when the Lehman Brothers bankruptcy left them unable to access assets.
Credit spreads have blown out across the board since July 2007, of course, but some of the biggest moves have taken place among mortgage-backed securities, and not just lower-quality subprime credits. Smith Breeden’s Dektar points out, for example, that the spread on the Bank of America Corp. triple-A-rated commercial MBS index, which used to yield 20 to 30 basis points more than the equivalent Treasury bond, skyrocketed to 370 basis points just before the government bailout plan was announced. The spread narrowed by 80 basis points over the ensuing five days, but that still left it at ten times the earlier norm.
Vogt sees hedge funds buying mortgage-backed security tranches either at the top of the capital structure — primarily triple-A-rated — or near the bottom. For instance, in pools where escalating defaults are expected eventually to redirect cash flow from mezzanine to senior tranches, managers may be able to pick up bonds that their research suggests are good for, say, 24 months of future payments at a price equivalent to just eight months’ payments.
Most managers are shying away from the middle tiers of MBS structures, where Vogt says small changes in the default rate or the severity of loss in the event of default make an enormous difference to the outcome. Depending on what happens to home prices and where investors sit in the cash flow waterfall, “they can be money-good or zero.” He adds that these middle tiers of mortgage-backed securities will become more appealing when the housing market has stabilized and it gets easier to predict future cash flows.
When liquidity was abundant, lenders were happy to let hedge funds borrow against credit portfolios, and the higher the average credit rating, the more they lent. Hedge funds and proprietary trading desks don’t buy paper at 30 basis points over Treasuries unless they can lever it enough — by 20-to-1 or more — to generate an acceptable return. As a result, the credit crisis put maximum selling pressure on the highest-quality assets, the exact opposite of the flight to quality normally associated with tight credit.
Count MKP among those few investors — and maybe the only major mortgage credit hedge fund — to see the train wreck coming. Lembke noticed a rising inventory of unsold homes in late 2005, followed by the emergence of early payment default among subprime mortgages in the spring of 2006. At the time, mortgage-backed securities rated triple-B-minus were trading at 90-plus cents on the dollar. “It was incredibly asymmetric,” Lembke recalls. “If you were wrong, they would go back to par; and if you were right — and we never dreamed it would be as bad as it got — we felt you could make 20 to 30 points.”
MKP placed its bet on that macroeconomic view. “I am sure our competitors had great statistical models,” Lembke says. “But they went right off a cliff with them.”
The firm uses computer models to sift monthly data on mortgage pools obtained from research services like San Francisco–based LoanPerformance HPI and Intex Solutions in Needham, Massachusetts, for clues about prepayment and credit trends.
MKP turned bullish on mortgage credit this year, but it’s not a long-only play. Lembke says the firm divides major sectors, like prime and subprime, into subsectors and then looks at all levels of the capital structure to find the cheapest segments to buy and the most overvalued to short — if possible. If a suitable short isn’t apparent in mortgage-backed securities, MKP scours other asset classes to find liquid instruments that have low basis risk, are closely correlated to the MBS market and can be cashed out when the anticipated move occurs.
Risk management seems to have kept MKP out of trouble at a time when exceptional volatility has caught so many mortgage investors off guard. Lembke marvels at the number of mortgage credits that were bought at what seemed to be attractive tranche prices and levered up, only to crash to unprecedented lows. He says the blow that knocked out Peloton Partners was a move anyone who carefully tracked the volatility of such assets could have predicted. “People spent all their time worrying about the default rate,” Lembke notes. “They missed the volatility.”
Mortgage credit investors tend to have relatively low portfolio turnover because liquidity is limited, but MKP probably trades a little more than its peers, says Lembke, so that it can test the true value of its holdings. It’s not enough to ask a third party for a price. Lembke points out that dealers, who typically hold mortgage-backed securities on their books and provide most third-party pricing, have a clear conflict of interest.
“You have to ask where they would commit capital,” Lembke says. “Sometimes — not always but all too often — that price may be materially below where they will give you a paper mark.”
As the credit crisis unfolded, dealers had to liquidate their MBS inventories for whatever they could get. To Dektar and Peter Nolan, product portfolio manager for securitized credit at Smith Breeden, selling has driven prices to bargain-basement levels for whole asset classes. Even before the government stepped in to bail out Fannie Mae and Freddie Mac in September, Dektar was buying mortgage-backed securities issued by the two agencies that were trading lower than they would have in normal markets. When the government acted, Smith Breeden made a killing as the discount evaporated.
Dektar was also finding values in Ginnie Maes, low-risk securities that came with an explicit government guarantee. Among commercial MBSs he found some securities at the top of the capital structure that were supported by good collateral and strong subordination trading at 8 to 12 points below fair value. And in subprime MBS he picked up low-risk, shorter-maturity securities with generous coverage against losses at discounts of 3 to 15 points. “Those are what we call beta opportunities,” he explains. “You get exposure to sectors where the babies are being thrown out with the bathwater.”
Smith Breeden’s portfolio got another boost when prices for these asset classes ran up after the federal bailout fund was first proposed. The firm also looks for alpha opportunities that depend more on individual security selection within a particular asset class. For example, Nolan says pricing in the subprime MBS world has become highly systematic, which is to say that securities of a particular vintage and initial rating are priced in line with the relevant tranche of the ABX index regardless of the underlying credit quality. The trick is to find bonds that warrant a higher valuation and to avoid bonds that are worth less than the market price.
That’s easier said than done. Like MKP, Nolan buys monthly data that lets him drill down to the individual loans in each mortgage pool and see how the credit risk changes over time as borrowers become delinquent, default or refinance and drop out. That’s no small task when a typical mortgage-backed security contains thousands of mortgages. But it’s worth the effort, and Nolan says loan characteristics — credit scores, an individual’s leverage, loan-to-value ratios, loan purpose and the location of an underlying asset — have “at least some predictive power” in determining whether a borrower is likely to default.
The number-crunching chore increases exponentially for collateralized debt obligations. A CDO that holds only mortgage-backed securities has hundreds of thousands of underlying loans. Although Smith Breeden has the information technology infrastructure to handle such analysis, Nolan says that CDOs are not a priority at the moment. He points out that every layer of securitization magnifies the potential errors as well as the complexity of the analysis. “We see the best opportunities not so much in CDOs as in the collateral they hold,” he adds.
Smith Breeden takes pride in its ability to forecast how borrower behavior will affect the value of mortgage-backed securities. Dektar says the slowdown in the housing market means that people will move less frequently and will not be able to refinance to extract cash from their homes, so he has extended the firm’s MBS portfolio duration to capture the longer expected average life of cash flows. He focuses on low-credit-risk Fannie and Freddie mortgage-backed securities at a premium to par, a segment for which slower prepayments increase the number of premium coupons expected and therefore enhance value.
Although the government rescue package should help restore confidence, prices of mortgage-backed securities probably won’t bounce back to precrisis levels overnight. But when investors ask Lembke if it’s time to go long and wait for the ride, he demurs. No matter how cheap mortgage credit is — both Lembke and McMahon expect better returns than on any other major asset class, including U.S. or European equities, financial equities or corporate credit — MKP isn’t quite willing to go all in. “There’s too much risk,” McMahon says. “Firms that try to catch this falling knife may get sliced up.”
