The massive deleveraging of the financial markets was bound to burn some hedge funds. The surprising part may be how few. Despite the frenzy of attention surrounding blowups brought on by the collapse of the U.S. subprime mortgage market, the majority of hedge funds avoided the carnage. In August the HFRI fund-weighted composite index fell by 1.31 percent. But if David Tsujimoto is right, the worst may not be over.
A large number of adjustable-rate-mortgage resets are due to occur late this year and in early 2008, meaning that further defaults and downgrades within the subprime market are likely. “The size of the structured debt market has grown tremendously in the past few years, and a lot of investors didn’t understand the risks very well,” says Tsujimoto, director of alternative investments for Tacoma, Washingtonbased Russell Investment Group.
Now, with the market scrutinizing the subprime sector more closely, banks and other regulated entities that are large holders of investment-grade tranches of collateralized debt obligations and other structured debt may see some fallout as well -- and their actions could set off the next leg of the subprime spiral.
As some of the largest investors in portfolios of below-investment-grade debt that were repackaged into investment-grade securities, many banks are heavily exposed to the subprime market. If a significant volume of that paper is downgraded by the rating agencies, Tsujimoto says, it is likely that some banks will be forced to sell to remain compliant with international capital requirements.
A March report by Santa Ana, Californiabased real estate research firm First American CoreLogic estimates that mortgage payments will increase by $42 billion when all outstanding adjustable-rate mortgages issued at the end of last year have been reset. That includes popular subprime 2/28 adjustable-rate mortgages, which carry low fixed rates for their first two years and higher floating rates tied to bank funding costs thereafter. Interest rates will typically increase by 2 to 3 percentage points at the first reset and then by 1 percentage point annually in subsequent years. For example, monthly payments on a $200,000 30-year mortgage with a teaser rate of 6.5 percent would increase by $345 (to $1,609, from $1,264) if the loan resets to 9 percent -- more than enough to push many subprime borrowers into default.
Of course, borrowers don’t always default when the rate resets. The risk depends both on how much monthly payments will increase and whether borrowers have any equity in their property. First American CoreLogic estimates that 25.4 percent of adjustable-rate mortgages due to reset in 2008 are written against properties that are already worth less than their purchase price -- nearly double the 12.9 percent rate for 2007. In addition, 75 percent of 2008 mortgage resets will be for subprime loans, almost all of which were originated in 2005 and 2006.
It is unclear whether the credit markets have discounted the bad news still to come. Although some hedge funds took investment-grade ratings at face value, Tsujimoto says the best managers ignored the ratings and did their own fundamental research on the bonds underlying each structured-debt portfolio. “Several of them have profited hugely in the subprime area,” he says. One such winner is New Yorkbased Paulson & Co., whose $4.5 billion Credit Opportunities Fund I and $2.3 billion Credit Opportunies Fund II were up a respective 26.67 percent and 32 percent in August.
For hedge funds and credit traders on the wrong side of subprime, the acid test will be how their investors feel about acknowledging that they own the losers, says Judy Posnikoff, a managing director at Irvine, Californiabased Pacific Alternative Asset Management Co. To avoid public scrutiny, insurance companies, pension funds and other institutional investors may dump sour funds before year-end. “There is more pain to come,” says Posnikoff.
