Alistair Lumsden and Steven Swallow realized in December 2005 that they had a problem with their asset-backed investment strategy: Their employer, Dutch bank Rabobank Group, didn’t allow them to buy protection on any of their long positions.
But Lumsden and Swallow, who are longtime friends and colleagues, knew full well that the mortgage market that was underpinning the $10 billion in structured-finance assets they were managing for Rabobank was teetering. So when they were introduced to executives at London-based hedge fund firm CQS by a former colleague, they made the leap. By October 2006 the CQS ABS Fund was up and running, and they were in charge of it, promptly turning their newfound freedom into profits.
In 2007, its first full year of operation, the ABS Fund delivered a net return of 45.18 percent; last year it did even better, returning 72.81 percent. It was a notable achievement in itself, even more notable considering that the hedge fund industry as a whole was down more than 18 percent in 2008. The fund has been volatile — Lumsden and Swallow are constantly combating a seesaw market — but it has been down only six of the 27 months of its existence through 2008, and now has $500 million in assets under management.
Tumultuous as the mortgage market has been, the two friends fear the worst is yet to come as lower home valuations and widening unemployment force homeowners to turn in their keys. If and when defaults rise, ABS valuations may drop further than they have already, creating a nightmare scenario as middle-class borrowers with good credit histories begin to default. Global exposure to the U.S. alt-A mortgages, which fall between prime and subprime mortgages in terms of risk — totals as much as $600 billion, roughly the same amount as the U.S. subprime market, and losses may yet escalate.
“Even good loan originators in the U.S. who really understood the business threw sensible underwriting out the window during the real estate boom,” Lumsden says. “Almost everyone was engaged in massive lending with very few checks on the creditworthiness of the borrower or, to be honest, the valuation of the underlying collateral.”
The two men note that the mortgage market may not be the only one affected — they say they are even more concerned about the potential impact on the monoline insurers, big companies like Ambac Financial Group and MBIA that write bond insurance.
Their worry is that these companies could be rendered insolvent if defaults rise and they have to make good on their vast insurance commitments. Lumsden says it would create a domino effect on the ratings of all kinds of monoline-insured bonds — municipal and corporate — and that across-the-board downgrades would be sure to follow.
Lumsden and Swallow know whereof they speak. They have decades of experience at the hard edge of loan origination, securitization and investment. Swallow, who is head of European asset-backed securities at CQS and a portfolio manager of the CQS ABS Fund, started out in 1987 at NatWest (now part of the Royal Bank of Scotland Group) and spent a decade in residential and commercial property loan assessment before joining Abbey National Bank in 1997. Lumsden, who is head of ABS investing at CQS and is the senior portfolio manager for the CQS ABS Fund, started his career at Abbey in 1993 as a trainee. He swiftly worked his way up, running a portfolio of mortgage- and asset-backed securities for Abbey National Treasury Services and taking primary responsibility for developing the bank’s $15 billion home-equity-loan portfolio before he joined Rabobank in 2001. (Swallow joined him there a year later.)
CQS, founded in 1999 by credit and convertible arbitrage expert Michael Hintze, today is a $7.5 billion firm that supports seven hedge funds pursuing strategies that include volatility trading in derivatives and directional and relative-value multistrategy credit arbitrage.
Having spent the better part of 12 years working together, the two 40-year-old friends have a cheerful way of stepping on one another’s sentences and finishing one another’s thoughts, but they take their division of roles seriously. The market crisis has them seeing things through a disturbingly dark lens.
In an early-January interview with Alpha London Bureau Chief Loch Adamson at CQS’s elegant headquarters on Grosvenor Place in London, Lumsden and Swallow reflected on the wide-ranging damage of the credit crisis, the huge problems facing bond insurers and why they fear that another wave of real estate depreciation is about to strike the U.S. and the U.K.
Alpha: When you launched the fund in the fall of 2006, did you have any idea how fast the U.S. real estate market would deteriorate?
Lumsden: It became evident very quickly. It became even more obvious in the beginning of 2007, when we realized that it wasn’t just going to be a U.S. subprime problem. So we moved from simply buying protection on some parts of the capital structure in U.S. subprime — positions that we’d had there as hedges against our longs — to going outright net short by selling down our longs. We went from being hedged long to strategically short quite quickly.
What form did that protection take?
Lumsden: Early on, we saw opportunities to buy protection on ABS CDOs. One of the things that we were, quite honestly, surprised by was the speed with which — once defaults starting rising and things went wrong — our worst-case investment scenario materialized.
What were your best trades?
Lumsden: Incredibly, some loan companies thought they were going to originate their way through the crisis but instead just drove faster toward the wall. Take New Century Financial, a U.S. subprime originator that was continuing to originate subprime loans into a market where its only exit was a full-blown sale or securitization. It had significant fixed costs, and — in reality — it should have cut staff costs and production. But it did just the opposite: It continued to originate large loans that we know cost 3 points to originate, so its cost was 103, and its exit was 87, and no company can continue to do that for very long.
Once you see something like that, it’s pretty obvious that the stock is overvalued, and you can buy put options because you know that what they are producing is going to absorb cash very, very quickly. The company filed for bankruptcy shortly thereafter.
Are there material differences between the U.S. and U.K. housing markets?
Swallow: The U.K. real estate correction has been far quicker than the U.S. correction. If you look at the U.K. correction now relative to the early 1990s, it bears no comparison — we are now in the same position after one year, if not worse off, than we were after three years in the early 1990s.
Lumsden: Absolutely, the decline in the U.K. from the peak has been quicker, although in absolute terms the U.S. decline still outstrips the U.K.
The most concerning thing, to me, is that I fear we may have only just started to see the impact of people losing their jobs on that price depreciation in the U.K. — and if you look at the last recession, you could argue it wasn’t really the interest rates that killed people, it was losing their jobs. That is what made British homeowners give their keys back. That is only just starting to happen here, and it could accelerate in the months ahead.
How would that affect U.K. banks?
Lumsden: One of the problems, looking at the European side now as well, is that everything is interconnected. So a lot of the German banks have had huge exposure to U.S. subprime through investing in CDOs and structured finance — but banks in mainland Europe don’t appear to have the same focus on mark-to-market accounting that exists in the U.S.
The fact that those institutions may eventually have to realize the full extent of their losses will continue to impact lending in their own local markets. So it is a global problem, and what the U.S. has actually done very well is export a lot of its problems to the rest of the world. The net effect is arguably that the U.S. financial system may suffer less pain than financial systems in Asia and Europe, where some banks have invested in a lot of monoline-insured asset-backed securities and CDOs — all of these different structures.
Where will the crisis strike next?
Lumsden: The next big event is likely to be the monolines’ eventual failure. And while you hear that most banks have taken that into account — and that may be true to some degree in the U.S. — there are a lot of European and Asian banks that are valuing monoline-insured books at very high levels relative to where they actually trade . . .
Swallow: . . . and fundamentally where they should trade. When the monoline insurers eventually do default and you don’t have any ability to claim any cash at any meaningful level from them, the losses you are going to take on the underlying assets, which are generally CDO assets, are going to be significant — if not almost entire. If you’ve got between $10 billion and $20 billion of monoline-insured ABSs on your balance sheet as a European bank, and you’ve only written down about 10 percent of it, you’ve got a long way to go.
How broad and deep is this problem?
Lumsden: If the banks were to value their portfolios in line with our models, some would be multiple times underwater from an equity-valuation perspective.
Swallow: This is arguably a highly politicized issue. On the one hand, you have large numbers of retail investors in the U.S. who hold monoline-insured municipal bonds, and on the other, you have European financial institutions with significant holdings of monoline-insured asset-backed securities. With so many different interests, maturities and timings of payments, any potential monoline insolvency would likely be messy, litigious and protracted.
Do you see any opportunities on the long side?
Lumsden: We are now facing a number of macroeconomic issues — it is no longer just a credit crisis. So I think where we go from here is going to be driven by the timing of any economic recovery, and that is a long-term issue. I don’t think we can expect the markets to do much over the coming year or so, but within that larger context, we are seeing some interesting opportunities — even on the long side, where we’re focused on shorter-duration, well-enhanced product with a large amount of subordination — product that will perform well across some pretty horrific scenarios where we see losses running at completely unprecedented levels.
Swallow: While we are absolutely not willing to call the bottom of the market — because that is a fool’s game — I think we are in uncharted waters. Investors who have money to put to work can find tremendous value. We’re seeing more value at the top of the capital structure in the U.S. and in Europe, in deals that are of quite short duration — i.e., the actual tranches that have got cash flowing now and are paying principal, or very close to paying principal.
