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SectionsJanuary 2 2008

Hedge funds find silver lining in subprime clouds

While the rest of the market reels from the subprime-sparked credit crunch, some specialist hedge funds which speculated on a downturn are reaping hefty returns. Silvia Pavoni looks at how they did it and where they will look next.
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One of the founding fathers of modern economic theory and an early contributor to The Banker, John Maynard Keynes, once said: “The market can stay irrational longer than you can stay solvent.” This maxim must have crossed the minds of at least a few of the fund managers that were waiting for the subprime sector to crash and were sustaining expensive short positions in anticipation of the crisis.

Hedge funds are traditionally secretive and information on their performance is quite scarce, whether things go well or not. But data that made it to the public domain shows just how successful some of their strategies have been.

A few of them were very successful, with returns as high as 1000% in the case of California-based hedge fund Lahde Capital.

Other funds that achieved stellar returns, in some cases more than 500%, include heavy hitters such as Paulson & Co and Hayman Capital.

The bet against low-quality subprime mortgages appears to have become one of the most profitable trades of all time, allegedly making more than $20bn in total this year.

New York-based Paulson & Co alone is said to have made $12bn profit from the trade at the end of November. Kieron Launder, chief investment officer at Rothschild Private Bank, believes that it is no accident that people such as Paulson had such results.

“Those who have done well out of this are people who understand and set up funds specifically to take [a particular] risk: Paulson and others shorted specific tranches of collateralised debt obligations (CDOs). They know the market and that’s their core business,” he says.

Focused, speculative positions were key. “There have obviously been some substantial moves in the market, so those positioned correctly made substantial amounts of money in the derivatives market,” says Michael Hampden-Turner, a director in the credit product strategy team at Citi.

The people who got it

Others have a slightly different opinion. “It’s not that hedge funds were massively bright, it’s just that they were awake,” says Jerome Booth, head of research for Ashmore Investment Management. “There are people that got it and there are people who didn’t get it. The amazing thing is that the banks didn’t get it. Although some say they did.”

The subprime crash has been a wake-up call for many. Investing in structures you do not fully understand is risky enough. Investing in structures whose behaviour is not clear or tested causes even bigger headaches. This led to some investors, who ought to have hedged their exposure but that didn’t expect things to precipitate as severely as they did, reacting too slowly.

Beware of the ultra confident

Financial markets seem to reset their memory every 20 years. The young talents of today’s banking world would not have had recollections of previous property market crashes in the US, where house price appreciation has continued since the 1950s. This, combined with the advent of securitisation, boosted investors and structurers’ confidence that more or less any product could be successful, even the ones based on risky assets such as subprime mortgages.

“Home prices have consistently appreciated in the US, and had risen by 25% in the past four years,” says Mr Hampden-Turner. “Analysts are not used to thinking in terms of negative house price appreciation.”

And he adds: “There is a big difference between the types of mortgage loans extended in 2006 and 2007 and previous years, recently mortgage loans were provided to people with lower credit scores.”

The subprime lending market went from $20bn five years ago to $600bn in 2006. Mr Hampden-Turner says: “A number of financial institutions retained super-senior tranches of collateralised debt obligations (CDOs) with the long-term view that they could withstand a bit of a mark-to-market volatility. These are now the banks that have been taking the big write-downs.”

But, if the majority of banks did not see the downturn coming, other investors did, mainly specialist funds.

The devil is in the detail

So, how did those specialist funds do it? Some said they analysed and followed the weakest subprime mortgage originators into the structures, says Mr Hampden-Turner.

Andrew Lahde, owner of Lahde Capital, said in a letter to investors: “Fellow CFAs probably remember learning about the mosaic theory, which distinguishes between plain old inside information and attaining information from different sources and combining them together to reach a conclusion that is virtually as good as ill-gotten inside information. I have so many sources of information, both the factual/

statistical type and the anecdotal type. Everything I see tells me the ABX [the asset-backed securities index] is going to fall further, as is the CMBX [the commercial mortgage-backed securities index], the equity market, the dollar, etc.”

In August, Mr Lahde defined his fund’s returns as “the top-rated performance for all hedge funds in the universe”. Series A of Lahde Capital’s fund was up 410% for the year then. How would he define its 1000% return in 2007 to November now?

Although not as high as Lahde’s, others have also achieved stellar performances. Hayman Capital and Corriente Advisors jointly run the Subprime Credit Strategies fund and were reported to have made a cumulative 526.5% return for the year to November. Paulson & Co, well known for making event-driven investments and for merger arbitrage investing, had a 550.8% return with the Credit Opportunities fund at end of October.

Others followed with impressively good performances. Harbinger’s subprime fund was up 65% as of September. London-based Credaris’s structured credit fund was up 40% as of October and reportedly has a specialist ABS fund with an even stronger performance

FrontPoint Partners, acquired by Morgan Stanley in 2006, is reported to have done well with a fixed-income opportunities fund, up 45% for the year to mid October. The firm also has a volatility fund up 27%, and two financial sector funds, up 45% and 52% respectively, through having shorted the equity of home builders, rating agencies, mortgage companies and financial firms heavily dependent on wholesale funding via securitisation.

Peloton Partners was reportedly up 63% with its ABS funds for the year to September 2007.

Acumen for sale

While specialist funds made high returns betting against subprime, some private banks are selling their investment acumen on the basis that they avoided these structures altogether. Pierre Mirabeau, of Mirabeau Banque, proudly comments that such structures were too risky for his bank’s conservative profile, even the ones rated as investment grade.

Mr Lauder agrees. He says: “[There has been a real] demand for structured products, where their behaviour has probably been untested before and where you have relatively concentrated risk. The mathematical models of the rating agencies and some of the banks that repackage these things, how far were they stressed? We were offered a lot of these products, which made relatively simple assumptions around the default rates and the recovery rate.

“The sophistication of certain financial products has gone further and faster than most people,” he says. “Some can keep up with it but most cannot. This means that some people didn’t understand it or were sold it too easily.”

Doubts have also been raised about banks’ conflicts of interests when it comes to these products, as they structure and sell them while also raising funds to invest in them. Jacques de Saussure, managing partner of Pictet, the biggest independent Swiss private bank, told FT Deutschland: “Although the difference between a private bank and investment bank is understood, many clients think: how do [global banks] manage our money, when they can’t handle their own balance sheets?”

What next?

While financial markets and policy-makers are busy trying to contain the effects of the credit market crisis, specialist investors have been setting up funds to gain from the next opportunities.

Many have been raising funds to invest in distressed debt, an area that has reached record volumes already in 2007. According to research company Private Equity Investment, a total of 16 distressed funds have been closed in the past year for an aggregate capital of $32.6bn, and 22 more funds are seeking a total capital of $24.8bn. In 2003, the number of distressed funds was 12 and their total raised capital was $5.5bn.

New York-based Cerberus Capital Management has set up the biggest fund with $7.5bn, followed by Minnesota’s CarVal Investors and New York’s Patterson Global Advisors, both with an aggregate capital of more than $5bn.

As for other sectors that might follow the fate of subprime mortgages, speculations are numerous. In his letter to investors, Mr Lahde says that he expects the collapse in value of subprime mortgage-linked securities to be repeated for bonds backed by commercial property loans in the event of a deep recession, which he also predicts. He also noted: “Our entire banking system is a complete disaster. In my opinion, nearly every major bank would be insolvent if they marked their assets to market.”

It will be interesting to see where hedge funds will make their next 1000% return from (see investment article, page 112).

TABLE: Top 5 Distressed Debt Funds Closed 2007 (YTD 13 DEC 2007) and Top 5 Distressed Debt Funds Currently Raising (AS of 13 DEC 2007)

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Silvia Pavoni is editor in chief of The Banker. Silvia also serves as an advisory board member for the Women of the Future Programme and for the European Risk Management Council, and is part of the London council of non-profit WILL, Women in Leadership in Latin America. In 2019, she was awarded an honorary fellowship by City University of London.
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