If the trade of the year in 2007 was to short the ABX, the subprime mortgage index, along with subprime lenders and subprime mortgages themselves, then the question hedge fund managers and their investors are now asking is: What happens next? And, more pressing, what’s the best way to profit from the massive dislocation in the mortgage markets?
“It is a trillion-dollar opportunity,” says Michael Hennessy, managing director of $1.2 billion Morgan Creek Capital Management, a Chapel Hill, North Carolina–based fund of hedge funds that caters to foundations and endowments. Morgan Creek is just one of many funds of hedge funds setting up specialty funds — another is the $15 billion alternative-investment firm Investcorp, listed in London and Bahrain — to take advantage of the distressed-investment environment, with an emphasis on mortgages.
Investors can choose from a growing number of such hedge funds. New firms, like New York–based One Williams Street Capital Management, started by David Shirr, former head of securitization at Lehman Brothers, are opening. Old ones, like Goldman, Sachs & Co., have launched specialty funds. Others, including the now famous $4.2 billion, New York–based Paulson Credit Opportunities Fund, founded by John Paulson, continue to play the mortgage market.
Meanwhile, multistrategy hedge fund firms are building up their mortgage desks. But many mortgage experts warn that multistrategy funds are not sufficiently prepared for the technical and quantitative nature of the mortgage markets. And will making money on the way out of the mortgage crisis be as easy as making money on the way in?
Paul Ullman, founder and CIO of $1.6 billion Highland Financial Holdings Group in New York, says that neither mortgages nor the housing sector will begin recovering any time soon. Ullman, who began his career on the mortgage desk at Solomon Brothers in the early 1980s, doesn’t expect either to improve until at least 2009. He also argues that the time for the big-picture, big-money bet of shorting the ABX index -— the very gamble that made money for a host of hedge funds last year — has passed.
“The time for the macro bet is, in my view, over,” says Ullman. “The way to make money in the mortgage market going forward is bond by bond.”
In fact, there is an entire school of thought that says the mortgage sector and, by extension, the banking and financial services sector are far from being out of the woods. “We have the worst housing recession since the Great Depression,” said Nouriel Roubini, a professor of economics at New York University’s Stern School of Business, during a recent panel discussion hosted by his research firm, RGE Monitor. “And it is not bottoming out; it is getting worse.”
For hedge funds now looking to profit, one obvious move is to short financial services companies and banks, and there are plenty doing so, including Paulson & Co. and Pershing Square Capital Management. Others, like Angelo Gordon & Co. and Maverick Capital, are looking at buying, or have bought, loan-collection companies. Trading the actual mortgages or asset-backed securities is trickier. It requires figuring out the statistical likelihood of defaults and payments on mortgage pools that may vary by type, location and rating.
All of which means that those unschooled in the sector can get burned. To avoid that, firms like Morgan Creek and Investcorp appear to favor funds that did well in 2007 and have developed expertise in the sector. Investcorp was a first-day investor, and eventually became one of the biggest investors, in Paulson Credit Opportunities Fund. Another favorite among funds of funds is $5 billion fixed-income specialist MKP Capital Management in New York. Expertise notwithstanding, a lot of mortgage specialists lost money last year. “What was not apparent to many of us, myself included, was how fast things would unravel,” notes Ullman.
Indeed, Highland Financial had a mixed year. A short fund did phenomenally well, up 190 percent in 2007, but other mortgage funds in its portfolio had double-digit losses. The firm regrouped and retooled. It hired new traders, including Gary Mendelsohn, a former proprietary trader at Morgan Stanley, and at the beginning of 2008 launched two new funds to take advantage of dislocations in the marketplace. The funds are buying up baskets of distressed mortgage- and other asset-backed securities trading at a discount.
