ALTERNATIVES - Mortgage Mania

With many struggling firms expected to liquidate their holdings, a handful of investors eagerly await fire-sale bargains.

FOR NEARLY NINE MONTHS, Donald Brownstein, founder and CEO of $650 million Stamford, Connecticutbased hedge fund firm Structured Portfolio Management, has been generating triple-digit returns through SPM Strategies Portfolio I -- a $50 million fund set up to short the subprime mortgage market. Last month, hoping to replicate that success, he launched the SPM Directional Mortgage Credit Fund, which seeks to benefit from the current liquidity crisis by acquiring high-quality structured paper from firms that are badly in need of cash and forced to sell at deep discounts. But this time around, returns could be harder to generate for SPM, as a handful of major banks are preparing to launch what could amount to a $100 billion version of its newest fund.

In mid-October, Citigroup, JPMorgan Chase & Co. and Bank of America Corp. announced plans for the Master-Liquidity Enhancement Conduit -- a joint fund that will look to acquire assets rated AA or higher from structured investment vehicles forced to liquidate their holdings. The Citigroup-led initiative is expected to be up and running by December and is being supported by the U.S. Department of the Treasury, which fears that multiple forced liquidations among SIVs could lead to a meltdown. The banks have already secured soft commitments from financial institutions totaling roughly $60 billion, as of late October. Lenders, however, want more specifics on the type of assets the funds will buy before they commit.

But Brownstein, who plans to cap the SPM Directional Mortgage fund at $500 million, isn’t too worried about the competition and believes Citigroup’s plan fails to address the core issues plaguing the credit markets. “The problems associated with the SIVs are not just ‘accounting’ problems,” says Brownstein, 63, whose firm has specialized in mortgage-related issues in the decade since its launch. “Subprime paper that has not been fully marked to market -- that is, marked way, way down -- won’t be worth any more just because it’s owned by an off-balance-sheet entity. This appears to me to be not as much a bailout as an ostrich act.”

Though bonds have been readily available, Brownstein says there has not quite been the unlimited supply of discounted paper that some were expecting. “The assets that commercial-paper conduits have used to deleverage have more often than not been effectively transferred to banks’ balance sheets -- not forced sales,” he says. Furthermore, several hedge funds holding structured paper have closed off redemptions to avoid fire-sale disposals.

Still, Brownstein, who began studying the mortgage industry on his own in the late 1980s while working as a philosophy professor at the University of Kansas, remains optimistic that as margin calls keep rising, firms will be forced to sell. And clearly he is not alone in his thinking, as investors such as Citi pursue the same idea.

Brownstein began his investment career in 1988 at Franklin Savings Association -- a Kansas savings and loan institution that was seized and liquidated by the government during the 1980s S&L crisis -- after teaching for two decades. There he helped develop quantitative methods for managing mortgage-backed securities. His intricate knowledge of the industry has already been a boost for the SPM Credit Fund.

When Santa Fe, New Mexicobased Thornburg Mortgage, an owner of triple-A-rated securities, was forced to unwind positions, the fund was quick to strike. Brownstein believes that such buying opportunities will be plentiful. “As the reality of the subprime situation becomes clearer, the market will gradually begin to price in ultimate values,” he says. “We believe we’ll begin to see more periodic deleveraging sales.”

To ensure that its portfolio has the long-term capital necessary to execute its investment strategy and to wait out the slow unwinding process, Brownstein has attached an 18-month soft lockup period to the SPM Credit Fund.

Though the asset-backed paper market registered historic declines throughout August, there has been a noticeable improvement in the sector following last month’s 50-basis-point rate cut by the Federal Reserve. Brownstein, however, believes short-term market improvements will have no bearing on the defaults that are inevitable.

“There are going to be large numbers of problems and probably defaults,” he says. “And they’re going to take place over a significantly longer period of time than people might expect.”

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