How to succeed in a crisis

AT WEDDINGS, YOU never know whom you might end up sitting down to eat with. For Kyle Bass, managing partner of Hayman Capital Advisers, a Dallas-based hedge fund, life changed at a wedding in Spain last year when he met the head of the securitization business at a leading Wall Street firm.

The other guests were perhaps less than enthralled by the conversation but Bass, who manages a global special situations fund, was riveted by it. "Basically he explained to me how Wall Street had been forced to invent the mezzanine CDO market in order to export, principally to new money investors in Asia, the sub-prime residential mortgage backed securities the Wall Street machine was churning out."

It was one of those moments when scales fall from the eyes. Bass suddenly saw that the US securitization industry had been pouring out toxic waste on an epic scale and was now desperately seeking new fools to buy it.

In the immediate aftermath of the liquidity seizure in financial markets over the summer and the rout in the sub-prime mortgage market, hedge fund managers collectively, as measured by the broad indices, showed poor and highly correlated returns: the exact opposite of what hedge funds are supposed to provide in falling markets. But those broad measures fail to capture the success of a few hedge fund managers who, whether through their own investment skill, their insights into the most exposed markets and decisive steps to put those views into action, or through their chosen style being one that benefits from dislocations and volatility, produced strong returns.

Now, as alternative fund managers rush to set up new distressed and opportunistic funds to acquire cheap assets after the event, for some, such as Hayman Capital Advisers, returns have already been stunning.

While the newly-weds set off from Spain on honeymoon, Bass hurried back to the US and got to work: some of it quantitative modeling but much of it more fundamental and investigative.

He spent a lot of time in Florida and California talking to mortgage originators. They made no particular effort to hide what was going on or to pretend that underwriting standards were at all stringent. After all, they weren’t going to hold any of these mortgage loans themselves. They weren’t subject to much in the way of regulatory oversight. "They told me that, in the environment then prevailing, they could originate anything. Money was essentially free," says Bass.

He contacted the Office of Federal Housing Enterprise Oversight and asked the chief economist to forward to him stores of raw data on US house prices, going back to the 1970s. He studied previous localized property crashes: Texas in the 1980s; California in 1991; more recently, Boston condominiums. His firm plotted the relationship, nationally and regionally, between house prices and house price affordability. "We saw that they followed almost parallel lines until 2003. Then, by the end of 2005, house prices had stretched to five standard deviations from the mean."

Bass visited the mortgage desks of the Wall Street underwriters, where bankers sought to dissuade him that any kind of crash was imminent, suggesting that although house price rises might slow, prices would never actually fall, and that borrowers would always find sufficient liquidity to refinance their mortgages. "I didn’t see a single piece of Wall Street analysis including assumptions even of flat, never mind falling, house prices, until UBS in November 2006." By then the equity of home builders was already flashing a glaring red warning signal and Bass had long since made his mind up.

Hearing words like "never" and "always" had been the final confirmation. This was an almighty house of cards that could collapse at any moment.

Federal Reserve interest rate policy had traded a tech bubble for a housing boom and, by the time the Fed started raising rates again in 2004, Wall Street had already built a huge securitization machine that needed feeding with new raw material.

The sub-prime lending market, which stood at just $20 billion a year five years ago, hit $600 billion in 2006. The last $1 trillion or so thrown on the mortgage fire never should have been lent out as it was against hugely overvalued collateral, by unscrupulous originators to inherently uncreditworthy borrowers.

The last unsteady layer plastered on top of this teetering edifice was slapped on by the ratings agencies, which chose to grant the same rating enjoyed by the US government to tranches of CDOs containing 80% sub-prime mortgage-backed securities that one leading bank credit strategist now characterizes as "complete shit".

Bass says: "The mistake here wasn’t one of marginal rating action. The fact that the ratings agencies even put investment-grade ratings at all on CDOs of sub-prime ABS is laughable and a decision for which they have never provided an adequate explanation. Triple-A is simply not triple-A any more. Until the ratings agencies admit their gross negligence in the flippant application of this gold standard, the markets will continue to have severe dislocations." He adds: "Even now, you see an agency downgrade $18 billion-worth of ABS but not downgrade the CDOs that own them."

Hedge fund performance is correlated

All styles underperform through the crisis

Source: Credit Suisse

Hedge fund managers are notoriously chary of disclosing fund returns, but data leaks into the markets from various sources, including private banks and funds of hedge funds, which closely monitor hedge fund managers’ returns. According to such market sources, from inception in December 2006 to mid-October 2007, Bass’s dedicated mortgage fund is up 463%, encompassing a year-to-date return of 426%. Meanwhile the global special situations fund, which has also taken short positions on the mortgage market and US corporate credit and is long Asia, was up 156% for the year to mid-October and by 210% since inception in February 2006.