How to succeed in a crisis
The credit market seizure vindicated a few brave hedge fund managers who had spotted the sub-prime crash coming, positioned themselves deftly, and made huge returns from it. These managers recount the challenges of deploying funds against the long-only herd, outline expectations for worse market disruptions ahead and analyze the public policy responses that threaten the potential returns of many investors now seeking to profit from distress. Peter Lee reports.
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
Bass rushed to set up a series of specialist funds to short the mortgage market, finally launching them to potential investors in the middle of September 2006, as soon as he possibly could, not even waiting for a month end. "My biggest fear through this time was not that the bet wouldn’t pay off but that we wouldn’t be in time to place it. We didn’t even have to take particularly inordinate risk to put it on. The potential risk and reward profile was the most favourable I have ever seen. It really was a once-in-a lifetime opportunity." 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.
Bass, in common with all hedge fund managers who spoke to Euromoney for this story, refuses to confirm or deny specific numbers. How did the funds manage these kinds of spectacular returns? It was not by simply going short the mortgage indices through derivatives. Bass explains: "We went short specific securitizations. We spent months identifying the worst mortgage loan originators and then tracked their loans, following them into specific pools and securitizations and then into CDOs of securitizations."
When so many of the world’s leading banks, which all routinely boast of their state-of-the-art risk management capabilities, are reporting losses arising from a failure properly to monitor and understand the risks embedded in structured mortgage and credit portfolios, bank shareholders should pay heed to Bass’s explanation of how his funds took these positions simply by following the worst trails of slime.
Investors should also be wary of alternative managers now seeking to set up distressed funds after having blown up investors in their CDOs.
Short is the new long and everyone wants to proclaim himself or herself a smart distressed investor. Private equity funds are doing it, emerging market investors, long/short managers, even CDO managers are doing it. But setting up funds and buying pieces of leveraged loans being puked out by Wall Street underwriters at 95 cents on the dollar, before the underlying businesses have suffered any damage, is not distressed investing. Going long bad loans at a small discount is not the same as shorting overvalued collateral on a clear-headed relative value analysis.
A rival hedge fund manager who has also profited from distress points out: "Most of the CDOs were put together by structurers, not credit specialists. So from March last year, when the underlying collateral started to look bad and the CDOs were still ramping up, first we shorted to the CDOs, then we shorted the CDOs themselves."
It got ridiculous. Betting against this phony construction was a near certainty. Back to Kyle Bass. He says: "We designed the funds with a three-year life in such a way that, if we were wrong, investors would lose roughly 11% a year or at most 36% of their capital over the life of the funds. But, if we were right, investors stood to make 10 times their original investment."
It was a 33/1 gamble that the US mortgage market had got overextended: a great price for a near certain bet.
Many investors to which the new funds were marketed instinctively grasped the rationale behind Bass’s analysis of the prevailing excess and the likelihood of a stunning correction. This was not a crash that was particularly difficult to spot coming. Indeed many people saw it coming. But large swathes of the US financial services industry were geared to deny the likelihood of any such unpleasant outcome and to keep the whole originate-securitize-distribute game going, from which so many were profiting so handsomely and in so many ways.
Bass had two Forbes rich-list individuals commit to the dedicated mortgage funds, only then to pull out after discussions with their long-standing Wall Street advisers.
Heading to zero
It would almost be worth paying out a portion of the fund’s stunning returns just to be a fly on the wall when those Wall Street advisers next sit down with these ultra-high-net-worth individuals.
Ten months into the life of the three-year funds, in mid-October 2007, Bass reports that many of the securities they shorted at par are now being marked down to an average of 58 cents on the dollar. Where does he think they might end up? "A lot of this stuff is going to zero. A lot of securitizations were originated with just 2% to 4% initial over-collateralization, hence the distress when cumulative losses nudge up to 5% to 7%. Where might cumulative losses in sub-prime come out? Perhaps 18% to 20%. That will wipe out an awful lot of investment-grade tranches."
ABS market provides liquidity for originators
Sub-prime and second-lien ABS issuance volume before the crisis
Source: Thomson Financial, Deutsche Bank
A lot of the ratings agency action so far has been in further downgrading tranches of securities that were already below investment grade. Soon the ratings agencies will have to downgrade many of the securities rated above triple-B, and that will lead to unwinds and forced selling in many of the mezzanine CDO structures that have no cashflow or market-value triggers but that cannot hold more than 50% of sub-investment-grade collateral. A lot of paper that is trading in the low 30 cents on the dollar right now – on a default-and-recovery-value basis – is still rated investment grade. In the last week of October, Standard & Poor’s downgraded 145 mainly triple-A and AA-rated tranches of 97 mezzanine CDOs, having earlier downgraded large volumes of underlying Alt-A, sub-prime and second-lien RMBS collateral. Bass concludes: "What we have seen so far is just the prelude to what is to come."
Bass wasn’t alone in anticipating the sub-prime blow-up and positioning for it. According to numbers shown to Euromoney by various market sources, including fund of hedge fund managers, others have also profited handsomely, notably John Paulson at Paulson & Co.
Paulson and his eponymous hedge fund firm are renowned in the fields of event-driven and merger arbitrage investing (see profile in Euromoney, December 2006), but also had the foresight and the credibility to establish a large credit opportunities fund last year to short the mortgage market. This is also, like Bass’s dedicated mortgage fund, reported to be up by well over 400% for the year.
Others have also managed strong returns. Credaris in London runs a structured credit fund that has risen some 40% this year, as well as specialist ABS funds with even stronger numbers.
Morgan Stanley's third quarter results were hammered by losses of $480 million in quantitative strategies run by a proprietary trading group inside its equities division. But the alternative investment managers in its asset management division did well. And certain funds run by FrontPoint partners, which Morgan Stanley acquired in October 2006, excelled, with a fixed income opportunities fund up 45% for the year to mid October, a volatility fund up 28% and two financial sector funds up 40% and 45%, by having shorted the equity of home builders, rating agencies, mortgage companies and financial firms heavily dependent on wholesale funding via securitizations.
Peloton Partners, the hedge fund founded by ex-Goldman Sachs trader Ron Beller, runs multi-strategy funds and ABS funds, with the latter reportedly up by 63% for the year to September.
So for all the Wall Street protestations that the summer’s crash was an extraordinary and unforeseeable event, quite a few people saw it coming. Indeed even more would have profited had not the markets that created the mess stayed irrational rather longer than the positions of some far-sighted investors remained solvent.
"The potential problems in sub-prime were being talked about for a couple of years," says Andrew Donaldson, chief executive at Credaris. "There were any number of long-short players who went short sub-prime in 2006 and many of them were carried out of their trades by the end of the year as credit spreads refused to budge and, if anything, ground in tighter. It became a very expensive proposition to be short a market that was continuing to perform. I suspect there were many more shorts in the third quarter of 2006 than there were in the first quarter of 2007."
Of course, it was mainly huge demand from synthetic CDOs and other structured credit vehicles, conduits and structured investment vehicles (SIVs), that drove spreads down even as mortgage market fundamentals deteriorated.
Indeed, the temptation simply to go long in such a bull market is very strong and fund of funds managers will have found many alternative funds in both credit and equity that were sold as market-neutral but which turned out to have become very long-biased by the time the markets tipped over. One private banker suggests that, across the long/short equity funds the bank monitors, net long positions amounted to 80% of investments by the early summer.
Michael Kelly, chief investment officer at FrontPoint Partners, says: "Over the last few years of very low volatility and cheap and easy credit, those managers who bought equity or credit on the dips were rewarded handsomely. Many of the most popular alternatives strategies – high-beta equity, quantitative equity, event driven, leveraged credit and those strategies driven by the carry trade, all did well and grew strongly. That’s why, when conditions changed in the summer, they mostly underperformed in a highly correlated way."
During this time, FrontPoint’s own financial analysts were regularly pointing out the vulnerabilities of the sub-prime mortgage sector and that a pick-up in delinquencies would force the ratings agencies to revisit their over-optimistic assumptions and eventually downgrade. Kelly says: "The chief difficulty for us in shorting the entire spectrum of structured credit vehicles was one of timing. Especially given the opacity with which many of these vehicles were created, it was very difficult to anticipate the timing of unwinds."
In the febrile market conditions of September and October, with risk appetite returning, equities rallying and spreads narrowing once again, those fund managers who successfully put on short positions to profit from the market distress earlier in the year, and who still see worse to come, especially in the sub-prime mortgage market, now face new worries.
An end to free markets
Already, central banks have rushed into action by cutting rates. Public policymakers are desperate to alleviate the worst of the coming housing crash, partly to avoid damaging their economies, partly to shore up political popularity. It appears that public and private sector forces are being exerted to prevent a second leg of the mortgage market crash: witness the US Treasury secretary blessing the creation by Citi, JPMorgan and Bank of America of a new über conduit to buy assets from SIVs and provide a relief for those vehicles dependent on rolling over funding in the now far from dependable asset-backed commercial paper market.
Is this some kind of bail-out fund, a mechanism for the banks to bolster the structured credit vehicles that they otherwise might have to fund directly on balance sheet, including vehicles that also buy a fair chunk of the banks’ own liabilities? Is it also a means for banks to avoid taking full mark-to-market hits on what might otherwise become widespread forced sales of assets into a market where there are no other remaining natural buyers?
One hedge fund manager says: "It’s not been a great few weeks for free market purists, has it?" It is very tough to take risk positions when the responses of the various authorities are so unpredictable.
ABS Fuelled the growth of CDOs
ABS/MBS/CMBS purchased by CDOs
Source: Bear Stearns
Many investors have sought to take advantage of this public policy response in the simplest and most obvious way – putting on yield-curve steepeners in anticipation of short-term rate cuts, the first of which the US Federal Reserve was quick to deliver. At FrontPoint, the only new strategy it has launched to profit from distress was the volatility fund it established at the end of 2006 to buy up cheap volatility across fixed income and current rates, as well as equities.
Looking further ahead, Kelly sees more market woe. "The ABX and sub-prime markets are now pricing rising levels of defaults on underlying mortgages which will play out over the next three years. If losses rise to 10%, then all the triple-Bs will be wiped out, if it’s 14% then all the single-As are gone." Kelly is not optimistic. "We anticipate that the severity of the housing market crisis will exceed even the current pessimistic expectations."
Unless the Fed can find a way to get mortgage rates down by several hundred basis points – and of the 25 largest providers of sub-prime financing, nine have so far disappeared and many of the survivors are impaired or in retreat – then the mapping of re-sets is very severe. "We’re just in the second inning of that," says Kelly.
Will Washington write a cheque to sort out the mess? Probably not. Rather, legislators are considering suggestions for a reformed personal bankruptcy code that would treat mortgages rather like unsecured corporate loans. After a standstill, a property might be revalued to a lower level, new and affordable debt-service terms decided for the borrower and original lenders forced to accept a partial write-off of their loans and prevented from seizing the property.
To most participants in financial markets, especially the vast majority of conventional investors long the cash markets, the sight of the world’s biggest banks, the US Treasury secretary and other national authorities coming together to promulgate what are always called "market solutions" to the so-called "financial crisis" is a reassuring one. But to those who identified irrational exuberance, crass over-valuations, many standard deviation moves away from fair value, and positioned themselves accordingly, these forces look like a sinister cabal intent on thwarting the operation of free markets. "Those forces are now unleashed. Would you really bet against them?" one fund manager asks.
Those forces still have plenty of work to do.
"What we have seen so far has not really been about credit events, it’s been about de-leveraging: a good question to ask is what this portends," says Donaldson at Credaris. "I won’t sit here and say that this has been an early indicator of the end of this credit cycle but equally I don’t believe this is over. You can’t go through the kind of trauma that many investors have just gone through – at the end of a very long benign period – and digest it quickly. So the practical question becomes: how do you position for what’s ahead?"
The funds run by Credaris, notably its flagship Alpha fund, are constructed around jump-to-default risk, correlation risk and credit spread risk. Before the summer crisis, when the corporate credit markets only saw idiosyncratic risk for individual corporate names that might be subject to LBO but saw no widespread systemic risk, the Credaris funds positioned themselves long of correlation and short credit spreads, overlaying those short positions on a base long portfolio of equity tranches of bespoke credit structures.
It reasoned that the most glaring over-valuations were in the higher credit quality and higher-rated instruments where spreads had ground in due to insatiable demand from all the SIVs and conduits. There was better value, and better running returns, in the equity tranches of CDOs, ever since the spike in correlation in 2005 that followed downgrades of the US car companies. The creators of securitizations and CDOs of securitizations were knocking these first-loss equity tranches out cheaply at a discount, just to keep the whole game running.
Those positions paid off handsomely over the summer. What comes next is harder to predict and even harder to position for.
Up until the summer, bulls and bears were able to fine-tune the expression of their views in highly liquid derivative instruments comprising a market many times bigger than the underlying cash markets. Now entire pockets of the fixed-income, structured credit and securitization markets are frozen, having closed down in August and not re-opened. For the entire financial system, this throws up glaring questions over the provenance of mark-to-market accounting. For individual investors, it creates new pressures.
"It’s all very well to have strong convictions, but while there is a premium to pay, we far prefer expressing those convictions in truly liquid instruments where you can adapt to changed circumstances quickly," Donaldson says. "What you don’t want to be is not in control of timing of your exit: forced selling must be a really dull way to manage portfolios."
Another fund manager, who has profited handsomely from the market distress, refuses to be quoted talking about his fund’s performance because he doesn’t want to become a target for unscrupulous investment banks. He sees the Achilles heel of the entire hedge fund industry having been revealed as dependence for funding and, by extension, for valuation, provided by massively self-interested prime brokers and investment banks with huge financial interests of their own to protect and further.
This fund manager suggests that some investment banks have, in the absence of other valid inputs, been presenting hedge fund investors with far below fair value marks on their securitized positions in an attempt to force them to sell or even squeeze them out of business and seize their assets on the cheap. "These people are no better than thieves," he says. "They run their own hedge funds, invest money with hedge fund managers, buy hedge fund businesses, run their own proprietary trading desks, provide credit, structure and distribute deals. There are just so many conflicts of interest."
It’s in the nature of bankers under pressure to play any crafty game they can to get out of trouble. "I’ve seen banks going to investors and say: ‘Look we’ll offer to sell you this package of triple-B-rated MBS and we’ll throw in a couple of hundred basis points up front and even guarantee to cover you for the first 30% of any eventual loss.’ Of course, the MBS they’re trying to sell like this are worth absolutely nothing."
Prime brokers and lenders to hedge funds might also see a very strong incentive, where markets are not functioning, to value clients’ securities more generously both to preserve valuations of the banks’ own exposures and to keep customers solvent to preserve them as a source of earnings and to forestall a fire-sale of distressed assets that would further damage the banks themselves.
Market participants certainly see reasons to be fearful, unless public and private sector players can engineer a rescue. Data are now coming in for 2005 vintage mortgages that have recently become subject to rate re-sets. The widespread assumption has been that these older mortgages are of better quality and that borrowers enjoy a greater equity cushion from house prices that have had longer to rise. However, that doesn’t help weaker borrowers who simply don’t have the income or spare cash to meet higher monthly payments.
What’s only just starting to emerge, and will become clearer from this month onwards, is that large percentages of 2005 vintage sub-prime mortgages are going into delinquency in the first month after rate re-sets. "A lot of the 2005 vintage is going to zero, as well," says one investor. "And the ratings agencies haven’t even done anything about the 2007 vintages either, where the sub-prime RMBS collateral is the worst on record. Their assumptions are so far off, the agencies can’t even calculate it. Over the next six months, we are going to be seeing the worst collateral performance in the history of the asset-backed securities markets."
Aside from any securities related to sub-prime mortgages, financial markets in mid-autumn seemed largely to have returned to the bullish assumptions that prevailed before the summer, although US stock markets were volatile amid dollar weakness over the anniversary of the great crash of 1987.
People want stock prices to go up and credit spreads to tighten. But it seems a fair guess that further outbreaks of volatility lie ahead.
In 1997, what began with the devaluation of the Thai baht climaxed with the failure of a huge US hedge fund and US authorities and private sector bankers struggling to mount a bailout. So where the correction that began in the US mortgage market might eventually strike is difficult to discern.
Asian stocks, particularly Chinese stocks listed in Hong Kong, rallied markedly after the Fed interest rate cut in September. Singapore-based hedge fund Artradis runs a $1.3 billion market-neutral long volatility bias fund called Barracuda that has shown annual returns of around 8% since inception in 2002. That’s nothing to write home about from the booming Asian stock markets where going long has paid off handsomely. It is costly to pay out premia to go long volatility and even in dispersion plays – going long volatility of individual stocks and short index volatility for example – funds have to earn back those costs before producing incremental returns.
The proposition for Barracuda, which invests in listed and OTC options, warrants, convertibles and variance swaps, is that returns are not correlated to the MSCI Asia index nor the Eureka Asia hedge fund index. During the periodic market tremors, such as in October 2005 and May and June 2006, Barracuda has shown its worth by producing strong returns uncorrelated either to the main market indices or to long/short Asian equity funds. In July this year, it returned 3% and in August 11% and is on course for a 20% annual return.
The next bubble
While the fund can benefit from volatility in rising markets, and its managers declare themselves long-term bulls of Asia, it is in bear markets, especially the early stages, that performance will stand out.
Julian Ings-Chambers is a manager of the volatility fund. He says: "We see more volatility ahead for Asia. We see no reason to believe that Asia can decouple from a US slowdown and it seems extraordinary that Asian markets should be at all-time highs, have doubled PE multiples in the past two years, when there are clear risks of earnings disappointments for exporters to the US, not to mention the near heart-attack we have just seen in the global credit markets."
Speaking in mid October, Ings-Chambers notes: "China is a bubble. Cyclical stocks, resource stocks, now trade like growth stocks on the basis that China will never stop growing."
It’s that word "never" again. As with sub-prime residential mortgage backed securities when structured credit vehicles were bidding them up, spotting that over-valuation isn’t hard. Positioning for it in a raging bull market, without getting wiped out, is. Investors have already forgotten how scared markets were just two months ago. Ings-Chambers says: "H-shares have rallied 80% in six weeks. If you wanted to try and pick the top and short into that, good luck."
It’s starting to sound rather familiar.