Institutional Investor's Alpha Magazine - March 2008 - (Page 49) vestment Management Co., one of the world’s biggest bond shops, also likes to trade the Treasury bond spread between cash and futures. He may buy a cash Treasury security and then hedge by selling a futures contract against which it is deliverable. “You are buying in the OTC market and selling into the exchange via the futures contract,” he says. “Sometimes the prices get out of line.” The positions create a steady cash flow, which he leverages by about two times its value to deliver returns that can approach 10 percent. To add to the mix, Edington, whose hobbies happen to include surfing, tries to catch the wave on what he considers the two or three best trading opportunities that come along every year. The first of his three funds looks for total-return plays in any asset class, but Rimrock offers a second fund to investors who prefer to limit their bets to the firm’s fixedincome expertise. In theory, each fund can reasonably be expected to earn close to 20 percent returns if the trades deliver, but if Edington is wrong, his income engine provides a cushion even in a bad year. Experience supports the premise; Rimrock has not had a down year since its founding in 1999 (and returns in its best years topped 20 percent). One key to Rimrock’s recent performance was its long position in interest rate options, which Edington bought as a play on volatility. The position was a natural hedge because volatility is often inversely correlated to bond prices. Edington wasn’t persuaded by the rosy arguments that policymakers had learned from past mistakes, more central banks were free from political interference and a global glut of capital would support asset prices. “Options prices were absurdly low by any historical standard in a world that seemed fraught with peril and leverage,” he says. Another successful hedge in 2007 was selling short the subordinated debt of Fannie Mae, a company originally sponsored by the government that buys qualifying mortgages. Edington saw one part of Fannie Mae’s business as “a 30-times leveraged monoline hedge fund that owned conforming mortgage-backed securities at a time when spreads on an option-adjusted basis were as narrow as they had ever been,” while the other part “received fees for being in a fi rst loss position on $2 trillion of U.S. mortgages in a housing bubble.” He argues that Fannie Mae’s implicit government backing might extend to its senior debt, but adds that if the housing market tanks, the subordinated debt will probably not be guaranteed. Yet when he put the trade on, it cost a relatively inexpensive 20 basis points per year to short the subordinated debt. “Our theme was to find cheap insurance,” Edington says. “A year ago there were so many things like that, it was difficult to pick the best.” Today, Rimrock has about $300 million under management: $200 million in its first two funds and $100 million in a fund launched in January to exploit mostly long opportunities among senior tranches in subprime mortgage bonds. Edington argues that if cumulative mortgage credit losses impair the senior notes to the extent that current deeply discounted market prices imply, Fannie Mae Photo by Ye Rin Mok/Wonderful Machine for Alpha and Freddie Mac will be bankrupt, a wholly unlikely circumstance. “The whole world is not pricing to the Great Depression,” he says. Fixed-income arbitrage takes yet another twist at Structured Portfolio Management, a Stamford, Connecticut– based firm with $800 million in assets. SPM specializes in mortgage arbitrage, mining the risk premiums related to mortgage prepayments. SPM founder and CEO Donald Brownstein says that with real estate values falling, lenders won’t make a loan unless the borrower puts up 20 percent, so anyone who bought at the top of the market may have to come up with additional cash to get a new loan. This is anything but attractive to homeowners, who may also balk at putting more money into a declining asset. Most will not refinance under such conditions, which pushes out the expected duration of mortgages — and the bonds they support. And that is why Brownstein now owns prime-quality, interest-only mortgage-backed securities, which pay the interest component of a mortgage payment for as long as the mortgage is outstanding. “The IOs won’t prepay, which means they are more valuable,” says the CEO, who hedges out interest rate risk in such holdings by buying Treasury futures. Such a strategy involves a complex calculation in which the credit quality of the borrowers is crucial. “Grandma can’t do this stuff,” Brownstein says. “You have to look at it piece by piece. It is very detail-oriented.” “The whole world is not pricing to the Great Depression,” says David Edington, CIO of Rimrock Capital Management. MARCH 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 49
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