Alpha - September 2007 - (Page 10)

head of commodities research at Goldman Sachs. “The ones that are currently in production won’t be up and running until the next decade, during which time supplies may remain tight.” There is also the issue of access. Though regulators have shown some signs they might ease current restrictions, hedge funds with less than $5 billion in assets are currently prohibited from trading on China’s mainland exchanges. Peter Fusaro, co-founder of online research and consulting firm Energy Hedge Fund Center, believe China’s rising demand for energy is appealing enough that hedge funds will continue to pour into the sector. “The bottom line is that we are in the middle of a demand-driven bull market in energy commodities like we have never seen before and probably won’t see again,” says Fusaro. — Dave Simons Despite such obstacles, industry observers such as Further Fallout? T Russell Investment Group’s David Tsujimoto: Sounding the alarm on more subprime troubles. he massive deleveraging of the ﬁnancial markets was bound to burn some hedge funds. The surprising part may be how few. Despite the frenzy of attention surrounding blowups brought on by the collapse of the U.S. subprime mortgage market, the majority of hedge funds avoided the carnage. In August the HFRI fund-weighted composite index fell by 1.31 percent. But if David Tsujimoto is right, the worst may not be over. A large number of adjustable-rate-mortgage resets are due to occur late this year and in early 2008, meaning that further defaults and downgrades within the subprime market are likely. “The size of the structured debt market has grown tremendously in the past few years, and a lot of in- vestors didn’t understand the risks very well,” says Tsujimoto, director of alternative investments for Tacoma, Washington–based Russell Investment Group. Now, with the market scrutinizing the subprime sector more closely, banks and other regulated entities that are large holders of investment-grade tranches of collateralized debt obligations and other structured debt may see some fallout as well — and their actions could set off the next leg of the subprime spiral. As some of the largest investors in portfolios of below-investment-grade debt that were repackaged into investmentgrade securities, many banks are heavily exposed to the subprime market. If a significant volume of that paper is downgraded by the rating agencies, Tsujimoto says, it is likely that some banks will be forced to sell to remain compliant with international capital requirements. A March report by Santa Ana, California–based real estate research ﬁrm First American CoreLogic estimates that mortgage payments will increase by $42 billion when all outstanding adjustable-rate mortgages issued at the end of last year have been reset. That includes popular subprime 2/28 adjustable-rate mortgages, which carry low ﬁxed rates for their ﬁrst two years and higher ﬂoating rates tied to bank funding costs thereafter. Interest rates will typically increase by 2 to 3 percentage points at the ﬁrst reset and then by 1 percentage point annually in subsequent years. For example, monthly payments on a $200,000 30-year mortgage with a teaser rate of 6.5 percent would increase by $345 (to $1,609, from $1,264) if the loan resets to 9 percent — more than enough to push many subprime borrowers into default. Of course, borrowers don’t always default when the rate resets. The risk depends both on how much monthly payments will increase and whether borrowers have any equity in their property. First American CoreLogic estimates that 25.4 percent of adjustable-rate mortgages due to reset in 2008 are written against properties that are already worth less than their purchase price — nearly double the 12.9 percent rate for 2007. In addition, 75 percent of 2008 mortgage resets will be for subprime loans, almost all of which were originated in 2005 and 2006. It is unclear whether the credit markets have discounted the bad news still to come. Although some hedge funds took Photo by Remy Haynes for Alpha 10 • INSTITUTIONAL INVESTOR’S ALPHA • SEPTEMBER 2007

Table of Contents Feed for the Digital Edition of Alpha - September 2007

Contents Letter from the Editor Longs & Shorts Pension Corner: Keeping the Faith The Good Guys: Going Public Interview: Barry Bausano - A Delicate Balance Cover Story: Cruel, Cruel Summer Profile: Phil Cooper - Alternative Flight Plan Strategies: Marshall Wace - TOPS in Its Field Profile: Fortis Investments - Banking on Alternatives Research Center: Top Equity Trading Firms Alpha Bytes: Desktop Duel Unhedged: Commentary - The Taxman Cometh

Alpha - September 2007

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