Institutional Investor's Alpha Magazine - October 2008 - (Page 56)

Mortgage-Backed Securities bonds supported by sound collateral from those that are questionable or impaired beyond hope. It’s not a game for the faint of heart. Antonio MuñozSuñé, chief executive ofﬁcer of EIM Management USA, the New York–based arm of EIM Group, Arpad Busson’s $15 billion, Geneva, Switzerland–based fund of hedge funds, concedes that although distressed mortgage credits may one day present “interesting opportunities,” managers who trade in corporate credit have neither the experience nor the infrastructure to analyze mortgage credit. Neither do mortgage-arbitrage players accustomed to trading highly leveraged portfolios of Fannie Mae and Freddie Mac bonds, for which credit risk was never a concern. “It’s not just a fundamental play,” cautions Muñoz-Suñé. “It’s also a macro play, a political play, a social play, a structural play, a liquidity play and a leverage play.” He knows of few managers who can analyze distressed-mortgage credit, understand the capital structures involved and combine that understanding and analysis with sound macroeconomic forecasting. Although EIM has closed out its successful exposure to the short subprime play, Muñoz-Suñé isn’t ready to reverse the trade. “We don’t feel there is enough visibility to be long mortgage credit right now,” he says. “We are not certain that the knife has reached the ﬂoor and is solidly stuck.” He believes it’s too early for the macro bet but not for idiosyncratic opportunities in speciﬁc subprime credits. He warns, though, that that too is a treacherous arena. A common mistake among many mortgage credit managers, says Muñoz-Suñé, is that they place too much faith in valuation models built on assumptions that apply in normal market conditions. Thus, he seeks out managers who have strict risk management controls designed to prevent disaster when models cease to work, as they inevitably do — and as they have done recently. Models in a new market — such as subprime mortgages — are particularly vulnerable because they have not been tested in times of stress. Muñoz-Suñé notes that most mortgage credit managers have a long bias, for which risk management often means no more than buying assets at a discount. “That works as long as you can hold the positions,” he says, a point newcomers like the now-defunct Peloton Partners in London and established but struggling mortgage players like Ellington Capital Management, based in Old Greenwich, Connecticut, and Dallas-based HBK Investments ignored at their peril. Stephen Vogt, CIO at Mesirow Advanced Strategies, a Chicago-based fund of hedge funds, agrees. Although Vogt sees good value in the sector, he will not place a big bet on mortgage-backed securities that trade infrequently in his A SWIFT FEDERAL INFUSION MAY NOT WORK SO SWIFTLY “ ailout,” “rescue,” call it what you will: Congress this month created a huge new buyer of toxic assets, and that should drive prices higher, right? Maybe not. Or maybe not just yet. Prices of nonagency mortgage-backed securities ticked up when rumors of the $700 billion government fund ﬁrst surfaced, and went even higher when the Treasury announced details of its original proposal. “Trades that were short Treasuries versus the other high-grade markets worked well,” says Daniel Dektar, chief investment ofﬁcer at Durham, North Carolina–based Smith Breeden Associates. “It signaled that we were headed for a more inﬂationary future and less likely into a depression.” Nobody knows what price the government will pay for securities under the Troubled Asset Relief Program, however. Treasury Secretary Henry Paulson Jr. and Federal Reserve Board chairman Ben Bernanke talked about something less than face value but above today ’s market price — a wide range for triple-A-rated subprime mortgage-backed securities that in October, when the bailout was announced, were trading at 50 to 60 cents on B the dollar, never mind the lower-rated tiers trading below 10 cents on the dollar. “TARP will bring some stabilit y in the marketplace, but it’s going to take time,” says Stephen Vogt, chief investment of ficer at Chicago-based Mesirow Advanced Strategies. “It’s not an overnight ﬁ x.” Some order may be imposed now after the government’s move to spend up to $250 billion of the $700 billion to acquire equity stakes in banks. The right price may depend on how the securities are valued on the sellers’ books. Accounting rules require investment banks to write down these assets to market value, though prices quoted for valuation purposes don’t necessarily reflect what a cash buyer would pay. By contrast, commercial banks often place these securities in “hold to maturity” portfolios that do not have to be marked to market. Although there have been some write-downs, book values are still higher than current market prices, according to Ajay Rajadhyaksha, New York–based director and head of U.S. ﬁ xed income and mortgage strategy at Barclays Capital. A government purchase at book value bolsters liquidity, but only a purchase at a premium to book will shore up a bank’s depleted capital base. Suppose an investment bank uses $75 for the “fair value” of a mortgage-backed security that a commercial bank books at $85. If the government buys the bonds at $75, then both banks get badly needed cash but the commercial bank must report a $10 hit to capital — the opposite of what the government wants (the commercial bank needs more capital, not less, to stimulate credit creation). If the bailout fund pays $85, the investment bank gets a $10 capital injection, but the commercial bank needs $95 to realize the same boost. “It is a capital issue, not just a funding issue,” explains Rajadhyaksha. Meantime, the prospect of renewed liquidity and fresh capital for banks weighed down by losses in mortgage-related credit did not, as hoped, immediately ease pressure in the short-term money markets, forcing the Federal Reserve to step in on October 6 as a buyer of commercial paper. Against that background a surge in the mortgage-backed securities market isn’t in the cards, and in any case the government fund can’t buy anything until the Treasury hires asset managers to run the program. Troubled ﬁ rms have to opt in too — something senior executives who would face limits on compensation are likely to resist. — N.O. 56 • INSTITUTIONAL INVESTOR’S ALPHA • OCTOBER 2008

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - October 2008

Institutional Investor's Alpha Magazine - October 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Process of Evolution The Good Guys: Israel's Champion Interview: Fast Lessons for Hard Times Cover Story: Industry Under Siege The New Hedge Fund Economics Good-Bye, Easy Money Caging the Shorts Strategies: Bottom Fishing Profile: Cult of Personalities Research Center: Alpha Awards: Eye of the Storm Alpha Bytes: Funneling the Chatter Unhedged: Commentary: Attention, Hedge Fund Shoppers

Institutional Investor's Alpha Magazine - October 2008

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