Institutional Investor's Alpha Magazine - October 2008 - (Page 57)

main fund. “We have too limited a budget to go far out on the illiquidity spectrum,” he says. To stave off forced selling, Mesirow has set up a new fund of funds that has a ﬁve-year life — a cross between the quarterly liquidity that funds of hedge funds usually offer and the ten-year commitment of a private equity fund. The initial focus will be on mortgage-backed securities, but the new fund will also tap managers of such distressed credits as defaulted corporate bonds (although Vogt says it could be a year or more before the time is ripe in that market). “You have to stay in the game,” says Anthony Lembke, co-head of investment at MKP Capital. “That means you cannot take business risk.” The ﬁrm dodged a bullet last March when Bear Stearns Cos., one of its prime brokers, imploded: By the time the ax fell, MKP had eliminated its position exposure and moved its assets to a backup clearing agent. At MKP a counterparty risk management team continuously pores over documents to make sure the ﬁrm knows where its assets are held, whether they are commingled or segregated, and what happens to overnight cash balances. “It’s not as sexy, but it can trump whatever expertise you have on the investing side,” says Lembke. Several money management ﬁrms, including some hedge funds, learned that lesson the hard way when the Lehman Brothers bankruptcy left them unable to access assets. Credit spreads have blown out across the board since July 2007, of course, but some of the biggest moves have taken place among mortgage-backed securities, and not just lower-quality subprime credits. Smith Breeden’s Dektar points out, for example, that the spread on the Bank of America Corp. triple-A-rated commercial MBS index, which used to yield 20 to 30 basis points more than the equivalent Treasury bond, skyrocketed to 370 basis points just before the government bailout plan was announced. The spread narrowed by 80 basis points over the ensuing ﬁve days, but that still left it at ten times the earlier norm. Vogt sees hedge funds buying mortgage-backed security tranches either at the top of the capital structure — primarily triple-A-rated — or near the bottom. For instance, in pools where escalating defaults are expected eventually to redirect cash ﬂow from mezzanine to senior tranches, managers may be able to pick up bonds that their research suggests are good for, say, 24 months of future payments at a price equivalent to just eight months’ payments. Most managers are shying away from the middle tiers of MBS structures, where Vogt says small changes in the default rate or the severity of loss in the event of default make an enormous difference to the outcome. Depending on what happens to home prices and where investors sit in the cash ﬂow waterfall, “they can be money-good or zero.” He adds that these middle tiers of mortgage-backed securities will become more appealing when the housing market has stabilized and it gets easier to predict future cash ﬂows. When liquidity was abundant, lenders were happy to let hedge funds borrow against credit portfolios, and the higher the average credit rating, the more they lent. Hedge Photograph by Baldomero Fernandez funds and proprietary trading desks don’t buy paper at 30 basis points over Treasuries unless they can lever it enough — by 20-to-1 or more — to generate an acceptable return. As a result, the credit crisis put maximum selling pressure on the highest-quality assets, the exact opposite of the ﬂight to quality normally associated with tight credit. Count MKP among those few investors — and maybe the only major mortgage credit hedge fund — to see the train wreck coming. Lembke noticed a rising inventory of unsold homes in late 2005, followed by the emergence of early payment default among subprime mortgages in the spring of 2006. At the time, mortgage-backed securities rated triple-B-minus were trading at 90-plus cents on the dollar. “It was incredibly asymmetric,” Lembke recalls. “If you were wrong, they would go back to par; and if you were right — and we never dreamed it would be as bad as it got — we felt you could make 20 to 30 points.” MKP placed its bet on that macroeconomic view. “I am sure our competitors had great statistical models,” Lembke says. “But they went right off a cliff with them.” The firm uses computer models to sift monthly data on mortgage pools obtained from research services like San Francisco–based LoanPerformance HPI and Intex Solutions in Needham, Massachusetts, for clues about prepayment and credit trends. MKP turned bullish on mortgage credit this year, but it’s not a long-only play. Lembke says the ﬁrm divides major sectors, like prime and subprime, into subsectors and then looks at all levels of the capital structure to ﬁnd the cheapest segments to buy and the most overvalued to short — if possible. If a suitable short isn’t apparent in mortgage- At hedge fund ﬁrm MKP Capital Management, Anthony Lembke (left) and Patrick McMahon see strong potential in undervalued mortgage-backed securities. OCTOBER 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 57

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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