Institutional Investor's Alpha Magazine - October 2008 - (Page 58)

Mortgage-Backed Securities backed securities, MKP scours other asset classes to ﬁnd liquid instruments that have low basis risk, are closely correlated to the MBS market and can be cashed out when the anticipated move occurs. Risk management seems to have kept MKP out of trouble at a time when exceptional volatility has caught so many mortgage investors off guard. Lembke marvels at the number of mortgage credits that were bought at what seemed to be attractive tranche prices and levered up, only to crash to unprecedented lows. He says the blow that knocked out Peloton Partners was a move anyone who carefully tracked the volatility of such assets could have predicted. “People spent all their time worrying about the default rate,” Lembke notes. “They missed the volatility.” Mortgage credit investors tend to have relatively low portfolio turnover because liquidity is limited, but MKP probably trades a little more than its peers, says Lembke, so that it can test the true value of its holdings. It’s not enough to ask a third party for a price. Lembke points out that dealers, who typically hold mortgage-backed securities on their books and provide most third-party pricing, have a clear conﬂict of interest. “You have to ask where they would commit capital,” Lembke says. “Sometimes — not always but all too often — that price may be materially below where they will give you a paper mark.” As the credit crisis unfolded, dealers had to liquidate their MBS inventories for whatever they could get. To Dektar and Peter Nolan, product portfolio manager for securitized credit at Smith Breeden, selling has driven prices to bargainexplains. “You get exposure to sectors where the babies are being thrown out with the bathwater.” Smith Breeden’s portfolio got another boost when prices for these asset classes ran up after the federal bailout fund was first proposed. The firm also looks for alpha opportunities that depend more on individual security selection within a particular asset class. For example, Nolan says pricing in the subprime MBS world has become highly systematic, which is to say that securities of a particular vintage and initial rating are priced in line with the relevant tranche of the ABX index regardless of the underlying credit quality. The trick is to ﬁnd bonds that warrant a higher valuation and to avoid bonds that are worth less than the market price. That’s easier said than done. Like MKP, Nolan buys monthly data that lets him drill down to the individual loans in each mortgage pool and see how the credit risk changes over time as borrowers become delinquent, default or reﬁnance and drop out. That’s no small task when a typical mortgage-backed security contains thousands of mortgages. But it’s worth the effort, and Nolan says loan characteristics — credit scores, an individual’s leverage, loan-to-value ratios, loan purpose and the location of an underlying asset — have “at least some predictive power” in determining whether a borrower is likely to default. The number-crunching chore increases exponentially for collateralized debt obligations. A CDO that holds only mortgage-backed securities has hundreds of thousands of underlying loans. Although Smith Breeden has the information technology infrastructure to handle such analysis, Nolan says that CDOs are not a priority at the moment. He points out that every layer of securitization magniﬁes the potential errors as well as the complexity of the analysis. “We see the best opportunities not so much in CDOs as in the collateral they hold,” he adds. Smith Breeden takes pride in its ability to forecast how borrower behavior will affect the value of mortgage-backed securities. Dektar says the slowdown in the housing market means that people will move less frequently and will not be able to reﬁnance to extract cash from their homes, so he has extended the ﬁrm’s MBS portfolio duration to capture the longer expected average life of cash ﬂows. He focuses on lowcredit-risk Fannie and Freddie mortgage-backed securities at a premium to par, a segment for which slower prepayments increase the number of premium coupons expected and therefore enhance value. Although the government rescue package should help restore conﬁdence, prices of mortgage-backed securities probably won’t bounce back to precrisis levels overnight. But when investors ask Lembke if it’s time to go long and wait for the ride, he demurs. No matter how cheap mortgage credit is — both Lembke and McMahon expect better returns than on any other major asset class, including U.S. or European equities, ﬁnancial equities or corporate credit — MKP isn’t quite willing to go all in. “There’s too much risk,” McMahon says. “Firms that try to catch this falling knife may get sliced up.” “We see the best opportunities not so much in CDOs as in the collateral they hold.” — PETER NOLAN, SMITH BREEDEN ASSOCIATES basement levels for whole asset classes. Even before the government stepped in to bail out Fannie Mae and Freddie Mac in September, Dektar was buying mortgage-backed securities issued by the two agencies that were trading lower than they would have in normal markets. When the government acted, Smith Breeden made a killing as the discount evaporated. Dektar was also ﬁnding values in Ginnie Maes, lowrisk securities that came with an explicit government guarantee. Among commercial MBSs he found some securities at the top of the capital structure that were supported by good collateral and strong subordination trading at 8 to 12 points below fair value. And in subprime MBS he picked up low-risk, shorter-maturity securities with generous coverage against losses at discounts of 3 to 15 points. “Those are what we call beta opportunities,” he 58 • 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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