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Subprime Defaults to Soar, Hurt Lenders, Funds Say (Update1)

Date: Friday, March 16, 2007
Author: Jenny Strasburg, Bloomberg

March 15 (Bloomberg) -- Harbinger Capital Partners and Paulson & Co., hedge-fund managers who profited when subprime- mortgage defaults surged, told investors that delinquent loans will soar and more lenders will disappear.

``We believe we are in the early stage of a correction in this market and that the market will eventually implode,'' New York-based Paulson & Co., which manages $11 billion, said in a letter to investors last week. Paulson said bad loans held by the riskiest borrowers will ``skyrocket'' and ``most, if not all, of the independent originators will go bankrupt.''

Paulson and New York-based Harbinger posted record gains last month on credit derivatives that increased in value as prices for securities backed by subprime loans fell. Paulson's 8-month-old credit fund gained 67 percent, swelling assets to almost $2 billion. Harbinger's $6 billion distressed-debt fund returned 8.1 percent, according to an investor update. Both firms said they continue to bet loan defaults will rise.

Investors holding mortgage-backed bonds stand to lose $100 billion from defaults on $10 trillion in outstanding home loans, Citigroup Inc. bond analysts said this month. Hedge funds have profited from the rising costs of insuring against defaults and from fears that Wall Street will finance fewer subprime loans, hurting new-home sales and the economy.

Banks ``will shut down their origination platforms,'' and the business of pooling subprime loans into packages of securities ``will all but disappear,'' Paulson said in its letter. ``While the bonds have fallen significantly, we think they have much further to fall.''

Greenspan Warning

John Paulson, president of Paulson & Co., declined to comment through a spokesman.

Former Federal Reserve Chairman Alan Greenspan said today that he expects subprime-mortgage defaults to ripple through other areas of the economy, especially if home prices fall. ``If prices go down, we will have problems,'' he said at the Futures Industry Association meeting in Boca Raton, Florida.

Hedge funds are private and mostly unregulated pools of capital whose managers can buy or sell any assets and participate substantially in profits from money invested. They are allowed to take short positions, which is a bet that the value of a security will fall.

They returned an average of 0.65 percent globally in February, which ended with a selloff that battered stock markets, according to Hedge Fund Research Inc. The industry oversees $1.4 trillion, the Chicago-based firm estimates.

Credit-Default Swaps

Harbinger's $6 billion fund that invests in high-yield debt and assets of troubled companies had 60 percent of its assets allocated to short positions, including bets on declines in mortgage securities, according to its monthly investor update from Philip Falcone, 44, the firm's founder and senior managing director. That compared with the fund's typical 35 percent allocation to short positions, according to an investor who declined to be named because the information is private.

``Note that these are individual collateral pools, not the ABX Indices,'' Harbinger said in its investor letter.

ABX indexes allow investors to buy into derivatives called credit-default swaps on multiple securities. Bearish investors have used ABX bets to wager against the health of subprime mortgage lenders.

More than two dozen mortgage lenders have closed or sold assets since the start of 2006 as delinquencies and defaults among high-risk borrowers climbed to their highest rate since at least 2003. Shares of New Century Financial Corp., Fremont General Corp. and other companies have plunged, while foreclosures have increased even among borrowers with high credit scores.


``We believe that the market will continue to be tested in the weeks and months ahead, as the subprime situation unfolds amid a choppier market backdrop,'' Falcone said in the letter.

Paulson wagered on declines in mortgage-backed bonds in every strategy it employs, including through funds that invest in companies going through mergers. ``While not directly related to merger activity, we thought the subprime short provided a valuable indirect hedge,'' according to the fund's investor letter.

The bet helped Paulson return 13 percent and 25 percent last month in its two merger arbitrage funds, which have $6 billion in combined assets, it told investors.

Kensico Capital Management, a Greenwich, Connecticut-based hedge-fund firm with more than $1 billion in assets, returned 5.4 percent in February in the onshore version of its Kensico Partners LP fund, bringing the gain to 8.6 percent at month's end, according to an investor.

`Stay Tuned'

The fund, which started in January 2000 and is closed to new investors, invests primarily in stocks. In the fourth quarter, Kensico added credit-default swaps on subprime mortgage securities it saw as ``particularly vulnerable to future losses, such as loans with low documentation or high ratios of loan to value,'' according to a quarterly update sent to investors Feb. 7. The letter came from Michael Lowenstein and Thomas Coleman, co-founders and co-presidents of the fund. Lowenstein, 48, declined to comment.

``We can make money if credit spreads return to the more historical norms, and we can make a lot of money if subprime mortgage losses are somewhat higher than forecast at the time of issuance,'' the managers told Kensico investors. ``Stay tuned.''

To contact the reporter on this story: Jenny Strasburg in New York at jstrasburg@bloomberg.net