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Hedge funds profit from sub-prime collapse, says Hennessee

Date: Wednesday, August 22, 2007
Author: Hedgeweek.com

Hennessee Group, an adviser to hedge fund investors and index provider, says that while some hedge funds focused on mortgage-backed securities have suffered well-publicised losses due to the decline in the sub-prime mortgages sector, many hedge funds have also been able to generate profits as a result of the decline.

Last October Hennessee reported that hedge funds had been using credit default swaps in several ways, including purchasing CDS on sub-prime mortgage-backed fixed-income securities and indices intended to profit from deterioration in credit quality among mortgage borrowers.

In what has been the best short sale theme since 2002, Hennessee says, many hedge funds have greatly benefited from the collapse in sub-prime mortgages through their short exposure to mortgage lenders and sub-prime mortgage-backed securities and indices. While some have focused on shorting mortgage lenders and buying credit default swaps on specific mortgage-backed bonds, others have purchases CDS on indices of these securities, the ABX series, with most focused on those securities issued in 2006 under more relaxed lending standards.

The ABX-HE-BBB- 06-2 Index (ABX Index of BBB-rated tranches issued in 2006) is now down by 60 per cent for the first seven months of the year. Several managers think there is still more downside for the lowest-level tranches, as they believe cumulative losses for sub-prime mortgage securities could potentially cause the value of the BBB-tranches to be worthless.

However, as has been widely publicised, several hedge funds with leveraged long bets on bonds backed by sub-prime mortgages experienced significant losses in the first half of the year. According to reports, these funds leveraged investor capital between 10 and 20 times, and held a collection of collateralised debt obligations and mortgage-backed securities, some of which were illiquid and 'marked to model'.

As the value of the underlying bonds fell, funds faced margin calls from lenders, which forced them to sell assets, further exacerbating losses. While BBB tranches have garnered the most coverage, even more senior tranches have been affected by the collapse, as the AAA tranche has declined by 1 per cent, the AA tranche by 2 per cent and the A tranche by 20 per cent up to the end of June. While many recent news stories have publicised hedge fund failures related to the sub-prime collapse, Hennessee says, in reality many hedge funds were expecting such an event and were able to profit from the decline.

Hennessee Group is a registered investment adviser that advises direct investors in hedge funds on asset allocation, manager selection, and ongoing monitoring of hedge fund managers. It compiles the Hennessee Hedge Fund Indices to benchmark individual hedge fund manager performance, but does not sell a fund of hedge funds product nor market individual hedge fund managers.