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Hedge funds soar on mortgage plays

Date: Monday, January 24, 2011
Author: Anthony Effinger and Katherine Burton, Washington Post

For 20 years, Don Brownstein taught philosophy at the University of Kansas. He specialized in metaphysics, which examines the character of reality itself. In a photo from his teaching days, he looks like a young Karl Marx, with a bushy black beard and unruly hair.

That photo is now a relic behind the curved bird's-eye-maple desk in Brownstein's corner office in Stamford, Conn. Brownstein abandoned academia in 1989 to try to make some money.

The career change paid off. Brownstein founded Structured Portfolio Management, a company managing $2 billion in five partnerships. His flagship fund, Structured Servicing Holdings, returned 50 percent in the first 10 months of 2010, putting him first in Bloomberg's ranking of the 100 best-performing hedge funds managing $1 billion or more.

The $1.2 billion fund rocketed 135 percent in 2009.

In percentage terms, Brownstein, 67, beat out funds run by bigger, better-known competitors, including Ray Dalio's Bridgewater Associates. Dalio, though, has three funds in the top 15. Brownstein also topped Steven Cohen's SAC Capital International (No. 53).

Brownstein did it by exploiting his expertise in something almost as esoteric as metaphysics: the market for exotic securities built from mortgages.

It was the crackup in housing and mortgage markets that brought the U.S. economy to its knees in 2008 and earned billions for hedge-fund managers such as John Paulson, who saw it coming and bet that mortgage securities would crash.

Brownstein and William Mok, Structured Portfolio's director of portfolio management, won't say how they made their 2010 killing. Their longtime strategy is to develop models that predict when homeowners will refinance mortgages - a move that reduces interest payments on mortgage bonds. They then buy securities they think are underpriced.

Many homeowners have been unable to take advantage of tumbling rates to refinance their mortgages because their houses are worth less than they owe on their loans. Investors who bet against a refinancing boom have profited.

'Every single risk'

The hedge-fund ranking uses data compiled by Bloomberg and information supplied by research firms, fund companies and investors. Three of the top 10 funds made money on mortgage bonds. The mortgage market is often lucrative for hedge funds because it is volatile, says Jeffrey Gundlach, chief executive at Doubleline Capital, a manager of mutual funds that trade mortgages.

"The mortgage market has every single risk," Gundlach says. People default, banks foreclose on housing loans and the government often changes the rules. "Any market that has risks morphs into opportunity," he says.

Another fund that profited from betting on mortgages is the $1.2 billion Nisswa Fixed Income Fund, run by Pine River Capital Management of Minnetonka, Minn. It ranks No. 7, with a 27 percent return. Nisswa's manager, Steve Kuhn, bought mortgage bonds selling at what turned out to be bargain prices. The fund returned 92 percent in 2009 and is up a cumulative 196 percent (through Oct. 31) since it was founded in 2008.

Gold jumped 24 percent to $1,359.40 an ounce in the 10 months covered by the ranking. The rally boosted Daniel Loeb's Third Point Offshore Fund to No. 8 among large funds, with a 25 percent return. Loeb invested in mortgages, too, in addition to his usual bets on stocks and bonds, according to people familiar with his holdings.

Overall, hedge funds had a lackluster year compared with 2009, when the top fund, run by David Tepper's Appaloosa Management, returned 132 percent. The same fund earned 21 percent in 2010. On average, the top 100 hedge funds rose 13.9 percent through October. The Standard & Poor's 500-stock index rose 6 percent in the same period.

Spotty performance aside, wealthy Americans are pouring money into funds. Half of all households with a net worth of $25 million or more invested in hedge funds in 2010, up from 35 percent in 2007, according to Spectrem Group.

Philosopher king

Brownstein's Structured Servicing Holdings has returned an average of 28 percent annually since February 1998, when the fund made its first trade. Its only losing year was 2008, when it returned negative 6 percent, according to an investor. But the average hedge fund dropped 19 percent that year.

The 50 percent gain through October earned Brownstein's investment team $87 million in fees.

Brownstein has prospered in a market dominated by math savants. The value of many mortgage bonds depends in large part on how long homeowners make payments at their current interest rate before either refinancing or defaulting. The top traders have proprietary formulas that predict behavior based on a homeowner's credit score, address, loan size, loan age and other factors.

The walls of SPM are scrawled with such formulas, worked out by Mok, a Salomon Brothers alumnus who has a bachelor's degree in computer science from Columbia University, and his team of doctors of math and physics. Brownstein's strength is his mastery of the logic behind the formulas.

"If you're wrong, he'll prove you wrong," Mok, 47, says.

Brownstein, the son of a Bronx furrier, these days looks more like entertainment mogul Barry Diller than the father of communism (much less hair, much nicer shirts). He says he loves his role.

"I'm here to argue," he says in a three-hour interview that ranged from ancient Greek philosophers Parmenides and Plato to foreclosures in Florida. "I'm in charge of pontification and arguing."

His career suggests a restless mind. After earning his PhD from the University of Minnesota, Brownstein started teaching in 1969 at the University of Kansas in Lawrence. He made documentary films on the side and once interviewed Beat Generation writers Allen Ginsberg and William Burroughs.

The shopping mall

A fight over a shopping mall in Lawrence in the mid-1980s led Brownstein, indirectly, to mortgage trading. A developer wanted to build the mall in a cornfield. Brownstein and others wanted the mall downtown. The project got Brownstein thinking about finance. He figured a downtown mall could attract an anchor tenant and use its lease payments as collateral for a bond that could be sold to investors to pay for the construction.

Brownstein wrote up his idea, and it was published in a real estate trade journal in 1987. The article led to an interview with William Marshall, who was then an executive at Franklin Savings Association in nearby Ottawa, Kan. Franklin hired Brownstein in 1989.

Franklin was an outpost of Wall Street on the plains. Chairman Ernest M. Fleischer built the thrift into one of the nation's largest savings institutions partly by using mortgage-security trading to reduce interest-rate risk.

Fancy financial engineering couldn't save Franklin from the savings-and-loan crisis. The Office of Thrift Supervision seized it in February 1990, eight months after Brownstein arrived. Brownstein stayed until 1992, when he went to work trading mortgages for Caisse des Depots & Consignations in its New York offices. There, he set up a new unit to buy the rights to collect interest on mortgages - the servicing rights. Owning the rights was like owning mortgage bonds, Brownstein says, and if you got them cheap enough, they could be profitable.

Many lenders were eager to sell, he says, because they wanted to lock in gains all at once rather than risk losing interest income if borrowers refinanced.

'Tea leaves'

Planning to do more deals for servicing rights, Brownstein set up Structured Portfolio Management in 1996. Then he pursued another angle. A popular security in the mortgage business is the interest-only strip, or IO. It's a bond backed by the interest payments from a portfolio of mortgages. Principal payments go into another security called a PO that's more attractive to conservative investors.

If a homeowner refinances, the PO owner gets paid sooner and the IO owner loses all of the interest that he was due to collect. The trick to valuing an IO is figuring out how many borrowers in the pool are going to pay off their mortgages early. So Brownstein and Mok spend time puzzling over prepayment speeds.

Mortgage bonds, including IOs, come in two variations: agency backed and non-agency backed. The first are built from mortgages insured by Fannie Mae and Freddie Mac. The two government-controlled companies own or guarantee repayment on half of all U.S. mortgages, a function that encourages lending.

A trader buying securities built from agency-backed mortgages, generally under $417,000 for a single-family home, has no credit risk.

In 1996, the market for securities backed by the bigger, nonguaranteed loans was just getting going, Brownstein says. Most trading was in bonds backed by Fannie and Freddie loans of roughly the same size and age. If interest rates fell, most of the homeowners in the pool refinanced at similar speeds.

Brownstein saw that IOs backed by non-agency mortgages were selling for less because the mortgages were more heterogeneous and harder to model. He separated the mortgages backing the bonds into groups with similar characteristics, including the mortgage size and attributes that even now he declines to identify. He set out to predict how each group would behave if rates fell.

Back then, Mok watched interest rates and the yield each security paid relative to Treasury bonds to figure out whether to buy or sell. That was before interest rates started falling in the early 1990s, prompting a wave of refinancing.

Now, traders use computer-driven models to predict whether and when a homeowner is going to cut off interest payments with a refinancing.

You have to really read the tea leaves to figure out if a mortgage bond is a good buy or not," Mok says.

In search of math minds

For its mortgage bet, Pine River Capital went so far as to open an office in Beijing in 2010 to tap a new pool of math experts. The firm has 10 people there doing quantitative research and software development, founder Brian Taylor says.

Numbers crunched in China are sent to an 11-person mortgage team in Pine River's office in New York. Taylor opened that office in 2008, when many banks bailed out of the mortgage-trading business and fired mortgage experts.

"Financial markets are prone to crisis," Taylor says, "and crisis always creates opportunity."

Pine River profited in the past two years by betting correctly that U.S. homeowners wouldn't pay off their mortgages as fast as they did in 2003.

In 2008, when rates were tumbling, IO bonds were trading at 9 cents on the dollar, says Kuhn, manager of Pine River's Nisswa Fixed Income fund. The price implied that 60 percent of borrowers would refinance within one year, he says.

No way, he thought. People wouldn't refinance because, unlike in 2003, the value of their houses had fallen. Those who could refinance confronted a mountain of paperwork at cautious banks.

In 2008, mortgage bonds plunged and the crisis caught up to Fannie and Freddie. The government seized them to ease concern that they would fail.

After the takeover, Fannie and Freddie stopped a key activity, Kuhn says. In addition to guaranteeing mortgages, the companies bought and sold securities in order to moderate fluctuations in rates. That also helped control price differences, or spreads, between various types of mortgage bonds, making it hard for traders to find arbitrage opportunities.

"There weren't a lot of nickels lying around," Taylor says.

Without Fannie and Freddie trading, the market is rife with opportunity, Kuhn says. But government control of the companies means that traders have to watch for government programs that make it easier for homeowners to refinance. He watches hours of C-SPAN, the cable channel that broadcasts government hearings. Sometimes he records them to watch in the evening.

"My wife is a good sport," he says.

Packaging mortgages

Daniel Loeb of Third Point normally invests in stocks and bonds of companies going through mergers and restructurings. He has owned mortgage securities since 2007. In 2009, they helped lift the fund 38.4 percent for the year, Loeb said in a letter to investors. He also noted they had performed strongly in 2010.

As of June, mortgage investments accounted for one-fifth of Third Point's assets, according to a letter to investors. Loeb used securities called re-remics for about half of his mortgage play.

Remic is an acronym for "real estate mortgage investment conduit." It's a trust - backed by thousands of mortgages - that pays interest. Remics are divided into tranches according to risk and sold to investors. Each tranche becomes a separate mortgage bond.

That makes them cousins of collateralized debt obligations, the bundles of mortgage bonds and other debt whose value plunged in 2007, helping to trigger the larger financial crisis.

Remics also tanked during the credit crisis as the mortgages backing them went into default. Many AAA remics, the least risky ones, lost their rating, and banks and insurers had to put up more capital to cover potential losses. To ease that burden, Wall Street has been repackaging the once-AAA-rated bonds into new trusts that have senior and junior securities.

Loeb is betting on the riskier junior slices, hoping they will pay a fat yield - as much as 20 percent, according to the letter to investors. As the credit crisis eased, those bonds rose in value, contributing to Loeb's 25 percent return.

Loeb also bet big on gold, a popular play for hedge-fund managers in 2010. He had about 6 percent of Third Point's assets in bullion in November, the biggest gold bet he's ever made, according to Third Point investors. He started buying in September, when the metal was trading at $1,250 an ounce, spurred by a U.S. report that said Washington can't sustain the deficits it's been running.

Gold is always popular during times of crisis. Brownstein, buoyant on a darkening November afternoon, says the emergency in his market has passed.

"The crisis was when housing prices were accelerating out of control," Brownstein says. Now, the pontificator-in-chief says, there are opportunities for hedge-fund managers willing to drill deep down into mortgage bonds and find value.

- Bloomberg News

A version of this article appears in Bloomberg Markets magazine's February issue.