“I simply love the mortgage market. It’s the best place to be right now.”

-Steve Kuhn, Pine River’s mortgage chief, at the 2012 SALT Conference


Absolute Return and Alpha:  Hedge Fund Firms are piling into the MBS market and putting up lofty returns, but high risks remain:

“Cerberus Capital Management, Pine River Capital Management and Canyon Partners are among dozens of firms to earn market-beating returns this year by investing in mortgage backed securities. The MBS strategy they employ has become, almost by default, the most attractive in the hedge fund industry.

Hedge funds that employ an MBS strategy are up an average of 6.43% through June, according the AR database, beating all other strategies tracked by the database and compares to a composite return of 2.65%.

The question is how long those lofty returns can last . . .”

Absolute Return and Alpha:

“There is about $8.9 trillion in total outstanding mortgage debt structured in securities as of the end of the first quarter, according to data compiled by Securities Industry and Financial Markets Association. That includes about $1.4 trillion in non-government agency residential and commercial mortgage backed securities (down from nearly $2.4 trillion in 2007) and about $7.0 trillion in agency MBS and collateralized mortgage obligations from Fannie Mae, Freddie Mac and Ginnie Mae (up from about $5.8 trillion in 2007).

The subprime mortgage securities at the center of the 2008 market dislocation have rallied since their dramatic sell-off but not fully recovered to peak 2007 prices.

Hedge funds have been snapping up all types of RMBS AND CMBS: prime and subprime, agency and non-agency. The prevailing view is that the U.S. is in the early stages of a housing market resurgence . . .”


Big returns, hidden volatility?

“There’s a lot of hidden risk in mortgage focused hedge funds,” said Raphael Douady, co-founder and research director of Riskdata, a data and software firm that tracks hedge fund returns and evaluates risk for clients. Douady said MBS managers have relatively smoother returns either because they consistently apply a conservative methodology or are too optimistic in valuing their relatively illiquid positions. That creates seemingly low volatility relative to other hedge fund strategies, which can trick investors into a false sense of security. “There’s a tendency to produce small, positive returns because of valuation flexibility, whether by active smoothing or simply conservative marking. But when the spread widens dramatically because of a big event in the market, it can cause a crash.”

“There is no easy or perfect hedge for MBS funds,” says Zilberchteine of DGAM. “But we like managers who actively hedge to minimize impact from substantial underperformance in the housing market or broader economy. You can be the best security picker in the world and still have the markets crush you.”


Markit’s ABX.HE.AAA.06-1 is a tradable credit default swap index that references a basket of 20 subprime RMBS bonds originally rated AAA that were issued to market in 2005. As the index prices in the chart fell, the cost of purchasing CDS as insurance against further losses increased.


Absolute Return and Alpha
by Lawrence Delevingne
July 31, 2012

Category: Credit, Hedge Funds, Investing

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

18 Responses to “Hedge Funds Pile into MBS, Go For Mortgage Gains”

  1. Orange14 says:

    “Hedge funds that employ an MBS strategy are up an average of 6.43% through June,” This is something to celebrate???? WTF is going on here. I can go and buy NLY which executes a leveraged strategy of buying MBS that are “guaranteed” by the USG (if there is such a thing) and out perform these hedge funds! I’m long NLY in my portfolio and even little old me who practices value based investing have done better than these folks. I assume also that these hedge funds follow the 2/20 rule as well leading me to ask, WHY does anyone invest with them? Maybe I should open up my own hedge fund. This is just madness.

  2. ConscienceofaConservative says:

    Two of the reasons for gains are lowering of default and severity assumptions and lower risk premiums resulting from quantitative easing. That said, while some of the pipe-line has been flushed, there’s still considerable 60+ delinquent mortgages backing those pools(more if you include mods and non-perfect pay loans). Considering that liquidations were delayed due to the bank foreclosure moratorium I would be skeptical here as we see liquidations pick up especially since foreclosure sales occur @ 20 discounts to market which would feedback negatively into the slightly improved severity assumptions we’ve been seeing in pricing.

  3. Global Eyes says:

    Desperate Hedge Fund operators are driven to MBS in hopes of a bailout if their gains become losses. Note how everything is still underpinned by an unstated government guarantee. TBTF might get replaced by 2M2E (too many to extinguish) – especially if interest rates rise.

  4. RW says:

    What Orange14 said: 6.43% is not too steep a hill if you’ve been into leveraged debt the past couple years. I’ve done considerably better in that segment of my portfolio through the mREIT’s run by American Capital — AGNC the past two years and the newer MTGE this year — although my overall debt portfolio is less because allocations overall are more conservative and mostly unleveraged.

    But I do think the MBS/CMBS market is beginning to look over-competed and overheated. For example, some outfits are adding securitized “own to rent” properties in their portfolio and that I think is very new and unfamiliar ground for hedge fund and mREIT operators alike. Starting to look like one of those known unknowns vs. unknown unknowns things.

  5. ToNYC says:

    All those high IQs chasing bags of relative crap signifying nothing but QE3 paper gains. What if they did something useful for their human race instead of leaving the 99% up the creek they sucked dry.

  6. “…Hedge funds that employ an MBS strategy are up an average of 6.43% through June…”

    as if..

    maybe, they should have /heard/ about Covered-Call Writing (?)

    too bad, those Idiots buried E.F. Hutton, instead of (Charlie) Merrill (Lynch)..

    the Stumbling Bull lives on~!, even, in 2 &20-ville..

    Good Going Guys (&Gals)~

  7. Jim67545 says:

    Short memories? The AAA garbage MBS bust, along with all of the NINJA, Low Doc, Alt A and such, were created to fill a demand from investors. While de facto US guaranteed debt at 200 or more bps over Treasuries might be attractive when I read, “Hedge funds have been snapping up all types of RMBS AND CMBS: prime and subprime, agency and non-agency.” I get de-je-vu all over again.

  8. Bob A says:

    “but high risks remain…” yea you mean like this maybe?

  9. symphony music says:

    The eminent domain risk exposure is tiny (but real) compared to the soon to-be-discovered-by-the-judges reality that the foreclosure process associated with securitized assets involves major undisclosed conflict and non-disclosure of facts at origination that questions the very viability of the original promissory note and mortgage lien (or deed in trust). This author’s remarks parrot the many that do not do their homework before posting a short term opinion. Be careful!

  10. Christopher says:

    What could possibly go wrong?

  11. ZenRazor says:

    Yes, Steve Kuhn does love MBS. Pine River Fixed Income is up over 40% annualized per year since its launch in 2008. Much of this was made in 2009, but he’s pushing 20% this year as are a few of the other MBS specialists. And many of them do actually hedge.

    As long as Bernanke wants to give away money I want to grab some, despite the risks. Just don’t be a pig.

  12. formerlawyer says:

    We had a saying in my law firm: Pigs get fed – Hogs get slaughtered.

  13. DeDude says:

    The compensation structure of hedge funds set them up to take extreme risk. They are basically control frauds. In most of them the management gets huge bites of the upsides and rarely suffer much of the downside. What could possibly go wrong with that compensation structure? As long as they for a few years can create the illusion that investors are getting more return than an index fund then the suckers will get sucked in and milked (and a blind toddler could do that with current accounting rules).

  14. [...] Hedge funds pile into home mortgages. [...]

  15. 873450 says:

    Are these funds betting raw animal spirits will soon induce the job creating 1% to create jobs via productive deployment of trillions of dollars they hoarded away? Notwithstanding election results? Notwithstanding their “uncertainty” about taxes and the economy?

    Absent dramatic job and income growth (secure jobs paying sufficient income to purchase homes and cover mortgage payments), jumping into MBS could be jumping into a train to nowhere.

  16. Alex says:

    Yeah, I’m with Orange and RW, but this makes me pretty nervous – I lost a lot of money on Thornburg in 2008, but I made most of it back on other mREITs since. This is making it look like it’s time to cut back, even though they look pretty good on the face of it. NLY has a pretty transparent portfolio, how bad can it get?

  17. ToNYC says:

    Somehow the schools forgot to tell the this post-Crash of ’08 students that they’d be needing to create their own job from the needs they see unfilled every time they look up from their iWTFad machines. The bones of high-wage mass manufacturing industry have been stripped and the empty building spaces need to be sublet to artisans to grow more custom and lasting usefulness from the ashes with the best technology available that their parents could not have dreamed of in their Youth.