Credit hedge funds game 'stupid' Wall Street

By Anthony Effinger, Katherine Burton, Bloomberg

January 05, 2015 at 08:20 AM

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(Bloomberg) — Brett Jefferson told his 5-year-old son this about Wall Street recently: "Never will you find a place where so many smart people do so many stupid things."

That's a good deal for Jefferson, 49, who has been profiting from bankers' blunders for more than a decade. His hedge-fund firm, Stamford, Connecticut–based Hildene Capital Management, vacuums up complex securities when others are shunning them as toxic junk. So does Michael Craig-Scheckman's Deer Park Road Corp., Bloomberg Markets magazine will report in it February issue.

"We make money because people on Wall Street make mistakes," says Craig-Scheckman, 62, whose firm is based in Steamboat Springs, Colorado.

Six years after the 2008 debt crisis exposed how clueless the smart people on Wall Street can be, both men are profiting from what could be called the schadenfreude trade — buying for pennies what big investment banks once flogged for dollars. Their bottom-fishing lifted them into the top five of Bloomberg Markets' annual ranking of the best-performing hedge funds managing $1 billion or more.

Craig-Scheckman's STS Partners Fund, up 23.9 percent in the 10 months ended on Oct. 31, took third place. Jefferson's Hildene Opportunities Fund, up 23.6 percent, came in fourth.

The top spot went to activist investor Bill Ackman's Pershing Square International, which returned 32.8 percent on investments including Allergan Inc. and Canadian Pacific Railway Ltd.

Outlier Ackman

Ackman was an outlier. Most managers on the list were debt traders, including a dozen funds dealing in bonds backed by mortgages and other assets, or quants — investors who use mathematical models to trade a variety of securities.

It was debt trading that powered the best quant fund on the list: Quantedge Global, which ranked No. 2, with a 32.3 percent gain. The firm is a group of hypereducated actuaries, most of them in Singapore.

The 15 people on Quantedge's investment research team hold degrees in math, economics, finance, financial engineering and physics from Harvard University, the University of Pennsylvania's Wharton School, the University of Oxford, the University of California at Berkeley and the Massachusetts Institute of Technology. They trade everything — stocks, bonds, currencies, commodities and insurance-linked securities such as catastrophe bonds, where their actuarial skills come in handy.

Yet it was fixed income that drove gains in 2014, a Quantedge Capital spokeswoman said in an e-mailed response to questions.

Mortgage rally

Mortgage funds did well in 2014 because home prices rose and fewer debtors missed payments on their loans — including the subprime borrowers whose debt hedge funds love. At the end of the third quarter, 18.8 percent of subprime home loans were delinquent, down from 27.2 percent in March 2010, according to the Mortgage Bankers Association. Bonds backed by home loans rallied for the fifth year, making analysts wonder how long the good times will last.

"Everyone thought mortgages were over," says Chris Acito, chief executive officer of Gapstow Capital Partners in New York, which has $1.1 billion invested in hedge funds that trade credit. Yet the party goes on.

"If people haven't defaulted on these yet, they probably won't," Acito says.

Better yet for the sketchy-debt crowd: There aren't enough old bonds to go around, Acito says. When prices get low enough, Wall Street's gaffes turn into gold. And with more homeowners paying their mortgages, that gold is going platinum.

Horrendous year

Hedge funds as a group had a horrendous 2014, with an average return of just 1.6 percent through October among the 2,400 funds that make up the Bloomberg Global Aggregate Hedge Fund Index.

Until October, managers complained that volatility in stocks and bonds made it tough to make money. Then, many got spooked and sold during October's plunge, missing a quick profit as prices rebounded. Some of the largest and best-known funds, caught up in crowded trades that went against them in October, lost the most.

Crowded trades

The preferred shares of U.S. government–controlled mortgage aggregators Fannie Mae and Freddie Mac were favorites among hedge funds, and they tumbled more than 50 percent when a court ruling went against investors. Merger-arbitrage managers lost big when drugmaker AbbVie Inc. dropped a plan to buy Shire Plc and Shire shed more than a quarter of its value in two days.

John Paulson, who had five funds in the top 100 in 2013, was among the biggest losers in 2014. His $19 billion firm, Paulson & Co., lost money in both Fannie-Freddie and AbbVie- Shire trades. His Advantage fund plunged 14 percent in October and 25 percent for the year as of Oct. 31.

The flagship fund of Claren Road Asset Management, majority owned by private-equity firm Carlyle Group LP, dropped 9.1 percent in the 10-month period on the Fannie Mae and Freddie Mac trade.

Two funds that did not make the top 25 nevertheless were the most profitable. No. 26 Viking Global Equities led that list, pulling in $573.3 million in incentive fees for the 10 months ended on Oct. 31. Israel "Izzy" Englander's Millennium International made $389.5 million even though it tied for 75th in performance, with a 7.4 percent return.

The top midsize fund, with assets from $250 million to $1 billion, was the Mauritius-based India Capital fund, run by Jon Thorn, which was up 47.2 percent in the ten months ended Oct. 31, after falling 21.7 percent in 2013.

Going skiing

STS's Craig-Scheckman floated through October's volatility. He and Deer Park Road Chief Investment Officer Scott Burg, a former offensive guard on the University of Colorado football team, buy mortgage-backed bonds that pay a healthy yield, and they are ready to hold them long term. Even if prices decline, they clip their coupons.

And if it snows, they go skiing. Craig-Scheckman is in the midst of constructing a new office building for his 19 employees at the base of the gondola at Steamboat Springs. They all get lockers and a ski pass as perquisites. If fresh snow lures them out at midday, they bring their mobile phones to complete trades.

Like many mortgage bond managers, Craig-Scheckman has an academic background. In the 1970s, he was pursuing a doctorate in X-ray astrophysics at New York's Columbia University, working on gas-scintillation technology for Geiger counters used in space probes, when it all started to feel like grunt work, he says. He had an uncle at Salomon Brothers. And his cousin, trader Asher Edelman, was a model for Gordon Gekko in the movie "Wall Street."

Worst loans

In 1978, Craig-Scheckman left physics and joined them in finance. He traded gold, then mortgage bonds. In 1993, he went to work for Englander's Millennium Management. Craig-Scheckman started Deer Park Road in 2003, moving his family to Steamboat Springs that same year.

Mortgage bonds that were minted from 2004 to 2007 are among Craig-Scheckman's favorites. That's when lenders offered negative-amortization mortgages, in which the payments didn't cover all the interest, so the principal just kept growing.

"These were the worst possible loans people could take," he says.

Lately, they've been among the best for Deer Park Road. Bonds backed by them tumbled so much that a little improvement in payment on the underlying loans boosts their value.

Exotic stuff

Hildene Capital's Jefferson trades exotic stuff too, and he does it without a physics degree. He grew up in Rye, New York, the son of a container-ship captain. More jock than geek, he majored in English and played lacrosse for Syracuse University in 1988 when it won the national championship. He played on a club team while working on an MBA from the Kellogg School of Management at Northwestern University.

Jefferson started his career in structured debt in 1997, when his bosses at Salomon Smith Barney asked him to figure out a new category of securities called collateralized loan obligations — bundles of corporate loans structured as securities. Back then, a little experience made him an expert, he says. He joined Marathon Asset Management in 2002 and ran the Marathon Structured Finance Fund until 2006. Under his watch, the fund never had a money-losing month, according to fund documents. Even so, he and Marathon CEO Bruce Richards parted ways.

"Mr. Richards and I had a disagreement," Jefferson says, declining to say more.

Sitting out

Jefferson spent the next two years sitting out the excesses of the mortgage bubble.

"I made the smartest investment decision of my life by not working in 2006 and 2007," he says.

He started Hildene in mid-2008 after subprime mortgages had collapsed and securities built from them, called collateralized debt obligations, plummeted. Of particular interest were bonds issued by banks and backed by trust-preferred securities. They're called TruPS CDOs, and specializing in them is a little like being a connoisseur of wine from Canada: There isn't much of it, and it's hard to make, but it can be superb if the growing season is good.

Or as Jefferson puts it: "When you're dealing with mainstream products, it's like shopping at the mall. Here, you're showing up at a Turkish bazaar."

TruPS CDOs are made from a kind of debt that U.S. banks started selling in earnest in 1996. That year, the Fed let bank holding companies raise capital by selling special securities to investors. The notes paid dividends, like preferred stock, and allowed the banks to treat those dividends like interest payments, which are tax deductible.

Bank bonanza

Better yet, the securities counted toward regulators' strictest capital requirements. To participate, a bank would set up a subsidiary — the trust — to sell the securities to investors. The trust would then loan the proceeds of those sales to the bank and use the bank's interest payments to provide dividends to investors.

Wall Street eventually got involved and started bundling the trust securities into CDOs, as they did with every other kind of debt. Citigroup Inc. created the first TruPS CDO in 2000.

This was a big development for small banks. Before the CDO deals, a little bank couldn't sell enough TruPS to attract an investor. The CDOs, by contrast, pooled diverse TruPS from around the country to limit the risk of default for the entire CDO. Citigroup, Merrill Lynch & Co., Credit Suisse Group AG and other investment banks sold $60 billion of TruPS CDOs from 2000 to 2007.

The Bubble pops

That year, the housing bubble popped, the mortgage market collapsed, and banks — especially smaller ones — began to look like dead lenders walking. Jefferson's Hildene started buying TruPS CDOs in May 2008, before the worst months of the financial crisis. His thesis was that fewer banks would fail than people thought and that the survivors would all have to repay their debts. If he was right, he'd make a killing.

Jefferson lived on the West Side of Manhattan then, and he says before he started buying the supercheap TruPS CDOs he would walk his dog, Luna, around the American Museum of Natural History, asking himself, "What am I missing?" He concluded it was other investors who were failing to pick some low-hanging fruit.

"If you did the work, you could understand it," he says.

One confusing feature of the securities: Banks are allowed to defer payments to debtholders at any time for up to five years. Prices plunged when banks deferred, because many investors assumed they had defaulted. Jefferson knew better and snapped them up.

When the financial crisis deepened at the end of 2008, Jefferson kept buying TruPS CDOs, in some cases paying less than a penny on the dollar. Soon, they were all he bought.

Court battles

Then he learned that it wasn't just buy and hold. When the worst of the credit crisis passed, other investors went trolling for TruPS. Instead of buying CDOs, like Jefferson, some tried to pry the best TruPS out of the CDOs at bargain prices, which would hurt investors such as Hildene.

Banks also tried to buy back TruPS they had issued, offering pennies on the dollar. When forced to honor the debt, some banks pleaded hardship, saying they were too busted to pay off the TruPS, Jefferson says.

He took a hard line: "If you're going to live, you're going to pay me," he says he told them.

He has gone to court multiple times to protect his investments. There are still cases pending. He says he and his staff watch the film "Braveheart" to get fired up.

Today, Jefferson says he's probably the biggest holder of TruPS CDOs. At a deep discount, the debt securities invented during the go-go years are a precious and rare commodity, he says.

Lacrosse coach?

Jefferson and Craig-Scheckman say they always get the same question from investors: How long can they keep finding jewels among the wreckage of 2008? In Jefferson's case, it could be a while. His TruPS could be paying dividends for another two decades because most have 30-year terms. Beyond that, he's not fussed.

"I like investing," he says. "But I may not be a distressed investor if there aren't distressed opportunities. I might go coach lacrosse."

Craig-Scheckman isn't fretting either. As long as there are people concocting new financial products on Wall Street, no matter how smart they are, they will make mistakes, he says.

And when he's not skiing a foot of fresh powder on Triangle 3, a steep pitch in the trees at Steamboat Springs, he'll be waiting for them.

How we crunched the numbers

Our rankings of hedge-fund managers are based on data compiled by Bloomberg hedge-fund specialist Anibal Arrascue and information supplied by hedge-fund research firms, hedge funds and investors. We have three lists of top performers: 100 funds with assets of $1 billion or more, 25 funds with assets between $250 million and $1 billion and the 20 most-profitable funds. (Due to ties, there are 101 large funds and 27 midsize listed.)

Assets and returns were for the 10 months ended on Oct. 31.

The first step in calculating profits was dividing a fund's net figure by 100 percent minus the sum of the management-fee and the incentive-fee percentages. If a fund didn't report its fees, we used the average of funds in our universe: a 2 percent management fee and a 20 percent incentive fee.

Using gross returns, we were able to reconstruct approximately what the assets were at the start of the year. Because we didn't have inflows or outflows, the asset numbers did not take asset flows into account. We subtracted original assets from current assets and multiplied the result by each fund's performance fee to derive the profit figures.

Size trumps returns

Management fees aren't included; we assumed they were used for the day-to-day operations of the fund.

Several funds appearing on the most-profitable ranking do not show up on our lists of top performers. That is because the size of a fund can trump returns when calculating profits.

Because hedge-fund returns can be difficult to obtain, our lists are not all-inclusive. In addition, some of the numbers were difficult to verify. Unless the information came from Bloomberg or the hedge-fund firm itself, we tried to verify it with other sources, including investors and other fund databases.

Onshore and offshore assets and returns were combined for a number of funds, while figures for other funds were only for the larger or better-performing class of the fund.

–With assistance from Laurie Meisler in New York and Anibal Arrascue in Skillman.

See also:

Outlook 2015: Annuity trends

4 experts make 11 predictions on stocks, economy for 2015

Fidelity's Feingold: 5 investing strategies for 2015

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