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Hedge Funds: Betting On Your Mortgage

Written By:
May 02, 2011 at 1:58 PM

Most homeowners are familiar with well-publicized details concerning the crack up of the housing and mortgage industries. One segment of the ... that benefit heavily from the woes were hedge funds. Bloomberg Financial reports that of the ten top performing hedge funds in 2010, three profited by investing in MBSs. Take Stamford, Connecticut based Structured Portfolio Management (SPM). Bloomberg Financial named SPM's Structured Servicing Holdings the top performing hedge fund for 2010 with a 49.5 percent return. Structured Portfolio Management had two other funds - SPM Core and SPM Opportunity, rated in the top 15. Both had returns of 30.8%.

A former philosophy professor at the University of Kansas, Don Brownstein founded SPM in 1997. Structured Servicing Holdings began trading in February 1998. Since its inception, the fund has earned an average return of 28 percent per year. In 2007, the fund had its best percentage gain, realizing a 185 percent return after subtracting management fees. The next year, when the typical hedge fund had a -19 percent return, Structured Servicing Holdings had a -6 percent return. In 2009, Structured Servicing Holdings gained 134.6 percent. SPM Core and SPM Opportunity earned 53.6% and 100.2% respectively.

Other hedge funds that invest in mortgage-backed securities include Third Point Offshore Fund, Nisswa Fixed Income Fund, SAC Capital International, MKP Capital Management, Hayman Advisors LP and Paulson & Co. Industry analysts estimate that Paulson & Co founder John Paulson took home as much as $3 billion in 2007 betting that the housing and mortgage markets would collapse.

How Hedge Funds Work

Hedge fund managers have the intent of gaining profits whether the market trends up, down or sideways. Unlike stocks and mutual funds, IRAs, pension funds, hedge funds consist of private investment funds that do not require registration with the Security and Exchange Commission. Managers may employ a host of diverse and complex strategies. They invest in a wide variety of assets, including equities, non-equities and derivatives, including mortgage-backed securities.

The rules allow hedge fund managers to purchase long or short positions on investment assets. A manager who takes a long position expects the asset will increase in value. A short position reflects the manager's belief that the asset will decline in value.

Management and Performance Fees

Hedge fund managers charge investors a management fee to cover the costs of operating these funds. Management fees run one to four percent a year with an average of two percent. In addition, managers earn performance fees, which pay for those huge bonuses that got news headlines. Generally, a fund's net asset value must exceed the previous year's worth to qualify for a performance fee. Hedge funds that attract institutional investors, such as universities, foundations, government and private pension funds, may have net asset values in the billions of dollars. Most hedge funds charge a performance fee of 20% on the returns. Some funds may charge as much as 50 percent.

Hedge Funds and Mortgage-Backed Securities

The values of mortgage-bonds backed securities depend on the length of time homeowners make their monthly mortgage payment before either refinancing or defaulting on their obligations. High performing hedge funds managers have developed proprietary formulas, which expect the likelihood of homeowners refinancing on defaulting on home loans. They analyze factors, such as credit scores, home location, loan amount, loan age and other elements, to determine the possibilities of payoff or foreclosure. Hedge fund managers like John Paulson and Don Brownstein buy securities that fit their criteria -- or short mortgage-backed securities.

Hedge Fund Investors

The average individual cannot invest in hedge funds. Regulations state that only accredited investors or qualified purchasers can purchase hedge funds shares. Accredited investors must meet one of the following requirements:

  • Net worth exceeding $1 million
  • Income of $200,000 for the past two years and expected to remain stable
  • Assets over $5 million

Qualified purchasers have to satisfy one of the following conditions:

  • $5 million in investment holdings
  • Family-owned business with a minimum of $5 million in investments
  • Business with at least $25 million in investments
  • Trust sponsored by qualified purchasers

Since regulators deem accredited investors and qualified purchasers as “more sophisticated,” which means they have the wherewithal to “protect” themselves, hedge funds did not come under the same scrutiny and restrictions associated with other investment vehicles. Therefore, managers had more leeway to structure funds and implement investment strategies. Since the financial crisis of 2008, regulators in the US and abroad have enacted regulations to provide more supervision of hedge funds.





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