Hedge Funds Profit From Sub-Prime Woes

by Carla Johnson, Investors Offshore.com

28 August 2007

Hennessee Group LLC, an adviser to hedge fund investors, has said that while some hedge funds focused on mortgage backed securities have suffered well publicized losses related to the decline in the US sub-prime mortgages space, many hedge funds have also been able to generate profits as a result of the decline.

In a previous press release, Hennessee Group reported that hedge funds had been using credit default swaps (CDS) 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, many hedge funds have greatly benefited from the collapse in sub-prime mortgages via their short exposure to mortgage lenders and sub-prime mortgage backed securities and indices, Hennessee observed recently.

While some have focused on shorting mortgage lenders and buying credit default swaps (CDS) on specific mortgage backed bonds, others have elected to purchase 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- traunches issued in 2006) is now down –60% for the year (through the end of July). 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 zero.

However, as has been widely publicized, several hedge funds with leveraged long bets on bonds backed by sub-prime mortgages experienced significant losses in the first half of this year. According to reports, these funds leveraged investor capital between 10 and 20 times, and held a collection of collateralized 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 selling of assets and further exacerbated losses. While BBB traunches have garnered the most coverage, even more senior tranches have been affected by the collapse, as the AAA tranche had declined -1%, the AA tranche fell -5%, and the A tranche had decreased -20%, as of the end of June.

According to Hennessee, while many recent news stories have publicized hedge fund failures related to the sub-prime collapse, the reality of the situation is that many hedge funds were expecting such an event and were able to profit from the decline.

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