The Winners & The Losers of The Subprime Blowup

Winners Amid Gloom and Doom

By JENNY ANDERSON
Published: March 9, 2007

http://www.nytimes.com/2007/03/09/business/09insider.html

Chaos spells opportunity on Wall Street.

When Amaranth Advisors, the $9.5 billion hedge fund, collapsed, Citadel Investments and JPMorgan swooped in for the leftovers. After the Sept. 11 attacks and Hurricane Katrina, reinsurance companies sprouted like weeds to take advantage of soaring premiums.

So it is no surprise that the meltdown of the subprime mortgage market is producing a who’s who of winners and losers among hedge funds.

Some hedge funds have made a killing. Paulson & Company, an $11 billion hedge fund in New York, had such a strong belief that the subprime market would fall apart that it started two funds last summer concentrated solely on expecting such a collapse. Paulson’s Credit Opportunities Funds, now with more than $1 billion, were up 67 percent for February and about 82 percent for the year to date. A spokesman for Paulson declined to comment.

Losers abound as well. Greenlight Capital, a $4.7 billion hedge fund in New York with a blue-chip reputation, has been hurt by the troubles of New Century Financial, a subprime mortgage originator. At the start of 2006, the fund owned about 5.5 million shares of New Century. A year ago, with the stock trading around $40, Greenlight’s founder, David Einhorn, joined the board after a proxy fight. He resigned from the board yesterday and the stock closed at $3.87.

Greenlight now owns 3.5 million shares, or 6.3 percent of common shares. A representative declined to comment yesterday.

Some hedge funds actually hedged from the start. In July 2005, TPG-Axon, a $7.5 billion hedge fund founded by a former Goldman Sachs trader, Dinakar Singh, invested $100 million in ResMae Financial Corporation, a residential mortgage originator and servicer. In February, ResMae filed for bankruptcy protection. (An affiliate of Citadel Investment Group has since agreed to buy the remains.)

TPG-Axon, however, also bet against the subprime sector to offset its exposure from the Resmae position, said a person briefed on the fund. TPG-Axon funds are up about 6 percent through February.

But the more nuanced tale in the subprime meltdown is that of Scion Capital, a $700 million hedge fund in Cupertino, Calif., founded by a former neurologist, Michael J. Burry. The fund made a smart bet — but one that was early and nearly brought the fund to the brink.

Scion Capital is a long-short value hedge fund, meaning that it looks for undervalued and overvalued stocks and bets for them or shorts them, betting the price will fall.

In May 2005, Mr. Burry decided that the housing market was overheated. Credit had been overextended and the appreciation in home prices had the earmarks of a bubble. He placed a bet that the subprime market would collapse.

To do so, he used credit derivatives to short — bet against — subprime mortgage tranches that are part of mortgage-backed securities. The derivatives were essentially insurance against a default, so he would make money when subprime started to deteriorate.

Mr. Burry ultimately entered into eight credit derivative agreements that effectively shorted the riskiest parts of subprime mortgage pools issued in 2005. That investment, which looks smart today, hurt the performance of the overall fund as the subprime market continued to hum.

Through the first nine months of last year, Scion Value Fund and the Scion Qualified Value Fund were down 16.4 percent, with a big chunk of that loss coming from credit derivative positions, some tied to mortgages and others related to corporate bonds, according to a letter to investors. The fund ended the year down about 17 percent, most of which was attributed to the credit derivative positions.

Yet at the end of the third quarter, Mr. Burry still had faith in his trade.

“Never before have I been so optimistic about the portfolio for a reason that has nothing to do with stocks” he wrote in his third-quarter letter to investors, referring to the credit derivative positions. The letter was confident — bordering on cocky —suggesting that others players jumping into the market would pay for being late to the game.

“But man oh man are they the overconfident big boys diving head first into the shallow end of the pool,” he wrote. “Despite our mark to market losses, we’re short the mortgage portfolio everyone would want if they knew what they were doing.”

But investors were wary. Rumors abounded that two significant investors wanted to pull their money because of the poor performance — departures like that, if true, might have sparked a run. Scion, it seemed, might be dead before it had the chance to be right. Dan Nero, chief financial officer and chief operating officer of Scion, declined to comment on investors’ perceptions.

Then Scion made a radical decision: It put the poorly performing credit derivative positions in a side pocket, essentially separating them from the main fund whose performance they were hurting.

Investors were required to enter into the side pocket, which locks up investor money until Scion decides to unwind it. Scion would not receive performance fees on the side pocket until it was liquidated.

Some investors were furious, said one investor because they were locked into a poorly performing fund that they hoped to exit. In essence, Scion erected a steel gate as investors were trying to get out the door.

“We thought it was in the best interest of shareholder because of the illiquidity of the market,” Mr. Nero said.

Then something funny happened: The subprime market imploded, and Scion’s investment looked a whole lot better.

The market entered a tailspin. Investment banks that had been financing mortgage originators put back loans that were in early default or violated the bank’s credit quality terms. Almost two dozen subprime originators declared bankruptcy.

When Mr. Burry first bet against the subprime market, few saw the carnage coming, and as a result the cost to insure subprime mortgage bonds did not reflect significant risk. According to research provider Markit, the cost to insure $10,000 worth of low-rated parts of subprime mortgage-backed securities in early August was only about $217.

But by the end of February, the cost to insure those subprime mortgage-backed securities shot up to almost $2,000, making Scion’s positions suddenly valuable.

Scion Capital’s bets, including its side pockets, started to pay off: through February, the funds are up 19 to 20 percent, according to a person close to the fund.

According to Hedge Fund Research, a Chicago-based firm, hedge funds investing in mortgage-backed securities were up 2.25 percent through February; the HFRI index, a measure of overall hedge fund performance, was up 1.81 percent through February.

Investors who were unwittingly locked into Scion were saved, at least for now. (The investment is expected to remain in place until 2008.) Patience paid. Or perhaps Scion was saved by timing and side pockets.

Either way, chaos created opportunity and Scion investors might feel lucky that they were locked in the castle.