While some headlines (including one or two in the FT) suggest there aren’t many upsides to the subprime lending turmoil for investors, the recent wave of subprime-linked debacles – the implosion of two Bear Stearns hedge funds; the winding up of a London-listed fund after big subprime losses; and the suspension of redemptions at a Florida fund invested in the sector – has produced some real winners.
Hedge funds betting on falls in bonds linked to US subprime mortgages raked in returns of almost 40 per cent last month as they profited from the crisis that has engulfed rivals, reports the FT on Wednesday.
A $2bn fund run by New York’s Paulson & Co was the single best-performing fund, rising almost 40 per cent after fees in June thanks to its dedicated bets against subprime mortgages, says the report.
Other hedge funds following similar strategies produced returns as high as 27.5 per cent in the month, while another manager has tripled investor money this year, according to investors. Two other funds that performed strongly in June were SCSF, run jointly by Texan hedge funds Hayman Capital and Corriente Advisors, which rose 27.5 per cent in the month; and San Francisco-based Passport Capital, which rose 13.8 per cent.
However, some managers are now warning that so many hedge funds piled money last month into bets against subprime that it had pushed up the cost too far. “It is becoming the trade du jour,” one manager told the FT.
Investors in hedge funds say many managers profited from subprime last month by holding short positions through credit default swaps, even in funds that are supposed to focus on equities. But some fear that undisclosed or mis-priced investments in the hard-to-value bonds and equity of structured products linked to subprime, such as CDOs, could lead to surprise losses at some funds as they report later this month.
Also, now that both S&P and Moody’s have moved decisively against subprime-backed debt – S&P on Tuesday threatened to downgrade the credit ratings on some $12bn of mortgage-backed bonds while Moody’s said it had cut or was reviewing ratings for $5.7bn of mortgage-backed bonds – the real fear is of a broader repricing of risk in credit markets.
This is “no small matter”, says Lex, reminding us that “the last time S&P moved so dramatically was about a decade ago, when it downgraded Japan”.
While it doesn’t matter so much for existing mortgage-backed securities, S&P’s move is more significant in its potential knock-on effect on higher-rated tranches and on the pricing of new issues, since AAA-rated tranches will require more expensive cushioning from lower-rated tranches.