US hedge fund makes 1,000% return betting against subprime

An article on Bloomberg today may explain this

Bass Shorted `God I Hope You're Wrong' Wall Street (Update1)
By Mark Pittman



Dec. 19 (Bloomberg) -- J. Kyle Bass, a hedge fund manager from Dallas, strode into a New York conference room in August 2006 to pitch his theory about a looming housing market meltdown to senior executives of a Wall Street investment bank.
Home prices had been on a five-year tear, rising more than 10 percent annually. Bass conceived a hedge fund that bet on a crash for residential real estate by trading securities based on subprime mortgages to the least credit-worthy borrowers. The investment bank, which Bass declines to identify, owned billions of dollars in mortgage-backed securities.
``Interesting presentation,'' Bass says the firm's chief risk officer said into his ear, his arm draped across Bass's shoulders. ``God, I hope you're wrong.''
Within six months, Bass was right. Delinquencies of home loans made to people with poor credit reached record levels, and prices for the securities backed by these subprime mortgages plunged. The world's biggest financial institutions would write off more than $80 billion in subprime losses, while Bass, his allies and a handful of Wall Street proprietary trading desks racked up billions in profits.
Bass and investors like him saw opportunity in a range of new investment tools that banks created to sell subprime securities worldwide. These included mortgage bond derivatives, contracts whose values are derived from packages of home loans and are used to hedge risk or for speculation. The vehicles allowed hedge funds like Bass's to bet against particular pools of mortgages.


Money to Be Made
From the bankers who expanded the subprime market, to the sales companies that mass-marketed high-risk mortgages, to the ratings companies that blessed investment-grade designations with securities based on such loans, there was money to be made, and everyone charged after it.
The new subprime derivatives, which amplified the risks of the underlying mortgages, were sold to banks and institutional investors. When borrowers started to default on high-yield, high- risk subprime mortgages by the thousands, the values of these leveraged securities plunged.
An index designed to be a proxy for the lowest investment- grade subprime mortgage bonds sold in the second half of 2005, the ABX-HE-BBB- 06-01, traded as high as 102.19 cents on the dollar when it started in January 2006 and today trades at about 30 cents on the dollar.
Private Island, Racing Porsche
Bass, a former salesman for Bear Stearns Cos. and Legg Mason Inc., had struck out on his own in early 2006. He started Hayman Capital Partners, specializing in corporate turnarounds, restructurings and mortgages. Bass isn't related to the Texas billionaire Robert Bass.
Bass named Hayman for the private island off Australia where he spent his honeymoon. He drove a $200,000 500-horsepower Porsche Ruf RTurbo with a built-in racecar-style crash cage.
A former competitive diver who had put himself through Texas Christian University in Fort Worth partly on an athletic scholarship, Bass was about to take his most ambitious plunge yet: betting home values would decline for the first time since the Great Depression.
``We were saying that there were going to be $1 trillion in loans in trouble,'' Bass says. ``That had really never happened before. You had to have an imagination to believe us.''


New Tools, Deep Research
Other early converts were Mark Hart of Corriente Capital Management in Fort Worth, Texas, and Alan Fournier of Pennant Capital in Chatham, New Jersey. In his earlier sales jobs, Bass had sold securities to Fournier. Now the two joined forces to research bad loans.
On the other side of their trades would be investors chasing the high yields from securities based on subprime loans. This group included Wall Street firms, German and Japanese banks and U.S. and foreign pension funds. They were reassured by the securities' investment-grade ratings, even as foreclosures started in some parts of the U.S.
The traditional way for a speculator to wager against, or short, the housing market was to sell the stocks of major home- building companies with borrowed money and repurchase them for a lower price if the shares fell.
Bass had tried that strategy in the past and found there were limits on its effectiveness, he says. There was always a danger that a leveraged buyout firm would bid for the home- building company and cause the stock to rise, which would cost anyone shorting the stock money.
Understanding the Trades
The new, standardized mortgage bond derivative contracts created a strategy with less risk and greater profit potential.
To learn about the contracts, Bass visited Wall Street trading desks and mortgage servicers. He met with housing lenders and hedge fund analysts. He read Yale Professor Frank Fabozzi's book on mortgage-backed securities, ``Collateralized Debt Obligations: Structures and Analysis.'' Twice.
``What I didn't understand was the synthetic marketplace,'' Bass says. ``When someone explained to me that it was a synthetic CDO that takes the other side of my trade, it took me a month to understand what the hell was going on.''
Bass and Fournier hired private detectives, searched news reports, asked Wall Street underwriters which mortgage companies' loans were at risk of default and called those lenders directly. In this blizzard of research, Bass turned up the California mortgage lender Quick Loan Funding and its proprietor, Daniel Sadek.


Guy `to Bet Against'
The hedge fund traders learned from a news account that Sadek was dating a soap opera actress, Nadia Bjorlin, and using profits from his mortgage company to fund a movie about car racing, in which she starred.
``When they started catapulting Porsche Carrera GTs and he says, `What the hell, what are a couple of cars being thrown around?' I'm thinking, `That's the guy you want to bet against,''' Bass says.
Bass called Quick Loan Funding directly. He says he got on the phone with a senior loan officer, identified himself and said he was interested in the mortgage business. As Bass tells it, the conversation sealed his determination to short Quick Loan's mortgages.
For his part, Sadek says he was never told that hedge funds had asked how his firm did business. He disputes Bass's characterization of Quick Loan's mortgages.
``If my loans were so bad, why did Wall Street keep buying them to securitize?'' Sadek says.
Recruiting Investors
Armed with their understanding of the loans they wanted to short and a plan for doing so, Bass, Fournier and Hart hit the road, making pitches to potential investors that the market was about to collapse.
``My biggest fear was that it was going to happen before I could get the money,'' Bass says.
One of Bass's first investors was Aaron Kozmetsky, a Dallas investor with whom he already had a business relationship. Kozmetsky's grandfather, George Kozmetsky, was one of the founders of Teledyne Technologies Inc. While Aaron Kozmetsky had invested in almost every venture Bass had ever offered, this time Bass put a note of urgency into his pitch.
``It was the first time he's said, `Drop what you're doing. You need to meet with me on this. Make time for me,''' Kozmetsky says. Kozmetsky invested more than $1 million.
Daniel Loeb, the chief executive of Third Point LLC, a New York-based company that oversees about $5.7 billion, had put money in another of Bass's pools. He describes Bass as ``probably the most astute salesperson who covered us.'' Loeb passed on Bass's subprime fund.
``I obviously missed the boat on that one,'' Loeb says now.


Laying the Bets
Loeb still did all right. He invested in Bass's main hedge fund that specializes in turnarounds, restructurings and bankruptcies. Loeb says that fund is up 160 percent this year.
Bass and Fournier focused on single-name mortgage bond derivatives to be more certain that their bets were right. Both bought only securities rated BBB and BBB-, rather than AAA rated securities, expecting them to pay off more quickly.
Bass says he raised about $110 million and used the leveraging effect of derivatives to sell short about $1.2 billion of subprime securities. Two-thirds of it was based on BBB rated mortgage instruments, some involving Sadek's loans. One was Nomura Home Equity Loan Inc. 2006-HE2 M8, an instrument based 37 percent on loans issued by Quick Loan Funding.
The remaining third of Bass's investment involved securities rated one grade lower, BBB-, some also incorporating Quick Loan Funding mortgages.
As Bass and Fournier executed their trades in August and September 2006, foreclosures were beginning to spread across the U.S.


`Fat Pitch'
``This is the fat pitch,'' Bass says. ``This is the once-in- a-lifetime, low-risk, incredibly high-reward scenario where we're going to be right.''
In January, Bass decided he needed ``to meet the enemy'' by going to the American Securitization Forum convention in Las Vegas and listening to presentations from managers of the synthetic collateralized debt obligations that took the other side of his trades.
``I came away relieved,'' Bass says. ``They said, `We know what we're doing. We've been doing it for 10 years. Our models are robust.'''
In May, two independent researchers, Joshua Rosner of Graham Fisher & Co. and Joseph Mason, of Drexel University, concluded in an 84-page study that the U.S. ratings companies Standard & Poor's, Moody's and Fitch had been wrong to bless billions of dollars of mortgage securities with AAA and BBB ratings.
After a May 3 presentation at the Hudson Institute in Washington, Rosner stood on K Street and lit up an American Spirit cigarette.
``The ratings are just wrong,'' Rosner says. ``Completely wrong.''
For Bass and Fournier, it was validation of their trading strategy. As investors worldwide began to panic, Bass and Fournier watched the values of their short positions soar.
(TOMORROW: Moody's, S&P stoke the demand for mortgage-based securities.)