06/01/2012

Bearish Hedge Funds Profit From MBS Rally

Hedge fund operators Dalton Investments, Metacapital Management and One William Street Capital have been cashing in on others’ bullishness on the U.S. housing market.

In recent months, those firms have been selling subprime-mortgage paper to large asset managers, including Pimco and Western Asset Management, that continue to snap up the securities based in part on a favorable outlook for housing prices. Among the sellers, the idea is to take advantage of that view by locking in profits. Indeed, the buying had driven up average values among triple-A-rated subprime-loan bonds with five-year lives by about 20 cents on the dollar during the first four months of this year, to about 60 cents.

Prices have hovered around that level ever since, allowing Dalton, Metacapital, One William Street and some of their peers to gradually unload more of their positions — something they continue to do today.

Dalton said the dynamic contributed to a 2% gain for its Dalton High Yield Mortgage Fund in April. The fund normally pursues a buy-and-hold strategy, but recently has “taken the opportunity to sell certain positions at attractive levels,” the Santa Monica, Calif., firm said in a note to investors last month. The investments Dalton sold included interest-only strips and bonds backed by second-lien loans. Buyers have been willing to pay more for such issues based on “the growing sentiment that the housing market may have bottomed.”

Dalton takes a different view. “Many of those claiming the bottom note that foreclosure filings have hit multi-year lows, [foreclosed real estate] investors are exiting the market as their profit margins have shrunk, and severities seen in certain collateral types have been moderating,” the investor note said. “After analyzing the data more thoroughly,” Dalton added, “we do not believe that it is simply a matter of time before we are back to pre-2008 levels.”

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