Donald (“Don”) Brownstein’s Mortgage Metaphysics Drives Gain in Top Hedge Fund
For 20 years, Don Brownstein taught philosophy at the University of Kansas. He specialized in metaphysics, which examines the character of reality itself. In a photo from his teaching days, he looks like a young Karl Marx, with a bushy black beard and unruly hair.
That photo is now a relic standing behind the curved bird’s-eye-maple desk in Brownstein’s corner office in Stamford, Connecticut. Brownstein abandoned academia in 1989 to try to make some money, Bloomberg Markets magazine reports in its February issue.
The career change paid off. Brownstein is the founder of Structured Portfolio Management LLC, a company managing $2 billion in five partnerships. His flagship fund, the abstrusely named Structured Servicing Holdings LP, returned 50 percent in the first 10 months of 2010, putting him at the top of Bloomberg Markets’ list of the 100 best-performing hedge funds managing $1 billion or more.
The $1.2 billion fund skyrocketed 135 percent in 2009.
In percentage terms, Brownstein, 66, beat out funds run by bigger, better-known competitors, including Ray Dalio’s Bridgewater Associates LP. Dalio, though, has three funds in the top 15. Brownstein also topped Steven Cohen’s SAC Capital International (No. 53).
Brownstein did it by exploiting his expertise in something almost as esoteric as metaphysics: the market for exotic securities built from residential mortgages.
It was the crackup in housing and mortgage markets that brought the U.S. economy to its knees in 2008 and earned billions for hedge-fund managers such as John Paulson, who saw it coming and bet that mortgage securities would crash.
Brownstein and William Mok, Structured Portfolio’s director of portfolio management, won’t say exactly how they made their 2010 killing. Their longtime strategy is to develop models that predict when homeowners will refinance their mortgages — a move that reduces interest payments on mortgage bonds. They then buy securities they conclude are underpriced.
Many homeowners have been unable to take advantage of tumbling rates to refinance their mortgages because their houses are worth less than they owe on their loans. Investors that bet against a refinancing boom have profited.
Two of Brownstein’s other funds are in a three-way tie for ninth place in the ranking of mid-size funds, which manage from $250 million to $1 billion. The SPM Core and SPM Opportunity funds were both up 31 percent.
The hedge-fund ranking uses data compiled by Bloomberg and information supplied by research firms, fund companies and investors. Three of the top 10 funds made money on mortgage bonds, according to Bloomberg data. The mortgage market is often lucrative for hedge funds because it’s volatile, says Jeffrey Gundlach, chief executive at Doubleline Capital LP, a Los Angeles manager of mutual funds that trade mortgages.
“The mortgage market has every single risk,” Gundlach says. People default, banks foreclose on housing loans, and the government often changes the rules. “Any market that has risks morphs into opportunity,” he says.
Another fund that profited from betting on mortgages is the $1.2 billion Nisswa Fixed Income Fund Ltd., run by Pine River Capital Management LP of Minnetonka, Minnesota. It ranks No. 7, with a 27 percent return after manager Steve Kuhn bought mortgage bonds selling at what turned out to be bargain prices. The fund returned 92 percent in 2009, and is up a cumulative 196 percent since it was founded in September 2008 through Oct. 31.
The top-performing hedge-fund managers also made money in emerging markets, particularly Russia, and in gold. The No. 2 large fund, with a 39 percent return, according to Bloomberg data, is the Russian Prosperity Fund, managed by Moscow-based Prosperity Capital Management. The No. 2 mid-size fund, with a 48 percent return, is also run by Prosperity, while the No. 1 mid-size fund, returning 50 percent, is a unit of Moscow-based VR Capital Group Ltd.
Gold jumped 24 percent to $1,359.40 an ounce in the 10 months covered by the ranking. The rally lifted Paulson & Co.’s Paulson Gold Fund 26 percent, making it No. 17 on the mid-size list, and helped to boost Daniel Loeb’s Third Point Offshore Fund Ltd. to No. 8 among large funds, with a 25 percent return. Loeb invested in mortgages too, in addition to his usual bets on stocks and bonds, according to people familiar with his holdings.
Overall, hedge funds had a lackluster year, with less impressive returns than in 2009, when the top fund, run by David Tepper’s Appaloosa Management LP, returned 132 percent. The same fund earned 21 percent in 2010.
On average, the top 100 hedge funds rose 13.9 percent through October, with Nos. 99 and 100 gaining just 6.7 percent. The Standard & Poor’s 500 Index rose 6 percent in the same period. A broad index of hedge funds compiled by Hedge Fund Research Inc. in Chicago rose 6.8 percent.
Spotty performance aside, wealthy Americans are pouring money into funds. Half of all households with a net worth of $25 million or more were invested in hedge funds in 2010, up from 35 percent in 2007, according to Spectrem Group, a Chicago-based research firm that tracks the affluent.
The surge doesn’t make sense, says Bill Berg, founder of Sigma Investment Management Co. in Portland, Oregon. Investors are paying high fees, Berg says, usually 2 percent of assets to cover hedge funds’ costs, plus 20 percent of any profits, for gains they could get from cheaper mutual funds. (All figures in the Bloomberg Markets ranking are net of fees.)
“People insist on viewing hedge funds as being different from normal investments,” says Berg, who picks fund managers for individuals and institutions. “They’re not.”
Only a few funds at the top of the ranks can justify their fees, Berg says.
“If you can get into a fund that’s in the top 10 percent, do it,” Berg says. “The problem is that those funds are probably closed to new investors.”
Some hedge funds have a new worry: the wide-ranging investigation of insider trading by the U.S. Justice Department. On Nov. 22, the Federal Bureau of Investigation raided the offices of Diamondback Capital Management LLC in Stamford, Level Global Investors LP in New York and Loch Capital Management in Boston. Diamondback and Level Global were started by alumni of SAC Capital Advisors LP, which received a subpoena in November demanding documents.
No firm or employee has been charged with wrongdoing.
Because of hedge funds’ fee structure, managers need healthy returns on a large pool of client cash to make big money. A 5 percent return on $10 billion is better than a 50 percent return on $100 million.
$2.25 Billion Profit
The most profitable fund in 2010 was Dalio’s Pure Alpha II, which earned Bridgewater $2.25 billion. His Pure Alpha 12% fund was No. 3, earning another $428.6 million in fees.
Westport, Connecticut-based Bridgewater manages $60 billion in hedge funds, making it the biggest hedge fund firm by assets.
The Pure Alpha funds made money betting against the U.S. economy, according to a person familiar with Bridgewater’s trading. Dalio and his managers bought U.S. Treasury bonds, which rallied as economic growth, which can produce inflation, remained anemic, the person said.
SAC Capital International was the second-most-profitable fund, earning $1.1 billion in fees through the first 10 months of 2010, according to Bloomberg data.
Brownstein’s Structured Servicing Holdings has returned an average of 28 percent annually since February 1998, when the fund made its first trade, a person familiar with its performance says. Its only losing year was 2008, when it returned negative 6 percent, according to an investor, while the average hedge fund dropped 19 percent.
The 50 percent gain through October earned Brownstein’s investment team $87 million in fees, according to Bloomberg data.
Brownstein has prospered in a market dominated by math savants. The value of many mortgage bonds depends in large part on how long homeowners make payments at their current interest rate before either refinancing or defaulting. The top traders have proprietary formulas that predict behavior based on a homeowner’s credit score, address, loan size, loan age and other factors.
The walls of SPM are scrawled with such formulas, worked out by Mok, a Salomon Brothers alumnus who has a bachelor’s degree in computer science from Columbia University, and his team of math and physics Ph.D.s. Brownstein’s strength is his mastery of the logic behind the formulas.
“If you’re wrong, he’ll prove you wrong,” Mok, 47, says.
Brownstein, who these days looks more like entertainment mogul Barry Diller than the father of communism (much less hair, much nicer shirts), says he loves his role.
Parmenides to Florida
“I’m here to argue,” he says in a three-hour interview that ranged from ancient Greek philosophers Parmenides and Plato to foreclosures in Florida. “I’m in charge of pontification and arguing.”
The son of a furrier, Brownstein grew up poor on Gun Hill Road in the Bronx, New York. He got his bachelor’s degree from Queens College before heading west for graduate school, earning his Ph.D. in philosophy from the University of Minnesota. He started teaching in 1969 at the University of Kansas in Lawrence.
Brownstein’s career suggests a restless mind. In Lawrence, he made documentary films on the side and once interviewed Beat Generation writers Allen Ginsberg and William Burroughs, author of Naked Lunch. Brownstein became friendly with Burroughs, a St. Louis native who had moved to Lawrence late in life.
A big drinker, Burroughs often showed up at parties at local farms with bags of pistols to distribute for target practice. Once, Burroughs brought a sack of hatchets to throw at trees.
“Everyone who had kids left,” Brownstein says.
A fight over a shopping mall in Lawrence in the mid-1980s led Brownstein, indirectly, to mortgage trading. A developer wanted to build the mall in a cornfield, while Brownstein and others wanted it downtown. The project got Brownstein thinking about finance. He figured a downtown mall could attract a big anchor tenant and then use its lease payments as collateral for a bond that would be sold to investors to pay for the mall’s construction.
Brownstein wrote up his idea and got it published in a real-estate trade journal in 1987. The article later led to an interview with William Marshall, a former professor at Washington University in St. Louis who was then an executive at Franklin Savings Association in nearby Ottawa, Kansas. Franklin hired Brownstein in 1989.
Franklin was an outpost of Wall Street on the plains. Chairman Ernest M. Fleischer built the thrift into one of the nation’s largest savings institutions partly by using mortgage-security trading to reduce interest-rate risk.
Fancy financial engineering couldn’t save Franklin from the savings-and-loan crisis. The Office of Thrift Supervision seized it in February 1990, eight months after Brownstein arrived.
Brownstein stayed until 1992, when he went to work trading mortgages for Caisse des Depots & Consignations, a state-owned French bank, in its New York offices. There, he set up a new unit to buy the rights to collect interest on mortgages — the so-called servicing rights. Owning the rights was like owning mortgage bonds, Brownstein says, and if you got them cheap enough, they could be profitable.
Many lenders were eager to sell, he says, because they wanted to lock in gains all at once rather than risk losing interest income if borrowers refinanced.
Brownstein set up Structured Portfolio Management in New York in 1996, planning to do more deals for servicing rights. Then he pursued another angle. A popular security in the mortgage business is the interest-only strip, or IO. It’s a bond backed by the interest payments from a portfolio of mortgages. Principal payments go into another security called a PO that’s more attractive to conservative investors.
If a homeowner refinances, the PO owner gets paid sooner and the IO owner loses all of the interest that he was due to collect. The trick to valuing an IO is figuring out how many borrowers in the pool are going to pay off their mortgages early. So Brownstein and Mok spend their time puzzling over prepayment speeds.
Mortgage bonds, including IOs, come in two variations: agency backed and non-agency backed. The first are built from mortgages insured by Fannie Mae and Freddie Mac. The two government-controlled companies own or guarantee repayment on half of all U.S. mortgages, a function that encourages lending. A trader buying securities built from agency-backed mortgages, generally under $417,000 for a single-family home, has no credit risk.
In 1996, the market for securities backed by the bigger, nonguaranteed loans was just getting going, Brownstein says. Most trading was in bonds backed by Fannie and Freddie loans of roughly the same size and age. If interest rates fell, most of the homeowners in the pool refinanced at similar speeds.
Brownstein saw that IOs backed by big, nonagency mortgages were selling for less because the mortgages were more heterogeneous and harder to model. He separated the mortgages backing the bonds into groups with similar characteristics, including the size of the mortgage and other attributes that even today he declines to identify. He thought he could predict how each group would behave when rates fell.
Brownstein has been refining the system ever since, with the help of Mok and his team of analysts. Mok started trading mortgages at Salomon in 1987, after attending the same training class attended by author Michael Lewis, who wrote about the experience in his book “Liar’s Poker” (W.W. Norton, 1989).
Back then, Mok watched interest rates and the yield each security paid relative to Treasury bonds to figure out whether to buy or sell. That was before interest rates started falling in the early 1990s, prompting a wave of refinancing.
Now, traders use computer-driven models to predict if and when a homeowner is going to cut off interest payments with a refinancing.
“You have to really read the tea leaves to figure out if a mortgage bond is a good buy or not,” Mok says.
For its mortgage bet, Pine River Capital went so far as to open an office in Beijing in 2010 to tap a new pool of math experts. The firm has 10 people there doing quantitative research and software development, Pine River founder Brian Taylor says.
Numbers crunched in China are sent to an 11-person mortgage team in Pine River’s office in New York. Taylor opened that office in 2008, when many banks bailed out of the mortgage-trading business and fired mortgage experts.
Slow to Refinance
“Financial markets are prone to crisis, and crisis always creates opportunity,” Taylor says.
Pine River profited during the past two years by betting correctly that U.S. homeowners wouldn’t pay off their mortgages as fast as they did in 2003, even though mortgage rates fell far and fast during both periods.
In 2008, when rates were tumbling, IO bonds were trading at 9 cents on the dollar, says Kuhn, manager of Pine River’s Nisswa Fixed Income fund. The price implied that 60 percent of borrowers would refinance within one year, he says.
No way, he thought. People wouldn’t refinance because, unlike in 2003, the value of their houses had fallen. Those who could refinance confronted a mountain of paperwork at newly cautious banks.
Kuhn gets excited when talking about the mortgage market. A Minneapolis native, he earned a bachelor’s degree in economics from Harvard University in 1991 and went to work trading municipal bonds at Piper Jaffray Cos. in Minneapolis.
He switched to mortgage bonds at Piper and then took a job doing the same activity at Cargill Inc., the food producer that started a trading operation out of its effort to hedge the prices of farm products. Kuhn left Cargill in 1998 for Citadel LLC, the Chicago hedge fund, where he traded convertible bonds.
In 2002, he joined Goldman Sachs Group Inc., again to trade mortgages.
In 2007, when the market started to wobble, Kuhn saw opportunity. He called up Taylor, a fellow Minnesotan, and offered his services. Taylor had set up Pine River in 2002 after 14 years at Minnetonka, Minnesota-based money manager EBF & Associates. Pine River is named for the town 150 miles (240 kilometers) north of Minneapolis where Taylor has a lake house. He was banished there for a year by a non-compete clause in his EBF employment contract that required him to move at least 100 miles away from the Twin Cities if he started a competing company. Pine River named its Nisswa funds after another town in northern Minnesota.
The collapse that Kuhn expected came in 2008, when mortgage bonds plunged. Then, the crisis caught up to Fannie Mae and Freddie Mac. The U.S. took them over that September to ease concern that they would fail and cease to back $5 trillion in mortgages.
After the takeover, Fannie and Freddie stopped a key activity, Kuhn says. In addition to guaranteeing mortgages, the companies bought and sold securities in order to moderate fluctuations in rates. That also helped control price differences, or spreads, between various types of mortgage bonds, making it hard for traders to find arbitrage opportunities.
“There weren’t a lot of nickels lying around,” Taylor says.
Without Fannie and Freddie trading, the market is ripe with opportunity, Kuhn says. But government control of the companies means that traders like him have to watch for government programs that make it easier for homeowners to refinance. He watches hours of C-SPAN, the cable channel that broadcasts government hearings. Sometimes he records them to watch in the evening.
“My wife is a good sport,” he says.
In 2010, you didn’t need to be a specialist to see that there was money to be made in mortgages. Daniel Loeb of Third Point normally invests in stocks and bonds of companies going through mergers and restructurings. He has owned mortgage securities since 2007. In 2009, they helped lift the fund 38.4 percent for the year, Loeb said in a letter to investors dated March 1, 2010.
“Mortgage securities contributed significantly to our returns during the fourth quarter and have also performed strongly so far in 2010,” Loeb wrote.
As of June, mortgage investments accounted for about one-fifth of Third Point’s assets, according to a letter sent to investors in August. Loeb used securities called re-remics for about half of his mortgage play, according to the letter. Remic is an acronym for “real estate mortgage investment conduit.” It’s a trust, backed by thousands of mortgages, that pays interest.
Remics are divided into tranches according to risk and sold to investors. Each tranche becomes a separate mortgage bond. That makes them cousins of collateralized debt obligations, the bundles of mortgage bonds and other debt whose value plunged in 2007, helping to trigger the larger financial crisis.
Remics also tanked during the credit crisis as the mortgages backing them went into default. Many AAA remics, the least risky ones, lost their rating, and banks and insurers had to put up more capital to cover potential losses. To ease that burden, Wall Street has been repackaging the once-AAA-rated bonds into new trusts that have senior and junior securities.
Loeb is betting on the riskier junior slices, hoping they will pay him a fat yield — as much as 20 percent, according to the August letter to investors. As the credit crisis eased, those bonds rose in value, contributing to Loeb’s 25 percent return.
Loeb also bet big on gold, a popular play for hedge-fund managers in 2010. Gold was the biggest position for George Soros and Paulson in September and the second-biggest position of commodity investor Paul Touradji, according to filings with the SEC. They invested in exchange-traded gold funds, shares of mining companies or both.
Gold appeals to investors worried about the value of paper money, Soros said at a meeting of the Canadian International Council, a nonpartisan group devoted to strengthening Canadian foreign policy, on Nov. 15.
“The big negative is that too many people know this,” Soros said. “There are a lot of hedge funds who are pretty heavily exposed.”
Loeb had about 6 percent of Third Point’s assets in bullion in November, the biggest gold bet he’s ever made, according to Third Point investors. He started buying in September, when the metal was trading at $1,250 an ounce, spurred by a U.S. government report saying Washington can’t sustain the deficits it’s been running. Gold was up 11 percent as of Jan. 5 from its close on Sept. 1.
Gold is always popular during times of crisis. Brownstein, buoyant on a darkening November afternoon, says the emergency in his market has passed.
“The crisis was when housing prices were accelerating out of control,” Brownstein says.
Now, there are opportunities for hedge-fund managers willing to drill deep down into mortgage bonds and find value, he says. Given his performance in 2010, other managers would do well to pay attention to the pronouncements of the pontificator-in-chief.