Cleaning Up on the Meltdown

By anticipating problems in the credit markets, a Yale-trained computer scientist and other asset managers are producing healthy returns

by Steve Rosenbush

Back in the fall of 2006, hedge fund manager Nandu Narayanan was thunderstruck by a relatively obscure economic metric, the ratio of credit to a country's gross domestic product. Back during the Asian economic crisis of the late 1990s, Malaysia's ratio was an astonishing 220%, or $2.20 in debt for every dollar of economic output. Yet as 2006 drew to a close, the ratio in the U.S. climbed to an eye-popping 370% to 440%, depending upon how it was measured. "To say that it was well north of anything ever seen in most countries of the world is a fact," Narayanan says. "Any rate rise in the U.S. was likely to cause big problems in the credit space." Thus, he deployed his assets to capitalize on this early warning sign of the looming meltdown in the U.S. credit market.

It was just the sort of big-picture thesis that managers of so-called macro funds seek. Narayanan was a disciple of some of the pioneers of macro funds. A Yale-trained computer scientist, he earned a PhD and an MBA at Massachusetts Institute of Technology's Sloan School of Management, where he studied with Paul Krugman, the prominent economist and New York Times columnist. His academic background had honed his ability to synthesize big ideas from reams of data. Narayanan had put those skills to practice by working for billionaire macro fund managers Julian Robertson, founder of hedge fund Tiger Management, and Bruce Kovner, founder of hedge fund Caxton Associates.

Opportunity in a Reversal

Narayanan had since founded his own fledging macro fund, the $100 million Trident Investment Management. Convinced that even a modest rise in interest rates would trigger a major downturn in the credit markets, Narayanan bet that the value of subprime mortgages traded in the financial markets would fall. He accomplished that by buying insurance polices on debt issued by subprime lenders and mortgage insurers. As the lenders and mortgage insurers were hit by rising default rates, the value of the insurance policies rose. He also employed the same strategy in the mortgage insurance market.

Now his fund is up 25% for the year as of the end of July, the last officially reported number. Through Aug. 24, Trident has returned 35% in 2007.

Narayanan thinks the returns from his bets on bad credit may rise, as companies encounter further troubles. That would send their credit prices lower, but boost Trident's returns. "If everything that we shorted goes to zero, we have the opportunity for a 200% return. While that is unlikely to happen, we are hoping to end up with returns in the 60% to 80% range," Narayanan says.

It's just one example of how savvy asset managers have profited from the credit meltdown, a major financial debacle that has the potential to become a significant drag on the economy. This summer's sudden reversal in the credit markets—when an era of low interest rates and easy lending standards suddenly changed direction—was just such an event, on par with the 1987 stock market crash or the bursting of the tech bubble in 2000.

Calling the Market Top

It's obvious, of course, that such periods of extreme volatility and market chaos create investor losses: Hedge funds run by major banks such as Bear Stearns (BSC) and Goldman Sachs Group (GS), for example, have sustained well-publicized poundings. Yet such events also create opportunities for asset managers and individual investors to stand apart from the crowd and generate huge profits.