Bloomberg News

Passport’s Burbank Hedges Slow Home Recovery: Mortgages

July 08, 2012

Passport Founder John Burbank

Passport Management LLC Founder and Chief Investment Officer John Burbank is extremely bearish on global stocks because he expects the U.S. and much of the world to fall into recession. Photographer: Jacob Kepler/Bloomberg

John Burbank, the hedge-fund manager who’s betting on a global recession, plans to follow rivals in buying U.S. mortgage securities without government backing amid increasing signs the housing market is recovering.

Burbank’s Passport Capital LLC will purchase non-agency mortgages to hedge investments that may underperform if property prices jump, said Jeff Kong, who’s leading the effort. Raphael Gonzalez, most recently JPMorgan Chase & Co. (JPM:US)’s co-head of trading for subprime mortgages, this month will join the San Francisco-based firm, which oversees $3.4 billion.

Other funds that are raising money for non-agency bonds or are already buying include Brevan Howard Asset Management LLP, D.E. Shaw & Co., Cerberus Capital Management LP and Canyon Partners LLC. They’re being lured to the $1.1 trillion market by property prices that are stabilizing after the biggest real- estate crash since the 1930s, projected yields that exceed corporate debt even with record defaults priced in, and expectations that Europe’s banks will sell to preserve capital.

“By adding a bigger credit component I have a portion that’s long the recovery,” Kong, who oversees $200 million in agency mortgage derivatives for Passport, said in a telephone interview. “The high returns available in RMBS have made mortgage strategies much more in vogue.”

Non-agency residential mortgage-backed securities lack guarantees from government-supported Fannie Mae and Freddie Mac or U.S.-owned Ginnie Mae. The underlying loans range from so- called subprime mortgages granted to borrowers with poor credit to jumbo debt too large for taxpayers-backed programs.

Housing Rebound

Passport currently has home-loan investments that will outperform if refinancing among taxpayer-backed debt remains subdued, a trend that may continue if a worsening economy prevents a robust housing recovery. Buying non-agency bonds provides a hedge against a quick housing rebound that would increase prices of properties seized in foreclosures and reduce defaults.

New funds began jumping into the market as prices declined in 2011 as Europe’s debt crisis roiled credit markets and the New York Federal Reserve tried selling securities it assumed during the 2008 bailout of insurer American International Group Inc.

The move paid off this year when values soared as European regulators sought to stem the region’s sovereign-debt crisis, reducing the likelihood of banks selling assets and U.S. economic growth stalling. The Fed has sold more than $20 billion of the securities this year, underscoring demand.

Subprime Returns

Non-agency securities backed by subprime or second mortgages issued during the market’s peak have returned more than 15 percent this year, according to Barclays Plc index data, as evidence grows of the housing recovery. The debt lost 5.5 percent last year, after gaining 26 percent in 2010.

The S&P/Case-Shiller index of property values in 20 cities dropped 1.9 percent in April from a year earlier, the smallest decline since November 2010, after decreasing 2.6 percent in the year ended March and 34 percent from the peak in 2006. Purchases of new U.S. houses rose in May to a two-year high, the Commerce Department said, as the Fed pushes borrowing costs to record lows.

Subprime bonds, whose collapse in 2007 triggered the last financial crisis, are yielding 8.5 percent including expected losses for debt with projected average lives of seven years or more, according to JPMorgan data. That compares with 7.8 percent for high-yield company bonds before accounting for defaults, Bank of America Merrill Lynch index data show.

European Sales

While the U.S. housing market is close to bottoming, it will take years for a full recovery, Kong said. European banks trying to reduce leverage and adhere to new capital rules will add to buying opportunities by selling U.S. non-agency debt, Passport’s Kong said.

“These assets reside in many places, including sovereigns or offshore banks, particularly German and French banks,” Kong said. “One of the events that I’m preparing for is if they do need to sell.”

Fourteen of the largest European banks held U.S. residential-bond assets valued at as much as $55 billion at the start of this year, representing a 21 percent drop from mid-2011, according to an April report by Credit Suisse Group AG analysts.

Burbank, 48, made $370 million for himself in 2007 betting on a tumble in subprime mortgages. Now he’s extremely bearish on global stocks because he expects the U.S. and much of the world to fall into recession. The hedge-fund manager is bearish on miners, financial and industrial companies and emerging-market stocks, the latter because he believes European banks don’t have the capital to lend to companies there.

European Banks

D.E. Shaw, the $26 billion New York-based investment firm that uses computer models to pick trades, is planning a fund called Alkali whose investments will include European bank loans and residential mortgage-backed securities.

“We believe that a substantial portion of Alkali Fund’s opportunity set will result from pressure on European banks to reduce their leverage,” the firm said in a document dated April 2012 that was obtained by Bloomberg News. “We expect that a deleveraging in Europe will occur both actively through asset sales and passively through a reduction in origination of credit and willingness to roll over debt as it matures.”

Motivated sellers of asset-backed securities will also include U.S. banks shutting down proprietary-trading desks, Brevan Howard said in a marketing document obtained by Bloomberg News.

Proprietary Traders

Passport’s Gonzalez and John Angelica, a securitized- products salesman, resigned from JPMorgan as the New York-based bank and Bank of America Corp. (BAC:US) were cutting senior mortgage traders and salesmen, people familiar with the matter said in March. The two biggest U.S. banks were under pressure to cut expenses as the asset-backed securities market declined and faced stricter capital requirements on the investments.

Passport hired Kong in December 2010 to start the firm’s mortgage strategy four years after Burbank’s bet on a tumble in subprime home loans, a wager that lost about 20 percent that year and then earned his fund 220 percent in 2007, he said in a June interview. It was a contrarian call, he said. He bought credit-default swaps that protected against losses in subprime- mortgage bonds, and they paid off when foreclosures soared in 2007, Bloomberg Markets reported last June.

Kong spent 10 years at Don Brownstein’s Structured Portfolio Management as manager of its $1 billion Structured Servicing Holdings LP. At the Stamford, Connecticut-based firm, Kong primarily traded so-called interest-only slices of non- agency mortgage bonds, whose returns are linked only to how fast borrowers refinance or default because holders aren’t repaid any principal.

Best Returns

The flagship fund returned 50 percent in the first 10 months of 2010, putting it at the top of the Bloomberg Markets list of the 100 best-performing hedge funds managing $1 billion or more. Kong’s fund at Passport rose 5 percent this year through May, according to a person briefed on the returns.

Returns that are topping other hedge-fund strategies is one reason why mangers are piling into the market, according to Rael Gorelick, co-founder and principal of $250 million Charlotte, North Carolina-based Gorelick Brothers Capital LLC, a dedicated fund of mortgage hedge funds invested in 20 managers, including those in non-agency and agency mortgage strategies, whole loans, commercial mortgage-backed securities and asset-backed securities.

“It’s the only thing making money,” Gorelick said in a telephone interview on June 26. “The primary reason people are buying is because of the returns. Capital will find the best risk-adjusted reward. Talent will flow to best risk-adjusted reward.”

Mortgage funds, including those focused on government- backed debt, rose 10 percent on average this year through June, compared with a 0.9 percent gain for hedge funds across all strategies, according to data compiled by Bloomberg.

To contact the reporters on this story: Kelly Bit in New York at kbit@bloomberg.net; Jody Shenn in New York at jshenn@bloomberg.net

To contact the editors responsible for this story: Christian Baumgaertel at cbaumgaertel@bloomberg.net; Rob Urban at robprag@bloomberg.net;


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