Timing is everything. Brad Friedlander quit his job overseeing $8 billion of bonds at Washington Mutual Inc. in 2008, six months before it became the biggest bank failure in U.S. history.
That year, he co-founded Angel Oak Capital Partners LLC to buy the same types of risky mortgages that brought down the bank. The Atlanta-based firm has grown to $1.4 billion, including $570 million in mutual fund (ANGLX:US)Angel Oak Multi-Strategy Income Fund (ANGLX:US), that returned 23 percent this year, beating 99 percent of rivals, according to data compiled by Bloomberg.
“During the financial crisis, these mortgages were labeled toxic assets and there was no rational thinking about what they were worth,” Friedlander, 35, said in a phone interview. “We saw an opportunity to participate in an eventual recovery.”
The housing crash that sunk WaMu, Lehman Brothers Holdings Inc. and dozens of mortgage originators to trigger the worst financial crisis since the 1930s has turned into a sustained recovery benefiting buyers of subprime and other risky home loans that fueled the boom. Angel Oak’s founders -- Friedlander, his WaMu colleague Sreeni Prabhu, and Michael Fierman, who had been a partner at SouthStar Funding LLC before it collapsed in 2007 -- all had ringside seats at the rise and subsequent crash of the mortgage market.
Now as the housing market picks up momentum, mortgage debt without the backing of the U.S. government is rallying, returning more than 20 percent a year in three of the past four years. The securities can deliver as much as 10 percent a year over the next two years, said Friedlander, as the housing rebound continues. Yields, currently in the 5 percent to 7 percent range, will attract investors looking for income in a world of record low interest rates, he said.
That view is shared with some of the world’s largest and best-known bond managers, including Jeffrey Gundlach’s DoubleLine Capital LP and TCW Group Inc., which also profited from the rebound in the $970 billion market.
“Non-agencies have more room to run than other asset classes,” said Philip Barach, co-manager of the $37 billion DoubleLine Total Return Fund (DBLTX:US), which had 29 percent of its money in the debt as of Oct. 31, according to the website of the Los Angeles-based company.
At Washington Mutual, Friedlander had been a money manager since 2003, helping oversee a $25 billion investment portfolio with responsibility for fixed income. In 2007, the bank’s stock (WAMUQ:US) fell 70 percent as home prices tumbled and at the start of 2008 the Seattle-based company reported its first quarterly loss since 1997 after writing down the value of its home-mortgage unit.
The bank’s holdings of non-agency mortgages, which represented the riskiest end of the market, were especially hard hit as the housing market plunged from its 2006 peak and foreclosures piled up. The debt includes prime, subprime and Alt-A, a type of home loan that typically didn’t require documentation such as proof of income.
As the mortgage market cratered, the banks that normally purchased the debt backed away, said Prabhu. “If they weren’t going to buy these securities, who would?” he said.
In May 2008, the pair started the new firm with Fierman, who had been a partner at SouthStar, an Atlanta mortgage company that at its peak originated more than $6 billion a year in subprime loans. In April 2007 SouthStar filed for bankruptcy after the securitization market for subprime mortgages shut down.
“The business came to a standstill overnight,” said Fierman. “It was over and we went home.”
They shared a view that even under very pessimistic assumptions for the economy and housing, prices for non-agency mortgages had fallen too far and that a patient investor would do well holding them.
The bond managers at Los Angeles-based TCW came to the same conclusion. The firm began buying non-agency debt in the second half of 2008 because “prices were not reflective of the underlying fundamentals,” Bryan Whalen, co-head of mortgage bonds, wrote in an e-mail.
The $8.4 billion TCW Total Return Bond Fund had 35 percent of its money in non-agency mortgages as of Sept. 30, according to the Los Angeles company’s website.
Washington Mutual was seized by government regulators on Sept. 26, 2008, and its branches and assets were sold to New York-based JPMorgan Chase & Co. (JPM:US) Its failure came less than two weeks after the demise of Lehman Brothers Holdings Inc.
Angel Oak raised money for its first hedge fund in July 2008 and a second in February 2009. The first fund suffered losses initially as the non-agency market fell further. The second roughly coincided with the market bottom. It has returned about 150 percent since inception, according to Friedlander. “There was a lot of analysis and a little bit of luck,” he said.
The funds bought higher quality non-agency debt, a blend of prime and Alt-A mortgages with senior positions in the capital structure, he said. While subprime debt was attractive, its volatility was too great for the investors the firm hoped to cultivate.
“It was going to be too wild a ride,” said Friedlander.
Angel Oak has focused on mortgages originated between 2003 and 2005. Friedlander’s Washington Mutual experience taught him that loans from that period were made with stricter underwriting standards than those made in 2006 and 2007, which meant borrowers were less likely to default.
The firm’s early hedge funds didn’t use leverage, he said. A more recent fund uses about two dollars of borrowed money for every dollar invested to enhance returns.
All of the funds, including the mutual fund, were aimed at individual investors seeking income. While yields on the securities have fallen from the 20 percent range in 2008, they are still attractive compared to other fixed-income options, said Friedlander.
“At a time when you are struggling to find yield, this is an opportunity to earn high single-digit returns with good collateral, said Steven Roge, a portfolio manager with Bohemia, New York-based R.W. Roge & Co., which oversees $200 million, including shares of the Angel Oak Multi-Strategy Income Fund.
The mutual fund, created in June 2011, was the top performer among funds that invest in mortgage-backed securities this year, Bloomberg data show. It had 78 percent of its money in non-agency mortgages as of June 30, 2012, according to Angel Oak’s website. The second best performing mortgage fund was TCW Total Return, which gained 13 percent.
The non-agency rally faltered in 2011 as Europe’s sovereign crisis and an acrimonious debate about raising the U.S. debt ceiling prompted investors to dump risky assets. The Federal Reserve Bank of New York’s decision to sell some of the mortgages it acquired bailing out American International Group Inc. (AIG:US) contributed to the slump in prices, Friedlander said.
TCW’s Whalen estimated non-agency mortgages fell 7 percent last year before rebounding more than 20 percent in 2012.
Friedlander’s original bet on mortgages was based on the premise that the securities were undervalued. “We were not relying on a housing recovery,” he said, “but clearly we will benefit from a housing recovery.”
Home prices in 20 U.S. cities rose 3 percent in September from a year earlier, the most since 2010, the S&P/Case-Shiller index showed last month. The median price of an existing home sold in October jumped 11 percent from a year earlier to $178,600, the steepest annual increase since November 2005, according to the National Association of Realtors. The group forecasts existing- home price may rise 5 percent in 2013, with comparable gains in 2014.
Housing will keep the rally in non-agency going, said Prabhu, even if gains going forward can’t match those of the past few years. “It is now more of an opportunistic asset class than a distressed class,” he said.
Supply and demand will also work in favor of investors, he said. The market has been shrinking steadily since 2008 because very little new supply has been created, and more buyers, including hedge funds, insurers and asset managers have been attracted to the space.
Over time, Friedlander expects his firm’s heavy concentration in non-agency to diminish, replaced by investments in structured products such as student loans, commercial mortgages and collateralized-loan obligations.
“This rally is not going to continue forever but we are not close to the end,” he said.
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