Bloomberg News

FBR Founder’s Fund Profits From Big Government Bemoaned by Bacon

January 17, 2013

For many hedge funds, financial rules and state intervention in markets are anathema. Emanuel J. Friedman, former co-chairman of investment bank Friedman, Billings, Ramsey Group Inc., sees them as an opportunity.

Friedman’s $2.6 billion EJF Debt Opportunities Fund surged 29 percent last year by making bets on how lenders would alter their capital structure after the Dodd-Frank Act, according to investors in the pool. Run from suburban Virginia, five miles west of the U.S. Capitol, it has averaged gains of 21 percent a year since inception in June 2008, compared with the 4.4 percent annual increase posted by other debt-focused hedge funds.

His approach comes at a time when some hedge-fund managers, including Third Point LLC’s Daniel Loeb and Moore Capital Management LLC’s Louis Bacon, bemoan political intrusion and complain that Washington is anti-business. Friedman, 66, was on the receiving end of government pressure himself eight years ago, when he left the bank he co-founded amid a probe and subsequent settlement with U.S. regulators over improper trades.

“While a lot of investors avoid uncertainty, others see it as a trading opportunity,” said Stephen Myrow, managing director of Washington-based ACG Analytics, a firm that provides political intelligence to hedge funds and other clients. “If you understand how government works and can properly assess the politics of the moment, you can capitalize.”

Friedman runs the debt fund with senior portfolio manager Jeffrey Hinkle, who joined EJF in 2007 after working as a stock analyst at FBR. Another veteran of Friedman’s old investment bank who followed him to the hedge fund is EJF Chief Operating Officer Neal Wilson, a former Securities and Exchange Commission attorney who helped manage FBR’s hedge-fund and private-wealth business. Wilson said the firm wouldn’t comment for this story.

Washington Base

Friedman’s strategy is to take advantage of the unsettled regulatory environment and government’s heavier hand in everything from bank oversight to housing policy.

It helps that EFJ operates in Arlington, Virginia, outside the traditional hedge-fund enclaves of New York and Greenwich, Connecticut. Proximity to Congress, the Treasury Department and the Federal Reserve, the nerve centers of the $700 billion banking bailout in 2008, hasn’t hurt. The debt fund has never had a losing year.

Friedman outlined his tactics in a December 2011 marketing document obtained by Bloomberg News, saying EJF takes advantage of the shift in power from financial executives to regulators by trading securities that banks will target to clean up their balance sheets in response to new rules.

Regulatory Pressure

“Catalysts” Friedman lists for his investments are Dodd-Frank, the Basel III international capital rules that began to take effect this year and “regulatory pressure to reduce operating leverage.”

Along with securities issued by banks, EJF bets on housing as well as collateralized debt obligations, which are made up of pools of real-estate loans. The Fed took on CDOs as part of its 2008 rescues of Bear Stearns Cos. and American International Group Inc. (AIG:US)

The debt fund gained 1.46 percent in 2011, 20 percent in 2010, 32 percent in 2009 and 14 percent over the second half of 2008. Firm-wide, Friedman’s EJF Capital LLC managed $3.1 billion at the end of July, according to an SEC filing.

Dodd-Frank

The genesis for one of EJF’s winning trades is tucked into section 171 of Dodd-Frank, the regulatory behemoth approved by Congress to lay out new rules for Wall Street in the wake of the credit crunch.

Named the Collins amendment after its advocate, U.S. Senator Susan Collins, a Republican from Maine, the provision on “leverage and risk-based capital requirements” bars lenders from using so-called trust preferred securities, or TruPS, to boost their capital ratios because of concern that the assets wouldn’t cushion losses during a crisis.

TruPS combine debt with equity, and lenders issued about $150 billion of the hybrid securities before 2009, according to the Federal Reserve Bank of Philadelphia. The assets were attractive for banks because they got a capital boost while being able to deduct interest payments from their tax bills.

Lenders could also suspend interest payments on TruPS if needed, which banks did to conserve cash during the financial crisis. That, combined with fears that banks would fail, sent the securities plunging.

TruPS Buybacks

Financial firms have now been buying TruPS back at a premium to their market values and retiring the assets because banks don’t want to pay yields in excess of 5 percent on securities that provide no benefit to capital, said Arthur Tetyevsky, a strategist at Jefferies Group Inc. in New York.

JPMorgan Chase & Co. (JPM:US) said in June that it would redeem $9 billion of TrUPs after the Fed proposed rules to implement the Collins amendment. Citigroup Inc. (C:US) announced the same month that it would buy back trust-preferred securities paying yields in excess of 8 percent, reducing the bank’s Tier 1 capital by $4.9 billion. Regulators view Tier 1 as the most important for loss absorption because it combines equity with retained earnings.

Yield-hungry investors have recently bid up TruPS, said Tetyevsky, who’s followed the hybrid securities market for more than 10 years. The rebound has been a boon for EJF, which bought the hybrids when they were cheap, an investor in the fund said.

“Traditional fixed-income buyers really abstained from investing in these instruments, because they can go up like a bond and go down like equity,” Tetyevsky said. “There is also more volatility and less liquidity in certain TruPs than in other investments, which at times requires the use of equity puts and credit-default swaps to hedge risk. It’s ideal for a lot of hedge funds.”

Dilution Bet

EJF has bought TruPS issued by lenders including Bank of America Corp. (BAC:US), Bank of New York Mellon Corp. and M&T Bank Corp., according to investors who asked not to be identified because the information is private. The fund’s strategies included predicting which banks would take advantage of relatively good financial health to redeem their hybrid securities after the Collins amendment, and arbitraging instances in which there are price discrepancies between assets issued by the same lender in different currencies.

A typical trade involved buying Keycorp (KEY:US) TruPS that would be affected by the Collins amendment and betting against the Cleveland-based bank’s shares on expectations that the lender would have to fill its new capital hole by selling stock, thus diluting existing equity holders, investors said.

Friedman has also profited from the U.S. government’s exit from programs it set up to save banks during the credit crisis, investors said.

TARP, Europe

The U.S. Treasury has been selling bank securities it received in exchange for rescue loans made under the Troubled Asset Relief Program. Making money through the anonymous government auctions, as Friedman has, requires being able to quickly analyze the health of banks in municipalities like Eden Prairie, Minnesota, and Cordova, Tennessee.

“When it comes to the banks and the financials, he knows them better than anyone,” said Jim Sullivan, who worked at FBR during the late 1990s and now runs a Washington-based investment firm, Sullivan Wood Capital Management LLC. “If he sees a value in something, something he thinks is attractive, he’s going to scoop it up.”

EJF is now expanding to Europe, where lenders may have to reduce their use of hybrid securities that combine debt with equity under Basel III, depending on how regulators interpret the new rules.

The firm is opening a London office to take advantage of opportunities similar to its TruPS strategy in the U.S., according to a person who asked not to be identified and wasn’t authorized to speak publicly. Friedman registered his firm in November with England’s Companies House, according to a regulatory filing.

Mortgage Bonds

Friedman isn’t the only hedge-fund manager who leveraged government policy to beat the industry last year. Firms that invest in mortgage securities, for instance, outperformed all hedge-fund strategies with an average gain of 20 percent in 2012, according to data compiled by Bloomberg.

Deepak Narula’s $1.6 billion fund Metacapital Management LP rose 39 percent through Dec. 14 by building trades around government efforts to help home owners refinance and predicting that the Fed would buy mortgage bonds to boost the U.S. economy. EJF also profited from mortgages, investors said.

More high-profile hedge fund managers have either misread political tea leaves or attacked government policy. John Paulson lost 19 percent in one of his biggest funds last year after he bet the European debt crisis would worsen, underestimating the resolve of policy makers to keep the euro currency bloc together.

SEC Probe

Paulson, who manages $19 billion, lost 51 percent in the same fund in 2011 after being too early to wager that an economic rebound would boost bank stocks.

Moore’s Bacon, whose firm oversees $13.5 billion, criticized Dodd-Frank in July as the “coup de grace” that would curtail interbank lending and hurt markets. His Moore Global Investments fund rose 8.8 percent last year, according to a person familiar with the matter.

Spokesmen for Paulson and Moore declined to comment.

Friedman, the son of a rabbi in Wilmington, North Carolina, started his financial career in the 1970s as a broker at Legg Mason Inc.’s (LM:US) Washington office. His interactions with government neighbors in the U.S. capital haven’t always been positive, particularly when he left FBR in April 2005 during an SEC investigation into the firm for violating insider-trading rules.

CompuDyne Complaint

He, Eric Billings and Russell Ramsey had started FBR 16 years earlier with $1 million of borrowed money. They took it public in 1997, and by 2003 were underwriting $1.7 billion of U.S. initial stock offerings, more that year than Citigroup, Morgan Stanley and Merrill Lynch & Co. The firm’s success enabled Friedman to make about $53 million in salary and bonuses from 1996 through 2005, according to SEC filings.

FBR focused on underwriting hot industries, including technology companies during the 1990s boom and real-estate investment trusts, which helped fuel the growth of the subprime-mortgage industry.

It was a 2001 private share offering by CompuDyne Inc., a maker of security systems for government buildings, that attracted SEC attention. FBR improperly allowed detailed information about the deal to spread throughout the investment bank, including to traders, the SEC said in a 2006 complaint.

FBR’s head trader shorted the stock before the offering was publicly announced, making the bank $343,773, the SEC said. FBR paid $7.8 million to settle the case, and Friedman personally paid $1.2 million after the SEC accused him of not doing enough to prevent the improper trading. He neither admitted nor denied the regulator’s allegations.

The SEC probe may have been a hidden blessing. Within five months of retiring from FBR, Friedman had founded EJF, joining an industry where the compensation made by successful money managers dwarfs that of banks.

“‘A hedge fund is a natural place to have a second act,” said Charles Geisst, a Wall Street historian at Manhattan College in New York. “If there’s been some kind of regulatory scrutiny, that’s not going to be as frowned upon.”

To contact the reporters on this story: Jesse Westbrook in London at jwestbrook1@bloomberg.net; Robert Schmidt in Washington at rschmidt5@bloomberg.net

To contact the editors responsible for this story: Edward Evans at eevans3@bloomberg.net; Maura Reynolds at mreynolds34@bloomberg.net.


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