As the market in shaky mortgages collapsed, some hedge funds raked in profits by betting on a decline in the ABX subprime index

There has been a lot of pain in the market for mortgages to people with shaky credit histories. Small, so-called subprime lenders are filing for bankruptcy. Shares of big lenders New Century Financial (NEW), NovaStar Financial (NFI), and Fremont General (FMT) are getting crushed, as concerns about rising customer defaults mount. But through all the misery, some savvy hedge funds are posting big gains.

How’s that? The hedge funds raking in fat profits from the meltdown in the subprime market have cleaned up by betting on a decline in the ABX subprime index, which measures the cost of insuring against defaults on subprime bonds. The index, created by London-based Markit Group, tracks 20 asset-backed bonds with a low investment grade credit rating. Beginning last fall a number of hedge funds began shorting the index—betting on a decline—either as a way to minimize their exposure to subprime bonds in their portfolios, or simply to profit from an anticipated sector rout. The ABX short bet came up a big winner when the index plunged in February, leading to a 34% decline for the year.

One of the hedge funds said to be cleaning up on the ABX short trade is Paulson & Co., a $7 billion fund led by former Bear Stearns BSC investment banker John Paulson. Traders familiar with Paulson say the hedge fund made a massive, leveraged short bet on the ABX index dropping. The fund reportedly scored a paper profit of hundreds of millions of dollars when the ABX index crashed, according to people familiar with the fund. Stuart Merzer, Paulson’s general counsel, declined to comment.

Ongoing Shakeout

Another hedge fund that has been feasting on the wreckage in the subprime universe is MKP Capital Management, a $5 billion fund that specializes in mortgage-backed securities. The fund, led by Patrick McMahon and Maurice Perkins, is up about 8% this year. People familiar with MKP say the fund’s managers soured on the subprime space early last year and began selling it subprime bonds and shorting the ABX index. An MKP spokesman declined to comment.

Indeed, the early indications are that the hedge funds making money on the ABX short trade may outnumber those that got burned holding either shares of subprime lenders, or faltering bonds. Hedge Fund Research, which tracks hedge-fund performance, says its mortgage-backed index rose 1.54% in February. For the year, the index is up 2.25%.

Of course, it’s still early, and the shakeout from the subprime meltdown is still being experienced. The full extent of the pain may not be felt by hedge funds until the big credit rating agencies start downgrading subprime mortgage-backed bonds, sometimes called CDOs (for collateralized debt obligations). There’s a lot of wiggle room when it comes to determining the value of a CDO in a hedge fund’s portfolio. Experts say a manager can postpone writing down the value of a bond until the rating agencies actually downgrade the security.

But those downgrades are coming. And when they do, the number of hedge funds coming out on the winning side of the subprime bet could shrink.

Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.

Source:

http://www.businessweek.com/investor/content/mar2007/pi20070308_900631.htm?campaign_id=rss_magzn