Hedge Funds Feed On Sub-Prime Woes

Jul 25 2007 | 12:04pm ET

Credit worries in the sub-prime space may be causing jitters on Wall Street, but it isn't bad news for everyone. FINalternatives recently spoke with two hedge fund managers who have produced lights-out returns this year by betting against the sub-prime space, and both managers expect the credit crisis to continue.

New York-based Balestra Capital’s eight-year-old hedge fund is enjoying one of its best years since inception, when it returned 100% during the dotcom gold rush. The firm’s $140 million global macro fund, Balestra Capital Partners, is up about 50% after fees through June, pushed mainly by gains shorting the sub-prime market.

The fund is currently shorting junk bonds against Treasuries and the ABX index, which is linked to 20 sub-prime home equity loans through a basket of credit default swaps. On the long side, about 17% to 18% of the fund is invested in energy equities and foreign currencies, specifically the yen and euro.

“We’ve got a fairly condensed portfolio at the moment because we think there’s going to be some serious trouble ahead,” says founder James Melcher.  

Melcher says the real estate market is currently in a “negative reinforcement cycle” because of the increasing number of unsold homes, and falling sales and prices for homes.

“Banking systems and regulators, in their infinite wisdom, have tightened up standards, making it nearly impossible for many of these people to refinance, so we see a coming deluge of forced foreclosures and sales,” he says. “The psychology has clearly changed here from the home as a great way to make money to people being underwater.”

Melcher says the number of vacant homes has almost doubled, reaching its highest rate ever, but the worst is yet to come.

“You’re hearing a lot of brave talk because nobody wants to spill the beans and create panic in the crowd, but the facts remain that this is a very serious circumstance.”

Andrew Lahde, founder of Santa Monica, Calif.-based hedge fund Lahde Capital, echoes Melcher’s sentiments.

“I see nothing but downward movement for the next 12 to 24 months. If home prices decline as much as I suspect, then it’s conceivable that even the double-As are worthless, which is probably not a view shared by many right now but it’s starting to become a little more popular,” says Lahde.

“Everyone’s starting to realize how bad these CDOs are, so it’s getting harder and harder to sell them. CDOs have been big buyers of these mortgages so if you take that out of the equation, the flow of funds from CDOs to securitizations to the end home buyer dries up, and makes it even harder to get loans. It’s just a vicious cycle.”

In his latest monthly investor letter, Lahde’s five-year predictions for home prices includes a 50% decline in Miami, 30% in San Diego, the Phoenix area and Las Vegas, and 20% in Los Angeles.

Currently, Lahde says his real estate hedge fund, U.S. Residential Real Estate Hedge V, is shorting the ABX all the way up to double-A tranche. “We’ve been positioned for this for eight months or so and don’t have any plans on getting out of trades anytime soon,” he says. Year to date, the fund is up 86.5% with some $40 million in assets under management.

So is it too late for investors to get into the white-hot sub-prime market? Lahde doesn’t seem to think so, and says he is “all in”—almost his entire net worth is invested either in Lahde Capital or the fund.

“Regardless of the level of the market in one month, I can tell you definitively that I will invest the money I am expecting to receive in the fund,” he says. “Why? Because however bad things look in one month, I am certain that they will continue to look even worse with each consecutive month that passes for many months to come.”

By Hung Tran

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