Q&A: ‘Mortgage Junkie’ Gets His Fix In Volatile Market

Feb 13 2009 | 3:47am ET

Investors who lost big last year betting on plain-vanilla equity hedge fund strategies may be well served to investigate opportunities in the mortgage market and reallocate to fixed-income funds, according to one hedge fund manager.

Pine River Capital Management made a killing in last year’s down market. The firm hired Steve Kuhn, a former portfolio manager at Goldman Sachs Asset Management, to run its Nisswa Fixed Income Fund, which debuted in September and returned better than 19% in its first four months of trading.

We recently caught up with Kuhn and spoke with him about the fund’s performance last year and what opportunities he sees going forward.

FINalternatives: How was the macro environment for mortgage hedge funds last year?

Kuhn: People ask me, “Why are you doing so well?” and I go back to the fact that the mortgage market is huge; it’s an $11 trillion market. Up until mid-2007, most bonds had very low risks. Triple-A-rated asset-backed securities had traded in 10 basis points for years and then all of a sudden they moved down by 40 to 50 bps.  The amount of risk in the market is at least 10 times as much as it was a year and a half ago.

Fannie Mae and Freddie Mac were huge relative-value players, and they’re not doing that anymore. Prop desks have either closed down or have greatly reduced the amount of capital that they have. A lot of other hedge funds are not doing relative value trades; they’re doing pure distressed-debt trading. The playing field is wide open and we’ve seen tremendous mispricing between different sectors of the mortgage market.

I love coming to work everyday, compared to 2005-2006, when there were no good trades and it was LIBOR +35 the entire year.  Now, it is moving 10 points in a day and it’s like Candyland for a mortgage junkie like myself.  The relative value opportunities are like none we’ve ever experienced.  Other hedge funds that just took a beta view missed the opportunity to have better returns with lower risks.

FINalternatives: How did you position the portfolio to generate returns?

Kuhn: There was no shortage of exciting trades last year and it was a great environment for me, who thinks of things in relative value terms…. A lot of our sub-strategies are negatively correlated with each other.  We had interest onlys, which benefit from slow prepayments, and at the same time we had TBA positions largely with a down in coupon bias, meaning positions that would benefit from faster prepayments in the TBA market.  And the relative pricings between these two markets were at times crazy.  By doing pairs trading there, we had the opportunity to make money in a variety of scenarios.

FINalternatives: What kind of impact will the new administration have on fixed-income players?

Kuhn: The mix of policy changes that will likely come out of the Obama administration will definitely have implications for prepayments and defaults and delinquencies on the non-agency side. I would’ve never guessed I would be spending three hours watching the C-SPAN coverage of Sean Donovan’s confirmation hearing. 

You have to know what the policy makers are saying because we’re not in a normal environment. Abrupt policy changes may force players in the market to be sellers driving down our bond prices.

It’s the Wild West in terms of predicting what the mortgage market will look like a year from now. We’re trying to structure our portfolio to do well under a variety of scenarios. We try to have bonds positively convex to policy changes.

FINalternatives: Good performance notwithstanding, we understand that Pine River was not impervious to redemptions last year. Can you talk about that?

Kuhn: Everyone knows how bad redemptions were last year—we had 22% firm-wide.  That seems like an egregious amount but when we tell investors that, they say, “That’s not so bad,” which is ridiculous because the world is not supposed to be like that. We right-sized the business in December by eliminating some of the redundancies to get our cost base down, but I think we’re in a better position than most.


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