A philoso­pher’s pay dirt

Phi­los­o­phy pro­fes­sor hits on a win­ning for­mula for his flag­ship fund


A one­time pro­fes­sor hits on the win­ning for­mula with mort­gage plays, rock­et­ing his hedge fund to top re­turns for 2010.

For 20 years, Don Brownstein taught phi­los­o­phy at the Uni­ver­sity of Kansas. He spe­cial­ized in me­ta­physics, which ex­am­ines the char­ac­ter of re­al­ity it­self. In a photo from his teach­ing days, he looks like a young Karl Marx, with a bushy black beard and un­ruly hair.

That photo is now a relic be­hind the curved bird’s-eye-maple desk in Brownstein’s corner of­fice in Stam­ford, Conn. Brownstein aban­doned academia in 1989 to try to make some money.

The ca­reer change paid off. Brownstein founded Struc­tured Port­fo­lio Man­age­ment, a com­pany man­ag­ing $2 bil­lion in five part­ner­ships. His flag­ship fund, Struc­tured Ser­vic­ing Hold­ings, re­turned 50 per­cent in the first 10 months of 2010, putting him first in Bloomberg’s rank­ing of the 100 best-per­form­ing hedge funds man­ag­ing $1 bil­lion or more.

The $1.2 bil­lion fund rock­eted 135 per­cent in 2009.

In per­cent­age terms, Brownstein, 67, beat out funds run by big­ger, bet­ter­known com­peti­tors, in­clud­ing Ray Dalio’s Bridge­wa­ter As­so­ci­ates. Dalio, though, has three funds in the top 15. Brownstein also topped Steven Co­hen’s SAC Cap­i­tal In­ter­na­tional (No. 53).

Brownstein did it by ex­ploit­ing his ex­per­tise in some­thing al­most as es­o­teric as me­ta­physics: the mar­ket for ex­otic se­cu­ri­ties built from mort­gages.

It was the crackup in hous­ing and mort­gage mar­kets that brought the U.S. econ­omy to its knees in 2008 and earned bil­lions for hedge-fund man­agers such as John Paul­son, who saw it com­ing and bet that mort­gage se­cu­ri­ties would crash.

Brownstein and Wil­liam Mok, Struc­tured Port­fo­lio’s di­rec­tor of port­fo­lio man­age­ment, won’t say how they made their 2010 killing. Their long­time strat­egy is to de­velop mod­els that pre­dict when home­own­ers will re­fi­nance mort­gages— a move that re­duces in­ter­est pay­ments on mort­gage bonds. They then buy se­cu­ri­ties they think are un­der­priced.

Many home­own­ers have been un­able to take ad­van­tage of tum­bling rates to re­fi­nance their mort­gages be­cause their houses are worth less than they owe on their loans. In­vestors who bet against a re­fi­nanc­ing boom have prof­ited.

‘Ev­ery sin­gle risk’

The hedge-fund rank­ing uses data com­piled by Bloomberg and in­for­ma­tion supplied by re­search firms, fund com­pa­nies and in­vestors. Three of the top 10 funds made money on mort­gage bonds. The mort­gage mar­ket is of­ten lu­cra­tive for hedge funds be­cause it is volatile, says Jef­frey Gund­lach, chief ex­ec­u­tive at Dou-ble­line Cap­i­tal, a man­ager of mu­tual funds that trade mort­gages.

“ The mort­gage mar­ket has ev­ery sin­gle risk,” Gund­lach says. Peo­ple de­fault, banks fore­close on hous­ing loans and the govern­ment of­ten changes the rules. “Any mar­ket that has risks morphs into op­por­tu­nity,” he says.

An­other fund that prof­ited from bet­ting on mort­gages is the $1.2 bil­lion Nis­swa Fixed In­come Fund, run by Pine River Cap­i­tal Man­age­ment of Min­netonka, Minn. It ranks No. 7, with a 27 per­cent re­turn. Nis­swa’s man­ager, Steve Kuhn, bought mort­gage bonds sell­ing at what turned out to be bar­gain prices. The fund re­turned 92 per­cent in 2009 and is up a cu­mu­la­tive 196 per­cent (through Oct. 31) since it was founded in 2008.

Gold jumped 24 per­cent to $1,359.40 an ounce in the 10 months cov­ered by the rank­ing. The rally boosted Daniel Loeb’s Third Point Off­shore Fund to No. 8 among large funds, with a 25 per­cent re­turn. Loeb in­vested in mort­gages, too, in ad­di­tion to his usual bets on stocks and bonds, ac­cord­ing to peo­ple fa­mil­iar with his hold­ings.

Over­all, hedge funds had a lack­lus­ter year com­pared with 2009, when the top fund, run by David Tep­per’s Ap­paloosa Man­age­ment, re­turned 132 per­cent. The same fund earned 21 per­cent in 2010. On av­er­age, the top 100 hedge funds rose 13.9 per­cent through Oc­to­ber. The Stan­dard & Poor’s 500-stock in­dex rose 6 per­cent in the same pe­riod.

Spotty per­for­mance aside, wealthy Amer­i­cans are pour­ing money into funds. Half of all house­holds with a net worth of $25 mil­lion or more in­vested in hedge funds in 2010, up from 35 per­cent in 2007, ac­cord­ing to Spec­trem Group.

Philoso­pher king

Brownstein’s Struc­tured Ser­vic­ing Hold­ings has re­turned an av­er­age of 28 per­cent an­nu­ally since Fe­bru­ary 1998, when the fund made its first trade. Its only los­ing year was 2008, when it re­turned neg­a­tive 6 per­cent, ac­cord­ing to an in­vestor. But the av­er­age hedge fund dropped 19 per­cent that year.

The 50 per­cent gain through Oc­to­ber earned Brownstein’s in­vest­ment team $87 mil­lion in fees.

Brownstein has pros­pered in a mar­ket dom­i­nated by math sa­vants. The value of many mort­gage bonds de­pends in large part on how long home­own­ers make pay­ments at their cur­rent in­ter­est rate be­fore ei­ther re­fi­nanc­ing or de­fault­ing. The top traders have pro­pri­etary for­mu­las that pre­dict be­hav­ior based on a home­owner’s credit score, ad­dress, loan size, loan age and other fac­tors.

The walls of SPM are scrawled with such for­mu­las, worked out by Mok, a Salomon Broth­ers alum­nus who has a bach­e­lor’s de­gree in com­puter sci­ence from Columbia Uni­ver­sity, and his team of doc­tors of math and physics. Brownstein’s strength is his mas­tery of the logic be­hind the for­mu­las.

“If you’re wrong, he’ll prove you wrong,” Mok, 47, says.

Brownstein, the son of a Bronx fur­rier, these days looks more like en­ter­tain­ment mogul Barry Diller than the fa­ther of com­mu­nism (much less hair, much nicer shirts). He says he loves his role.

“I’m here to ar­gue,” he says in a three-hour in­ter­view that ranged from an­cient Greek philoso­phers Par­menides and Plato to fore­clo­sures in Florida. “I’m in charge of pon­tif­i­ca­tion and ar­gu­ing.”

His ca­reer sug­gests a rest­less mind. Af­ter earn­ing his PhD from the Uni­ver­sity of Min­nesota, Brownstein started teach­ing in 1969 at the Uni­ver­sity of Kansas in Lawrence. He made doc­u­men­tary films on the side and once in­ter­viewed Beat Gen­er­a­tion writ­ers Allen Gins­berg and Wil­liam Bur­roughs.

The shop­ping mall

A fight over a shop­ping mall in Lawrence in the mid-1980s led Brownstein, in­di­rectly, to mort­gage trad­ing. A de­vel­oper wanted to build the mall in a corn­field. Brownstein and oth­ers wanted the mall down­town. The project got Brownstein think­ing about fi­nance. He fig­ured a down­town mall could at­tract an an­chor ten­ant and use its lease pay­ments as col­lat­eral for a bond that could be sold to in­vestors to pay for the con­struc­tion.

Brownstein wrote up his idea, and it was pub­lished in a real es­tate trade jour­nal in 1987. The ar­ti­cle led to an in­ter­view with Wil­liam Mar­shall, who was then an ex­ec­u­tive at Franklin Sav­ings As­so­ci­a­tion in nearby Ot­tawa, Kan. Franklin hired Brownstein in 1989.

Franklin was an out­post ofWall Street on the plains. Chair­man Ernest M. Fleis­cher built the thrift into one of the nation’s largest sav­ings in­sti­tu­tions partly by us­ing mort­gage-se­cu­rity trad­ing to re­duce in­ter­est-rate risk.

Fancy fi­nan­cial en­gi­neer­ing couldn’t save Franklin from the sav­ings-and-loan cri­sis. The Of­fice of Thrift Su­per­vi­sion seized it in Fe­bru­ary 1990, eight months af­ter Brownstein ar­rived. Brownstein stayed un­til 1992, when he went to work trad­ing mort­gages for Caisse des De­pots & Consigna­tions in its New York of­fices. There, he set up a new unit to buy the rights to col­lect in­ter­est on mort­gages — the ser­vic­ing rights. Own­ing the rights was like own­ing mort­gage bonds, Brownstein says, and if you got them cheap enough, they could be profitable.

Many len­ders were ea­ger to sell, he says, be­cause they wanted to lock in gains all at once rather than risk los­ing in­ter­est in­come if bor­row­ers re­fi­nanced.

‘ Tea leaves’

Plan­ning to do more deals for ser­vic­ing rights, Brownstein set up Struc­tured Port­fo­lio Man­age­ment in 1996. Then he pur­sued an­other an­gle. A pop­u­lar se­cu­rity in the mort­gage busi­ness is the in­ter­est-only strip, or IO. It’s a bond backed by the in­ter­est pay­ments from a port­fo­lio of mort­gages. Prin­ci­pal pay­ments go into an­other se­cu­rity called a PO that’s more at­trac­tive to con­ser­va­tive in­vestors.

If a home­owner re­fi­nances, the PO owner gets paid sooner and the IO owner loses all of the in­ter­est that he was due to col­lect. The trick to valu­ing an IO is fig­ur­ing out how many bor­row­ers in the pool are go­ing to pay off their mort­gages early. So Brownstein andMok spend time puz­zling over pre­pay­ment speeds.

Mort­gage bonds, in­clud­ing IOs, come in two vari­a­tions: agency backed and non-agency backed. The first are built from mort­gages in­sured by Fan­nie Mae and Fred­die Mac. The two gov­ern­ment­con­trolled com­pa­nies own or guar­an­tee re­pay­ment on half of allU.S. mort­gages, a func­tion that en­cour­ages lend­ing.

A trader buy­ing se­cu­ri­ties built from agency-backed mort­gages, gen­er­ally un­der $417,000 for a sin­gle-fam­ily home, has no credit risk.

In 1996, the mar­ket for se­cu­ri­ties backed by the big­ger, nonguar­an­teed loans was just get­ting go­ing, Brownstein says. Most trad­ing was in bonds backed by Fan­nie and Fred­die loans of roughly the same size and age. If in­ter­est rates fell, most of the home­own­ers in the pool re­fi­nanced at sim­i­lar speeds.

Brownstein saw that IOs backed by non-agency mort­gages were sell­ing for less be­cause the mort­gages were more hetero­ge­neous and harder to model. He sep­a­rated the mort­gages back­ing the bonds into groups with sim­i­lar char­ac­ter­is­tics, in­clud­ing the mort­gage size and at­tributes that even now he de­clines to iden­tify. He set out to pre­dict how each group would be­have if rates fell.

Back then, Mok watched in­ter­est rates and the yield each se­cu­rity paid rel­a­tive to Trea­sury bonds to fig­ure out whether to buy or sell. That was be­fore in­ter­est rates started fall­ing in the early 1990s, prompt­ing a wave of re­fi­nanc­ing.

Now, traders use com­puter-driven mod­els to pre­dict whether and when a home­owner is go­ing to cut off in­ter­est pay­ments with a re­fi­nanc­ing.

“You have to re­ally read the tea leaves to fig­ure out if a mort­gage bond is a good buy or not,” Mok says.

In search of math minds

For its mort­gage bet, Pine River Cap­i­tal went so far as to open an of­fice in Bei­jing in 2010 to tap a new pool of math ex­perts. The firm has 10 peo­ple there do­ing quan­ti­ta­tive re­search and soft­ware devel­op­ment, founder Brian Tay­lor says.

Num­bers crunched in China are sent to an 11-per­son mort­gage team in Pine River’s of­fice in New York. Tay­lor opened that of­fice in 2008, when many banks bailed out of the mort­gage-trad­ing busi­ness and fired mort­gage ex­perts.

“Fi­nan­cial mar­kets are prone to cri­sis,” Tay­lor says, “and cri­sis al­ways cre­ates op­por­tu­nity.”

Pine River prof­ited in the past two years by bet­ting cor­rectly thatU.S. home­own­ers wouldn’t pay off their mort­gages as fast as they did in 2003.

In 2008, when rates were tum­bling, IO bonds were trad­ing at 9 cents on the dol­lar, says Kuhn, man­ager of Pine River’s Nis­swa Fixed In­come fund. The price im­plied that 60 per­cent of bor­row­ers would re­fi­nance within one year, he says.

No way, he thought. Peo­ple wouldn’t re­fi­nance be­cause, un­like in 2003, the value of their houses had fallen. Those who could re­fi­nance con­fronted a moun­tain of pa­per­work at cau­tious banks.

In 2008, mort­gage bonds plunged and the cri­sis caught up to Fan­nie and Fred­die. The govern­ment seized them to ease con­cern that they would fail.

Af­ter the takeover, Fan­nie and Fred­die stopped a key ac­tiv­ity, Kuhn says. In ad­di­tion to guar­an­tee­ing mort­gages, the com­pa­nies bought and sold se­cu­ri­ties in or­der to mod­er­ate fluc­tu­a­tions in rates. That also helped con­trol price dif­fer­ences, or spreads, be­tween var­i­ous types of mort­gage bonds, mak­ing it hard for traders to find ar­bi­trage op­por­tu­ni­ties.

“ There weren’t a lot of nick­els ly­ing around,” Tay­lor says.

With­out Fan­nie and Fred­die trad­ing, the mar­ket is rife with op­por­tu­nity, Kuhn says. But govern­ment con­trol of the com­pa­nies means that traders have to watch for govern­ment pro­grams that make it eas­ier for home­own­ers to re­fi­nance. He watches hours of C-SPAN, the cable chan­nel that broad­casts govern­ment hear­ings. Some­times he records them to watch in the evening.

“My wife is a good sport,” he says.

Pack­ag­ing mort­gages

Daniel Loeb of Third Point nor­mally in­vests in stocks and bonds of com­pa­nies go­ing through merg­ers and re­struc­tur­ings. He has owned mort­gage se­cu­ri­ties since 2007. In 2009, they helped lift the fund 38.4 per­cent for the year, Loeb said in a let­ter to in­vestors. He also noted they had per­formed strongly in 2010.

As of June, mort­gage in­vest­ments ac­counted for one-fifth of Third Point’s as­sets, ac­cord­ing to a let­ter to in­vestors. Loeb used se­cu­ri­ties called re-remics for about half of his mort­gage play.

Remic is an acro­nym for “real es­tate mort­gage in­vest­ment con­duit.” It’s a trust— backed by thou­sands of mort­gages — that pays in­ter­est. Remics are di­vided into tranches ac­cord­ing to risk and sold to in­vestors. Each tranche be­comes a sep­a­rate mort­gage bond.

That makes them cousins of col­lat­er­al­ized debt obli­ga­tions, the bun­dles of mort­gage bonds and other debt whose value plunged in 2007, help­ing to trig­ger the larger fi­nan­cial cri­sis.

Remics also tanked dur­ing the credit cri­sis as the mort­gages back­ing them went into de­fault. Many AAA remics, the least risky ones, lost their rat­ing, and banks and in­sur­ers had to put up more cap­i­tal to cover po­ten­tial losses. To ease that bur­den, Wall Street has been repack­ag­ing the once-AAA-rated bonds into new trusts that have se­nior and ju­nior se­cu­ri­ties.

Loeb is bet­ting on the riskier ju­nior slices, hop­ing they will pay a fat yield — as much as 20 per­cent, ac­cord­ing to the let­ter to in­vestors. As the credit cri­sis eased, those bonds rose in value, con­tribut­ing to Loeb’s 25 per­cent re­turn.

Loeb also bet big on gold, a pop­u­lar play for hedge-fund man­agers in 2010. He had about 6 per­cent of Third Point’s as­sets in bul­lion in Novem­ber, the biggest gold bet he’s ever made, ac­cord­ing to Third Point in­vestors. He started buy­ing in Septem­ber, when the metal was trad­ing at $1,250 an ounce, spurred by a U.S. re­port that saidWash­ing­ton can’t sus­tain the deficits it’s been run­ning.

Gold is al­ways pop­u­lar dur­ing times of cri­sis. Brownstein, buoy­ant on a dark­en­ing Novem­ber af­ter­noon, says the emer­gency in his mar­ket has passed.

“ The cri­sis was when hous­ing prices were ac­cel­er­at­ing out of con­trol,” Brownstein says. Now, the pon­tif­i­ca­tor-in-chief says, there are op­por­tu­ni­ties for hedge­fund man­agers will­ing to drill deep down into mort­gage bonds and find value. A ver­sion of this ar­ti­cle ap­pears in Bloomberg Mar­kets mag­a­zine’s Fe­bru­ary is­sue.


Daniel Loeb of Third Point sees op­por­tu­nity in re-remics.


Steve Kuhn found mort­gage bonds he felt were un­der­priced.

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