How one hedge fund seized on fall­out from Dodd-frank

EJF Debt Op­por­tu­ni­ties prof­its on moves the U.S. forces lenders to make

The Washington Post Sunday - - TAKING STOCK - BY JESSE WEST­BROOK AND ROBERT SCH­MIDT

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 (FBR), 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, it has av­er­aged gains of 21 per­cent a year since its 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’s Daniel Loeb and Moore Cap­i­tal Man­age­ment’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 hedge­fund 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 en­v­i­ron- ment and government’s heav­ier hand in ev­ery­thing from bank over­sight to hous­ing pol­icy.

It helps that EFJ op­er­ates in Ar­ling­ton, out­side the tra­di­tional hedge-fund en­claves of New York and Greenwich, Conn. 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.

“Cat­a­lysts” that 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 made up of pools of real-es­tate loans. The Fed took on CDOs as part of its 2008 res­cues of Bear Stearns and Amer­i­can In­ter­na­tional Group.

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. Fried­man’s over­all firm, EJF Cap­i­tal, man­aged $3.1 bil­lion at the end of July, ac­cord­ing to an SEC fil­ing.

The ge­n­e­sis for one of EJF’s win­ning trades is tucked into Sec­tion 171 of Dod­dFrank, the reg­u­la­tory be­he­moth ap­proved by Congress to lay out new rules for Wall Street af­ter the credit crunch.

Named the Collins amend­ment af­ter its ad­vo­cate, Sen. Su­san Collins (RMaine) the pro­vi­sion on “lever­age and risk-based cap­i­tal re­quire­ments” bars lenders from us­ing 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 in New York.

JPMor­gan Chase said in June that it would re­deem $9 bil­lion of TruPS af­ter the Fed pro­posed rules to im­ple­ment the Collins amend­ment. The same month, Cit­i­group said that it would buy back TruPS 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 has fol­lowed the hy­brid se­cu­ri­ties mar­ket for

21% Av­er­age gains per year since its in­cep­tion in June 2008 com­pared with . . .

4.4% an­nual in­crease posted by other debt-fo­cused hedge funds

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 cred­it­de­fault 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, Bank of New York Mel­lon and M&T Bank, 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 TruPS that would be af­fected by the Collins amend­ment and bet­ting against the Cleve­land-based bank’s shares on ex- pec­ta­tions 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.

The 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, Minn., and Cor­dova, Tenn.

“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. “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 United States, ac­cord­ing to a per­son who wasn’t au­tho­rized to speak pub­licly. Fried­man reg­is­tered his firm in Novem­ber with Bri­tain’s Com­pa­nies House.

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 rose 39 per­cent through Dec. 14 by build­ing trades around government ef­forts to help homeowners 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 the 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 pol­i­cy­mak­ers 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, N.C., started his fi­nan­cial ca­reer in the 1970s as a bro­ker at Legg Ma­son’s Washington of­fice. His in­ter­ac­tions with government neigh­bors in the 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.

He, Eric Billings and Rus­sell Ram­sey 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 ini­tial stock of­fer­ings, more that year than Cit­i­group, Mor­gan Stan­ley and Mer­rill Lynch. 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, 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.”

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