Hedgie MKP Capital’s Pat McMahon Sees Greek Default & Debt Restructuring, a la Argentina
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Low Rates, Slow Growth
MKP Capital’s founder Patrick McMahon is looking for the global economy to weaken and for rates to drop. His plays? Aussie and Swedish interest rates, and cash.
In 1995, after nearly a decade at Salomon Brothers, where he was a partner in the fixed-income unit, McMahon founded MKP Capital Management. The Northern New Jersey native and his fellow Salomon alumni, partners Anthony Lembke and Maurice “Chip” Perkins, today oversee $4.26 billion in assets, and have expanded from mostly asset-backed securities and other structured credits to global macro strategies.
MKP RUNS TWO FUNDS,MKP Credit and MKP Opportunity, which are mostly institutional. MKP Credit appeared among Barron’s Top 100 Hedge Funds in 2011, and both funds made the list in 2010. MKP Credit and MKP Opportunity have returned 12.21% and 9.83%, respectively, on an annualized basis from inception (March 1999 and August 2001, respectively) through the first quarter of 2011. In the midst of 2008’s “Great Unwind,” as McMahon dubs the massive deleveraging of financial institutions and consumers, U.S.-focused MKP Credit posted a flat performance, before posting a 17.1% gain in 2009. The global MKP Opportunity fund was up 9.8% in 2008 and 12.8% in 2009.
The funds differ substantially in their strategies. MKP Opportunity trades across world markets in interest rates, currencies and underlying equities and bonds. MKP Credit focuses on agency and nonagency residential and commercial mortgage-backed securities, as well as asset-backeds and corporate debt. It will go long or short in either cash or derivatives markets.
McMahon was already a skeptic about global gross-domestic-product growth prior to the Federal Reserve’s glum forecast last week. He doesn’t see it exceeding about 4% annually for the next few years as many countries, including the U.S., avoid making painful fiscal and monetary changes. He sees European interest rates coming down toward U.S. levels and the euro weakening against the dollar.
While McMahon doesn’t believe a third version of quantitative easing, or QE3, is in the cards, he thinks the Fed’s low-interest-rate policy amounts to the same thing—an ongoing stimulus program. “Governments right now are unwilling to deal with pain. There is still significant leverage in place, and structural problems are not being dealt with. They are borrowing liquidity now and trading that for lower-trending growth later. The Great Unwind is still under way.”
Europe, he says, is “borrowing future productivity by propping up Greece and other debtor countries. We think it would be better for the global economy to deal with the problems now. It would involve Greece defaulting, moving out of the euro, devaluing its currency, and making it a more attractive market. Greece would again become a very large tourism spot. Jobs would return. It would be similar to Argentina, when they devalued their currency.”
ULTIMATELY, GREECE WILL NOT be able to repay its debts, McMahon predicts. The European Central Bank “is helping Greece roll over the debt. But the burden has to be spread out. The ECB is providing money to Greece, but only the taxpayers shoulder the burden. The underlying bondholders and banks should, too. If Greece were a company, it would have defaulted, and bondholders would get some fraction on the dollar,” conjectures McMahon. Greece doesn’t necessarily need more cash, it needs to restructure its debt so that it is not, in effect, insolvent.
One reason that Greece isn’t defaulting is the widespread fear about a domino effect in Italy, Ireland and Spain, where banks have bigger exposures. Even so, a Greek default would be preferable. Yield spreads on sovereign debt have been widening since the ECB bailout, a sign of the market’s worries.
The weakness will keep interest rates low. “Rates in the U.S. are not going higher, not until 2013 some time. Investors could be in for very low, or negative, real rates of return for years.”
That said, MKP Capital is long interest rates in parts of Europe and Asia, in particular, euro interest rates, Sweden and Australia, expressing the trade via interest-rate swaps. “China’s raised rates, and that significantly impacts Australia, and the demand for commodities. But we think the fears of inflation are overblown,” he adds, and that some commodities will come down in price.
MKP Opportunity has two simultaneous bets on Australia: It’s long Aussie interest rates and short the nation’s dollar. Both are predicated on the firm’s view that the economic outlook for Australia is too rosy. The markets, says McMahon, are pricing in strong Chinese growth, even though China’s recent data have pointed to slower gains ahead. Any weakness in commodities demand would also hit Australia.
The firm has grown more wary of commodities of late, closing out a bullish bet on oil via index options once oil prices hit the firm’s target earlier in the year. As a part of its change in thinking, it’s also short the New Zealand dollar as a play on weaker commodity prices.
The Japanese earthquake in March has been another factor in the MKP Capital view that global GDP will remain subdued. “Growth assumptions in corporate earnings were already too high,” says McMahon. “And Japan is such a big part of the global supply chain. At the same time, housing numbers in the U.S. were worsening for most of this year.”
The earthquake helped push MKP Credit down by 1% in March, although it did rebound. According to MKP’s first-quarter newsletter: “At the start of the year, we believed that non-Japan Asia countries were experiencing relatively high rates of inflation, and that this inflation was likely to be persistent. We also observed that several central banks were slow to react, allowing for low or negative real rates, despite strong economic growth and inflation. Our view was that these central banks would be forced to increase rates. However, as a result of the Japanese earthquake and its aftermath, all rates in the region dropped.”
MKP Credit has gone heavily into cash. “We view cash as an investment,” McMahon says with a smile. “Prices in the mortgage-backed-bond market are back above the depths, where they were during Lehman’s bankruptcy, to around 2009-10 levels.” He thinks they’re overpriced.
“We still don’t think the mortgage market is oversold enough for us to start buying. The regulatory market is not helping—banks aren’t lending, the U.S. jobs numbers are still deteriorating, and the housing data are turning over.”
As a result, the Fed is keeping short rates low, which in turn puts downward pressure on long Treasury rates. McMahon projects that yields on the 10-year Treasury will fall to 2% in the next year, from about 3% currently. And MKP will play that trend, cautiously.