Volcker Rule Creates Opportunity for Hedge Funds
In Bankers’ Stead
By ERIN E. ARVEDLUND | Barron’s
Hedge-fund Seer Capital has seized on the retreat of banks’ proprietary desks to carve out a profitable niche in mortgage-backed securities.
- One of Seer Capital Management’s best-timed bets was its founding in 2008, anticipating both the bottom in bond prices and big banks’ departure from proprietary trading.
After several years of strong returns, the hedge fund now manages $2.1 billion, mostly in the securitized-credit and bond markets. These markets were at the heart of the financial crisis, which not only raised banks’ fears of risk, but resulted in tougher regulatory standards. Among the new restrictions are the pending Volcker rule forbidding certain sorts of in-house trading by banks, and U.S. and international accounting measures that raise the amount of money lenders have to put aside if they want to hold many of the types of securities that Seer buys and sells.
Sensing there would be an opportunity, Philip Weingord left Deutsche Bank more than five years ago and over time brought along colleagues Richard d’Albert, Karen Weaver, and Michael Lamont. Before founding Seer, Weingord, now 52, had been a trader, both at Deutsche and before that at the former Credit Suisse First Boston.
Jennifer S. Altman for Barron’sSeer Capital’s Weingord has made money in J.C. Penney, Fannie Mae and Punch Taverns. He’s not a fan of Sallie Mae.
“In the old days, hedge funds would compete with banks for attractive investment opportunities,” he notes. “Now the banks are retreating to more of an agent role,” relying on the funds as partners.
SEER CAPITAL FOCUSES on distressed and special situations in residential and commercial mortgage-backed bonds, which make up about 60% of its portfolio. It also buys asset-backed securities, and other debt. The New York-based firm’s mortgage and credit research skills have pointed it toward companies that have been in the news lately, such as J.C. Penney, Fannie Mae, and Freddie Mac . Its approach has also given it a negative view of student loans and the lenders that specialize in them, such as SLM, better known as Sallie Mae.
Weingord and his group have been especially active traders in debt issues affected by the troubled department-store giant. Earlier in the year it bought commercial-mortgage-backed securities (CMBS) that included J.C. Penney (ticker: JCP) loans because it expected the issues to gain as the commercial market recovered. It took profits in the J.C. Penney-related CMBS after the company reported disappointing earnings in August and the debt markets began to research the effect J.C. Penney store closings would have on these issues. (CMBS include loans from a variety of sources like hotels, office buildings, and shopping malls.)
Whether J.C. Penney goes bankrupt or not, it will have to close more stores, which affects both its and other borrowers’ debt because the retailer is often an anchor tenant in a mall, notes Weingord. Seer Capital analyzes the effect on cash flows from “not only lease expirations, but also the likelihood of a store closing, based on its per- square-foot sales, regional economic outlook, and the asset’s competitive position in the area,” he says. “We also assess scenarios that include secondary impact of an anchor store’s departure, whereby other tenants may be entitled to rent concessions if the anchor goes dark.” More-senior J.C. Penney debt is so well protected that it will be fine in almost any scenario.
ALTHOUGH NOT SO well known in this country, Punch Taverns, a special-situation debt holding, has been a mainstay for the London financial media for years. The company (PUB.U.K.) was formed from the Bass beer family of British pubs, and now owns about 4,000 drinking-and-eating establishments.
Punch, which has gone through a dizzying succession of buying and selling properties since it was created in 1997, today has 2.5 billion British pounds ($4 billion) worth of mortgage-like borrowings, secured by real estate, which are now in restructuring. The company took on the debt to make acquisitions, but cash flows have dropped as competition has increased, and restrictions on smoking have limited the bars’ appeal for some.
When Seer Capital began buying the senior notes in the second quarter, they were yielding 7%. Recent gains in price have brought the yield down to 6.25%, providing the firm with a 7% total return in just a few months. Post-restructuring, “we believe over the next six months these bonds could rise much further in price. This would be a fantastic return for a senior, well-protected, well-collateralized investment,” says Weingord. Punch is expected to propose a revised restructuring in early December.
Punch represents the kind of opportunity that once would have gone to proprietary trading desks. “Pre-[financial]-crisis, Wall Street trading desks acted both as market-makers and proprietary traders,” he says. “If still the case, it would have been difficult for Seer to build a large position at an attractive price.”
The firm has done well exploiting its opportunity. Seer Capital Partners Offshore Fund returned 25.9% in 2012, 2.1% in 2011, 24.9% in 2010, and about 14% annually since inception. Year to date through October, Seer gained 9.5% net of fees, which are 1.5% management and 20% of performance annually.
AVOIDING PROBLEMS ALSO improves returns. “We’ve sold out of deals backed by student loans,” says d’Albert, Seer’s co-chief investment officer. “They have performed well. But the thing to consider is they’re long-duration bonds, and you have a credit story where borrowers continue to pile on debt,” he says.
U.S. borrowers owe $1.2 trillion in student-loan debt–from the government and private lenders such as Sallie Mae (SLM). That surpasses all other kinds of consumer borrowing except mortgages. The overall three-year default rate on federal government student loans is 14.7%, up from 13.4% a year ago, according to U.S. Department of Education figures released at the end of September. That includes students at for-profit institutions, private nonprofits, and public nonprofits. The highest three-year rate, 21.9%, was for students at for-profit schools.
Making school more affordable has become a matter of public debate, so there’s uncertainty about the future terms and conditions of the loans. If more of them can be forgiven in personal bankruptcy, default rates could rise. And in the case of high default rates in a student-loan-backed security, “it’s only institutional investors who lose out,” notes d’Albert.
Weingord expects default rates could go as high as 35%, so this is one area he’s happy to leave to the banks.