Sub prime or Sublime?

July 19, 2007 |

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The main stream media has done it again, and the latest feeding frenzy is the sub prime mortgage sector.  Sure, we all knew that money on the street was too cheap and consumers have been over extending themselves, particularly with respect to housing.  But as with every other panic selling situation the media has fanned the fire which has resulted in numerous hedge fund blowups, closures, and liquidations.  It’s understandable; mainstream investors gather the bulk of their intelligence from the newspaper.  These investors, trustees and board members then turn to their fund of fund managers and institutional allocators for answers.  The typical response, however, is to put in redemptions first, and ask questions later.  Rather than allowing their managers to position themselves for great buying opportunities, the average allocator prefers to exacerbate illiquidity and losses by forcing their managers to sell.  This is an age old problem within the markets and is likely to continue in cycles for decades to come. 

As structured finance becomes more sophisticated and complex, however, the potential for disaster is magnified.  In particular, structurers continue to repackage questionable securities, or repackage subordinate tranches of other structured securities in order to garner an “investment grade” rating. This works well as long as someone is buying, but once liquidity is required, the house of cards begins to collapse.  Smarter investors, however, are becoming more adept at understanding fund flows and the media impact therein and are employing proper liquidity management tools (i.e., leverage facilities, lock ups and redemptions terms, etc.).

So why is HFL jumping on the bandwagon with commentary on the sub-prime issue?  Well, it’s all about low hanging fruit.  As we have seen in the past with excessively oversold markets (e.g., distressed in 2002 and converts 2004 and 2005), the smart money is ready and waiting to buy at the bottom and reap years of rewards while the mainstream sits on the sidelines and licks their wounds inflicted by painful forced liquidations.  Consider this HFL’s call out to all players with experience in the sub prime sector: now is the time to start thinking about ramping up your own sub-prime vulture funds!  Whether you’re a victim of a downsized prop desk or a shuttered hedge fund, now is your chance to strike gold. 

Will mainstream investors think you’re crazy for starting a sub prime fund?  Certainly.  There will, however, be no shortage of astute investors that understand the signs of an oversold market and smell the opportunity for huge profits.  Furthermore, expect barriers to entry and competition to be low at this stage of the game.  Given the recent press, don’t expect capital raising to be a slam dunk.  Focus on a few core investors that are educated enough to understand the game.  Then, after 12 months of outsized returns, expect a significant ramp up in AUM.  Just be mindful of your asset liability matching; fund liquidity management will be a topic of future posts.

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