Event Driven Hedge Funds           “a
Event Driven Strategies• Bankruptcy (in and out of…)  – High Yield/Distressed  – Credit Swaps• Corporate reorganization; r...
High Yield/Distressed Debt         Investing
Fixed Income Markets and Funds
Fixed Income Strategies•   Relative Value     –   Long debt of one company and short debt of another in same industry; US ...
Spectrum of Fixed Income                          InvestingAsset Backed Securities    CDO’s                       Commerci...
Trade Strategies and RiskTrade Strategies         Return Sources           Risk Characteristics   Typical Risk AllocationH...
Global Fixed Income MarketRisk Sector IssuesDuration     Treasuries; Global AAAsCredit       High Yield, Distressed, Emerg...
Credit/Distressed/High Yield Sector            Opportunities• Stable credit markets and economic  growth• Lack of integrat...
Correlation of Monthly Returns          1991-2004              High Yield    10 year      MBS (3)   Three-       High     ...
Benefits of High Yield and         Distressed Investing• Capital appreciation                  Correlation to Treasuries  ...
High Yield Investment Thesis• Record new capital inflows, migration from other  asset classes• Interest rates near four de...
High Yield Investment Thesis            (Continued)• HY market remains inefficient  – Long only charter of majority of inv...
State of High Yield Distressed              Markets• Historically low spreads• Near record level of issuance• Default rate...
Definition of Distressed Investing• Undervalued, under followed, out of favor of  oversold securities• Small to middle mar...
Distressed Debt Opportunities•   Low interest rates, thirst for yield     Year            Bonds B-       Leveraged    and ...
Credit Markets and CreditDerivatives
Market Forces Change the        Rules of Credit Investing•   Equity declines drove re-allocations to fixed income     – Si...
Currently Very Few Easy         Opportunities• End of the bear credit  market in 2003• Spreads have  tightened to extreme ...
Outperformance Is More    Demanding Than Ever• Are we being correctly compensated?  – Risk premium close to zero• How does...
Discussion Outline• Recent market environment• New market-implied techniques to  manage credit risk• Introduction to the B...
Market-Implied Measures     Provide Additional InsightMarket-implied measures from the: Equity Market – Barra Default Pro...
Merton’s Structural Model of           Default• Default occurs at debt maturity if the firm  value  is below the liabiliti...
Merton’s Structural Model of               Default                   No DefaultV0                                D        ...
Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
The Market of Credit• Size and sophistication of market has  grown enormously  - Notional exceed $2 trillion  - Single nam...
Credit Derivatives• Instruments whose payoff is a function  of a reference assets credit  characteristics• Transfer the ow...
Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
Single Name Credit Modelling• Structural approach: default when the company asset value  is less than its liabilities• Spr...
Credit Default Swaps• Most common credit derivative (over  50% of the market)• Provides protection against default of a  r...
Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
Correlation Products Modelling• Contracts that reference the default of more than one obligor• One of the fastest growing ...
Collateralised Debt Obligations• Application of securitisation technology  – Synthetically transferring assets off balance...
Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
Latest Innovation• CDS options• Default Swaptions• Credit Default Swap Index (Trac-x,  iBoxx)• CDO squared• Option on CDO ...
Growth of Credit Default Swaps             2000    2001    2002    2003    2004Global CDS   893     1,189   2,306   3,500 ...
Special Situations/Events•   Identify Drivers/Destroyers of Value     –   Overcapacity     –   Cyclical downturns     –   ...
Credit Analysis•   Net income is not cash     – EBITDA          •   EBITDA/Interest Expense          •   Long Term Debt/EB...
Examples of Multi-Strategy/Event Funds
Examples of Multi-Strategy Funds• Concordia  – 25% to distressed, 12% to credit relative value and 11% to    volatility ar...
Etolian Capital Credit Arbitrage
Kellner DiLeo Cohen & Co• Investment Strategies (market neutral)   –   Merger Arbitrage Fund   –   Convertible Arbitrage F...
Pinewood Capital Partners• Long, short and long/short positions in high yield  & investment grade debt, commercial and  in...
Dickstein Partners• Event Driven Situations  – Merger Arbitrage  – Distressed/High Yield Securities  – Event Driven Strate...
Dickstein Partners
Canyon Capital
Canyon Organization
Canyon Credit Culture
Canyon Capital
Canyon Capital Direct Debt      Investments
Canyon Capital
Angelo Gordon Alpha Credit Fund• $8.5 billion in assets   – 116 staff        • 56 investment professionals        • 22 acc...
Angelo Gordon Alpha Credit Fund• Intra-Company Credit Arbitrage   –   Senior vs. Subordinated   –   Parent vs. subsidiary ...
Taconic Event Investing• Portfolio Composition  – Merger Arbitrage – 23%  – Distressed/Stressed – 49%  – Capital Structure...
Sagamore Hill Multi-Strategy  Market Neutral Investment Fund• Net Return Target = Risk  Free + 5-8%                       ...
Sagamore Hill Strategies:              Event Driven• Distressed   – Fundamental-driven research of securities in, near or ...
Sagamore Hill Strategies:             Relative Value• Capital Structure Arbitrage   – Intra-company relative value among s...
Sagamore Hill Strategy:              Volatility Capture• Convertible Arbitrage   –   Global portfolio   –   Mispriced vola...
Structured Credit Programs
Mortgage Backed Securities• Value Proposition   – Mortgage market is large, liquid but not entirely efficient   – Preferre...
JP Morgan Asset Management• Program Details  – Leverage of 10-15 times net assets  – Return objective 8-12% over full mark...
Mortgage Backed Securities        Common Types of Trades• Coupon Swap: Long one coupon vs. duration-neutral short  positio...
Basis Yield Alpha Fund• Diversified Global Structured Credit Securities and Derivatives    –   Asset Backed Securities (AB...
Concordia Advisors• Concordia Advisors hired Christopher Dillon and  James Wise, former co-heads of JPMorgan’s  tax-exempt...
Introduction to Asset Securitization• “What is a Mortgage”• Mortgages as a Fixed Income investment• What else can you secu...
Tradable Fixed Income Supply                 U.S. Dollar Denominated Debt Market                                          ...
What are Mortgage Backed “Pass-Through”               Securities?                   +            +            =         Se...
Agency Conforming MBS Origination Process                                                                                 ...
Non-Conforming MBS Origination Process                                             Individual Mortgages                   ...
Who Buys Mortgages?                    Mortgage Security Holdings byBanks and            Investor Type in 2002…Agencies dr...
Overview of the U.S. Mortgage               Securities Market•   Largest Sector of the U.S. Debt Market:     –   Aggregate...
What’s the catch?• You are purchasing a product with an  imbedded call option  – Duration is very hard to determine.  – Va...
"Duration" Deserves Special       Focus in Mortgages...• Modified duration, Macaulay duration, cashflow duration: all  mea...
Prepayment Risk• Prepayment Option   – Any payments by borrower made in excess of scheduled principal     payments are cal...
Duration and Convexity•     Duration (simply):                      price                                              yie...
Options and Convexity• If you are long a call option – are you long  gamma or short gamma?• Why is being long an MBS simil...
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Event driven hedge_funds

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Pre-crisis perspective. Now more than ever it has relevance with the emergence of "Vulture" Hedge Funds (VHF). The VHFs are an important part of the "ecosystem", to achieve a true market equilibrium, unhampered by 'subsidies'.

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Event driven hedge_funds

  1. 1. Event Driven Hedge Funds “a
  2. 2. Event Driven Strategies• Bankruptcy (in and out of…) – High Yield/Distressed – Credit Swaps• Corporate reorganization; restructuring• Fundamental change in business environment; competition• Lawsuits; legislation• M&A• Structured Bonds (Mortgage Backed Securities)
  3. 3. High Yield/Distressed Debt Investing
  4. 4. Fixed Income Markets and Funds
  5. 5. Fixed Income Strategies• Relative Value – Long debt of one company and short debt of another in same industry; US and International• Capital Structure Arbitrage – Long municipal debt, short corporate debt – Long senior debt, short subordinated – Long high yield, short equity – Long 1 year short 10 year of same company• Event Driven – Relies on catalyst to release value • M&A arbitrage • Bankruptcy or exit from bankruptcy • Corporate restructuring, exchange offers, recapitalization, asset sales, debt buyback • Ratings trigger downgrading from investment to high yield• Credit/Distressed – Relies on mispricing of security risk • High yield • Corporate credit arbitrage • Distressed securities (debt and equity)• Directional Long/Short – Long • Safer end of distressed (between high yield and distressed) • Secured Financing • Loan syndicated debt – Short negative credit view of industry of issuer
  6. 6. Spectrum of Fixed Income InvestingAsset Backed Securities CDO’s Commercial Real Estate Credit Derivatives Leveraged CreditEquipment Middle Market Large Loans Correlation Trading Leveraged LoansCommercial Loans Subordinated Classes Credit Default Swaps DistressedFuture Flow High Yield Bonds Direct Lending Baskets Mezzanine DebtConsumer Real Estate Special Situations Indices Special SituationsSpecial Situations ABS Mezzanine Lending Direct PlacementDirect Portfolio Lending CDO High Yield BondsMezzanine Lending High Grade ConvertiblesDistressed PIPESDerivatives ETC’s DerivativesResidential Mortgages High Grade Credit Governments Emerging Markets MunicipalsHome Equity Agencies Agencies Sovereigns General ObligationsAlt-A US Treasuries US Treasuries Corporate Letters of CreditPrime Non-Dollar Treasuries Non-Dollar Treasuries Asset-Backed Securities HealthcareWhole Loans Repo Repo Direct Lending Moral ObligationsCMO’s Futures Futures Derivatives Project FinanceMezzanine Lending Interest Rate Derivatives Interest Rate Derivatives Project Finance Revenue BondsDerivatives Structured Finance Distressed Commercial Real Estate Derivatives
  7. 7. Trade Strategies and RiskTrade Strategies Return Sources Risk Characteristics Typical Risk AllocationHY Commercial Paper Carry Low 10-30%Default Arbitrage Carry and Price Action Low 10-20Short HY Basket, Long Carry and Price Action Low 20-30HY Market BasketIndex Carry Trading Carry Low 10Long HY Loan Market, Price Action and Carry Low 20Short HY Loan BasketHY Arbitrage Price Action and Carry Medium 0-30Intracapital Price Action and Carry Medium 10-20Long/Short Market Price Action Medium 10SubsectorsNew Issues Price Action Medium 5L/S Specific Names Price Action High 30Long Specific names Price Action, Carry High 10Short Specific Names Price Action and Carry High 10HY Municipals Price Action and Carry High 5Cash/Derivatives Basis Price Action and Carry High 5TradingSingle Name Volatility Price Action High 5
  8. 8. Global Fixed Income MarketRisk Sector IssuesDuration Treasuries; Global AAAsCredit High Yield, Distressed, Emerging MarketVolatility MortgagesCurrency Non-dollar sovereigns; AAAs
  9. 9. Credit/Distressed/High Yield Sector Opportunities• Stable credit markets and economic growth• Lack of integration across credit spectrum (inflection points) – Investment to high yield – High yield to distressed – Across capital structure – Across term structure of debt in a company
  10. 10. Correlation of Monthly Returns 1991-2004 High Yield 10 year MBS (3) Three- High Stocks (6) (1) Treasuries Month Grade (2) Treasuries Corporates (4) (5)High Yield 1.00 0.06 0.295 0.0348 0.3123 0.512010 Year 1.00 0.83 0.72 0.93 (0.04)TreasuriesMBS 1.00 0.29 0.09 0.233-mos 1.00 0.18 0.09TreasuriesHigh Grade 1.00 0.12CorporatesStocks 1.00 Notes: (1) ML High Yield Master Index (2) ML 10 Year Treasury Index (3) ML Mortgage-Backed Index (4) ML three-month Treasury Index (5) ML High Grade Index (6) Wiltshire 5000 Stock Index
  11. 11. Benefits of High Yield and Distressed Investing• Capital appreciation Correlation to Treasuries and Corporate Securities and high current 1992-2004 US IT US LT LB income Govt Govt Aggregate Bond• Diversified returns CSFB High 0.00 0.11 0.19 Yield Index from various asset classes CSFB Lev Loan -0.05 0.00 -0.01• Market liquidity Distressed Index• Lower volatility than equities, other
  12. 12. High Yield Investment Thesis• Record new capital inflows, migration from other asset classes• Interest rates near four decade lows – Search for yield, income – Rising rates hurt Treasury/Corporate debt• Default rate in decline after 2002 peak• New issue market biased to stronger credits• Improving corporate balance sheets, corporate governance, disclosure• Increase presence of commercial banks in underwriting and trading
  13. 13. High Yield Investment Thesis (Continued)• HY market remains inefficient – Long only charter of majority of investor base – Limited price transparency – Price sensitivity to funds flows – Dealer dominated market; liquidity “gaps” – Market not integrated to other parts of the capital structure
  14. 14. State of High Yield Distressed Markets• Historically low spreads• Near record level of issuance• Default rate in 2004 fell from 3.2% to 1.2% – Long term average of 4.4% – 1994-1998 average of 2.1%• Credit quality of new issues deteriorated by ratings, leverage and coverage ratio – Maintain discipline in high lead; leads to opportunities in distressed
  15. 15. Definition of Distressed Investing• Undervalued, under followed, out of favor of oversold securities• Small to middle market companies• “Distressed” segment – Companies in or near reorganization and/or default – Undervalued securities trading at deeply discounted prices resulting from severe financial, operational or economic problems• “Stressed” segment – Under followed or out of favor securities trading at discounted prices resulting from cyclical or sector downturns, financial stress and uncertainties
  16. 16. Distressed Debt Opportunities• Low interest rates, thirst for yield Year Bonds B- Leveraged and improving economy led to or Lower Loans B+ record issuance of junk bond and or Lower leveraged loans in 2003-5 2002 3.4% 7.5%• Combined with mortality rates will 2003 10.1% 20.8% yield high supply of distressed 2004 20.6% 34.5% (record) (record) Years After Issuance Until Default Rating B Marginal 2.9% 6.9% 7.4% Default Rate Cumulative 2.9% 9.5% 16.2% Default Rate CCC Marginal DR 8.0% 15.6% 19.6% Cumulative DR 8.0% 22.3% 37.5%
  17. 17. Credit Markets and CreditDerivatives
  18. 18. Market Forces Change the Rules of Credit Investing• Equity declines drove re-allocations to fixed income – Simultaneously government yields decreased to all time lows – Credit default rates neared all time highs – Pension fund shortfalls (Focus on ALM)• Credit markets are increasingly complex – Universe of assets is expanding rapidly – Spread products are becoming more complicated – Limited headcount to cover expanding number of issues
  19. 19. Currently Very Few Easy Opportunities• End of the bear credit market in 2003• Spreads have tightened to extreme levels – Lowest since 1998• Demand still high – Non-traditional Source: S&P investors
  20. 20. Outperformance Is More Demanding Than Ever• Are we being correctly compensated? – Risk premium close to zero• How does a long-only investor win/outperform? – Spreads have nowhere to go• Move to – Lower-quality / higher-yielding – Find names with value still
  21. 21. Discussion Outline• Recent market environment• New market-implied techniques to manage credit risk• Introduction to the BDP (Barra Default Probability)• Practical Examples• Questions and answers
  22. 22. Market-Implied Measures Provide Additional InsightMarket-implied measures from the: Equity Market – Barra Default Probabilities (BDP) Bond Market – Barra Implied Ratings (BIR) Derivatives Market – Credit Default Swaps (CDS) Coming soon… Crossover –Empirical Credit Risk (ECR) Equity Risk Implied Spreads (ERIS)
  23. 23. Merton’s Structural Model of Default• Default occurs at debt maturity if the firm value is below the liabilities value• We thus need – A model of firm value process – Estimate of default point• Merton identified equity as being long a call option on the firm value• Merton identified a bond as being short a put option on the firm value
  24. 24. Merton’s Structural Model of Default No DefaultV0 D Default Probability of Default T 0
  25. 25. Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
  26. 26. Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
  27. 27. The Market of Credit• Size and sophistication of market has grown enormously - Notional exceed $2 trillion - Single name (CDS, CLN) to full blown portfolio based instruments (FtD, Synthetic loss tranches, CDO squared)• Initially used by bank loan managers to hedge• Now: insurance companies, hedge funds, asset managers, etc
  28. 28. Credit Derivatives• Instruments whose payoff is a function of a reference assets credit characteristics• Transfer the ownership of credit risk between buyers (of protection) and sellers (of protection)• Diversification, yield enhancement• Credit risk is traded independently of the instruments that generate the risk
  29. 29. Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
  30. 30. Single Name Credit Modelling• Structural approach: default when the company asset value is less than its liabilities• Spread relies on the internal structure of the company• Can’t exactly fit a spread curve and can’t be used to price complex credit derivatives• Reduced-form approach: the credit process is directly modelled via its probability of occurence• Flexibility to fit a spread curve and extendable to price complex credit derivatives
  31. 31. Credit Default Swaps• Most common credit derivative (over 50% of the market)• Provides protection against default of a reference entity (isolates credit risk component) - Protection buyer retains market exposure of reference entity - Protection seller gets leveraged exposure to reference entity
  32. 32. Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
  33. 33. Correlation Products Modelling• Contracts that reference the default of more than one obligor• One of the fastest growing areas of credit derivatives – nth-to-Default Baskets – CDO’s (static, managed, synthetic etc)• Methodologies used to price these instruments – Default-time simulation (Normal, t, Archimedean copulas) – Semi-analytical approach• The normal copula is the “benchmark” model for multi-obligor credit derivatives
  34. 34. Collateralised Debt Obligations• Application of securitisation technology – Synthetically transferring assets off balance sheet via credit derivatives• Asset pool is divided into tranches – Tranches have different risk/return characteristics – Payment to tranches is subordinated• Risk on a CDO arises from the loss distribution of the underlying asset pool – Characteristics of individual underlying’s – Joint correlated behaviour of underlying’s
  35. 35. Agenda• The Credit Market• Single name credit• Correlation products• Latest Innovation• Risk Vision
  36. 36. Latest Innovation• CDS options• Default Swaptions• Credit Default Swap Index (Trac-x, iBoxx)• CDO squared• Option on CDO tranches• Constant Maturity Default Swap (CMDS)
  37. 37. Growth of Credit Default Swaps 2000 2001 2002 2003 2004Global CDS 893 1,189 2,306 3,500 4,920US 3,359 3,835 4,094 4,462 4,636Corporate(IG + HY)
  38. 38. Special Situations/Events• Identify Drivers/Destroyers of Value – Overcapacity – Cyclical downturns – Rising raw material costs – Outsourcing manufacturing and service – Elimination of trade/tariff barriers – Aging populations in developed nations• Extraordinary events – Re-capitalization – Restructurings – Liquidations – Spin-offs – Management Changes – Contests for Control; Proxy Contests – Stock Repurchase; Special Dividend – Business Repositioning – Regulatory review/investigation
  39. 39. Credit Analysis• Net income is not cash – EBITDA • EBITDA/Interest Expense • Long Term Debt/EBITDA • (EBITDA-Capital Expenditures)/Interest • EBITDA/Revenues – Interest Expense – Capital Expenditures – Free Cash Flow – Long Term Debt – Debt Repayment Requirements• Qualitative Analysis – Quality of management – Equity sponsors – Event Risk (Consolidation; IPO; Technology or Regulation issues; Refinancing – Cyclical vs. Defensive industry – Ranking and Capital Structure – Bond Covenants
  40. 40. Examples of Multi-Strategy/Event Funds
  41. 41. Examples of Multi-Strategy Funds• Concordia – 25% to distressed, 12% to credit relative value and 11% to volatility arbitrage.• Wexford – 35% net long high yield against which they are carrying a 15% duration weighted short in treasuries and a 25% long position in the distressed book; 25% net long special situation equities.• Deephaven – 30% in relative value equity, 25% in convertible arbitrage, 20% in event driven, 10% in distressed/ capital structure arbitrage, 5% in global macro and 5% in credit opportunities.
  42. 42. Etolian Capital Credit Arbitrage
  43. 43. Kellner DiLeo Cohen & Co• Investment Strategies (market neutral) – Merger Arbitrage Fund – Convertible Arbitrage Fund – Distressed and High Yield Securities Fund – Special Situations Fund – Multi-Strategy Fund • 40% Distressed/high yield • 23% Convertible Arbitrage • 27% Merger Arbitrage • 10% Special Situations• Investment Professionals – CIO – Three Portfolio Managers – Four analysts Distressed Analyst• $600 mm under management
  44. 44. Pinewood Capital Partners• Long, short and long/short positions in high yield & investment grade debt, commercial and industrial loans, municipal bonds and exchange traded and OTC derivatives• Staffing – CIO – Director of Reseach + 3 analysts – Head Trader – Risk Manager
  45. 45. Dickstein Partners• Event Driven Situations – Merger Arbitrage – Distressed/High Yield Securities – Event Driven Strategies• $450 Capital• Six Investment Professionals
  46. 46. Dickstein Partners
  47. 47. Canyon Capital
  48. 48. Canyon Organization
  49. 49. Canyon Credit Culture
  50. 50. Canyon Capital
  51. 51. Canyon Capital Direct Debt Investments
  52. 52. Canyon Capital
  53. 53. Angelo Gordon Alpha Credit Fund• $8.5 billion in assets – 116 staff • 56 investment professionals • 22 accounting/operations • 6 client service professional• Percent of assets by strategy – Distressed securities – 30% – Leveraged loans (CLO) – 18% – Real estate – 18% – Convertible arbitrage – 12% – Merger Arbitrage – 4% – Cash – 10% – Other (Credit arbitrage, private equity, etc) – 18%
  54. 54. Angelo Gordon Alpha Credit Fund• Intra-Company Credit Arbitrage – Senior vs. Subordinated – Parent vs. subsidiary – Short vs. long maturities – Bond vs. credit default swap – Bond vs. equity• Inter-Company Arbitrage – Relative value within industry of credit rating – Individual credits vs. credit indices• Outright Longs/Shorts – Longs/Shorts based on fundamental research• Structured Transactions – Long/Short CDO hedging – Exploiting differences in instrument characteristics – Options on default swaps
  55. 55. Taconic Event Investing• Portfolio Composition – Merger Arbitrage – 23% – Distressed/Stressed – 49% – Capital Structure Arbitrage – 32%• Distressed/Stressed – Invest at the senior level (secured or senior); turns into cash and/or credit worthy senior debt• Capital Structure Arbitrage – Mispricing of different levels of stressed company’s capital structure • Bonds underpriced because of bondholder fear and equity overpriced because of equity investors greed – Long senior bond and short junior bond or equity
  56. 56. Sagamore Hill Multi-Strategy Market Neutral Investment Fund• Net Return Target = Risk Free + 5-8% Strategy Current Allocation• Areas of Focus Event 16% – Event Driven Distressed 16% • Distressed, Special Merger Arbitrage 15% Situations, Merger Arb. Capital Structure 14% – Relative Value Long-Short Credit 7% • Capital Structure, Equity Equity Market 7% Neutral, Long/Short Credit Neutral – Volatility Capture Convertible 16% • Convertibles, Volatility Arbitrage Trading Volatility Arbitrage 9%
  57. 57. Sagamore Hill Strategies: Event Driven• Distressed – Fundamental-driven research of securities in, near or recently emerged from bankruptcy – Domestic and European allocation – Deal sourcing; on the run; private opportunities• Event Driven – Special Situations – Mispriced securities with clear valuation catalysts including litigation, regulatory actions, spin-offs, refinancing – Excess returns from superior due diligence to capture excess risk premiums created by risk averse investors• Merger Arbitrage – Quantitative, fundamental and regulatory concerns – Use of options to mitigate risk and add value – Domestic and European focus
  58. 58. Sagamore Hill Strategies: Relative Value• Capital Structure Arbitrage – Intra-company relative value among securities and derivatives within a capital structure • Debt-equity, debt-option, senior-subordinated, structural arbitrage and pari-passu • Balanced portfolio has minimal risk exposures• Long-Short Credit – Fundamental credit research • Asset values, business fundamentals, legal considerations and capital structure – Domestic and European allocation – Isolate mispriced credit risk• Equity Market Neutral – Equity Long/Short – Statistical quantitative equity portfolio construction
  59. 59. Sagamore Hill Strategy: Volatility Capture• Convertible Arbitrage – Global portfolio – Mispriced volatility, credit risk, event risk – Quantitative and fundamental valuation techniques – Integration of convertible with other strategies within the firm• Volatility Arbitrage – Relative value trading (time spreads, skew and dispersion trades) – Relative value between derivatives of related securities – Focus on equity and foreign exchange markets
  60. 60. Structured Credit Programs
  61. 61. Mortgage Backed Securities• Value Proposition – Mortgage market is large, liquid but not entirely efficient – Preferred Habitat by major players indifferent to relative value • Banks buy to yield; shorter-duration mortgages • Homeowners borrow to buy/refinance; must pay current coupon • Mortgage servicers driven by hedging needs• Mortgage Backed Securities and Related Instruments – Mortgage pools; adjustable rate loans; interest only loans; balloon payment loans; non-performing loans; Commercial MBS; Private Label Mortgage Securities; CMOs, Mortgage derivatives, etc.• Position Analysis – Risk/cheapness; Carry; Duration; Convexity – Identify shifts in investor preferences
  62. 62. JP Morgan Asset Management• Program Details – Leverage of 10-15 times net assets – Return objective 8-12% over full market cycle (3-5 years) – $30 bln in long and long/short• Organization – Three senior mortgage portfolio managers – Three quantitative research and risk management analysts – Support from head of fixed income
  63. 63. Mortgage Backed Securities Common Types of Trades• Coupon Swap: Long one coupon vs. duration-neutral short position in another coupon – Buy FNMA 6%, Sell FNMA 5.5%• Trading Rolls: Long coupon in one settlement month vs. short same coupon in different month – Buy Sep GNMA 6%; Sell Oct GNMA 6%• Butterfly: Long “center” short “wings” – Buy FNMA 6%, Sell FNMA 5.5% and 6.6%• Agency-to-Agency: Long/short agencies in same coupon – Buy FNMA 5.5%, sell GNMA 5.5%• 30-year vs. 15-year: Buy FNMA 20 year 5%, Sell FNMA 15 year 4.5%• Mortgage vs. Treasuries or Swaps: Long (or Short) mortgage basis with expectation of spread compression (or widening) vs. Treasuries or swaps
  64. 64. Basis Yield Alpha Fund• Diversified Global Structured Credit Securities and Derivatives – Asset Backed Securities (ABS) – Mortgage Backed Securities (MBS) – Collateralized Debt Obligations (CDO) – Collateralized Loan Obligations (CLO)• Market Opportunities – Diversification benefits of pool of assets and high recovery rates – Lower default risk and credit migration – Uncorrelated to other asset classes – Premium from Illiquidity and complexity and because traditional fund manager investment mandates stop at investment grade – Issuance in 2004 of $160 billion• Personnel – Three portfolio managers – Four analysts
  65. 65. Concordia Advisors• Concordia Advisors hired Christopher Dillon and James Wise, former co-heads of JPMorgan’s tax-exempt structured product group to manage a new fund, The Concordia Municipal Opportunities Fund, which will launch Oct. 1.• Fixed income, interest rate neutral relative value fund will invest exclusively in the U.S. municipal bond market.• Concordia has $1.2 billion in assets under management in eight other hedge funds.
  66. 66. Introduction to Asset Securitization• “What is a Mortgage”• Mortgages as a Fixed Income investment• What else can you securitize?
  67. 67. Tradable Fixed Income Supply U.S. Dollar Denominated Debt Market US Treasuries 25% Mortgages 43% US Agency 15% Corporates ABS Sov/Supers 13% 2% 2% (2002 Information)
  68. 68. What are Mortgage Backed “Pass-Through” Securities? + + = Securitized Mortgage Pool or Pass-throughs • A number of similar mortgages (underlying collateral, design, rates and maturities) are combined into a single group • Mortgage documents associated with this group are delivered to a custodian and are assigned an identification (pool) number • A Mortgage Backed Security (MBS) is issued with a face amount equal to the cumulative outstanding principal balance of the mortgages (original balance) • The mortgages that have been pooled together serve as the collateral for the security • Most MBS are guaranteed and/or issued by a U.S. Government Agency (FNMA, Freddie Mac or GNMA)
  69. 69. Agency Conforming MBS Origination Process Individual MortgagesResidential loans Average Balance $125,000 Gross WAC: 8.50%originated within the Pooled by Mortgage Banksconforming Agencyguidelines are Judged for Sale by Balanceguaranteed by an Conforming (2000 cap of $275,000), Non-Conforming Documentation and Pay HistoriesAgency, sold to the ggStreet then eithertraded in pass-through form or used GNMA 8.50% 8.50% FNMA/FHLMCto structure a CMO… BOUGHT BY AGENCIES -.44 % -.06 % (servicing fee) (guarantee fee) -.25 % -.25 % (next FHA/VA 8.00% 8.00% FNMA or FHLMC 30 Yr. page) Mortgage Banking TRADING (Sells - Buys) Trading Desk CMO Desk PO 6.5 yr F Z STRUCTURING Floater $50mm P2 CMOs $40mm 20 yr $100mm 6.5 yr REMICs PA PB 4 yr $250mm $50mm S E.G.: $500 FNMA issue 5 yr 10 yr Inverse Floater $10mm 6.5 yr END Agencies Banks & Insurance PURCHASERS Mortgage ~ 20% Companies & Servicers Regional Desks ~ 40-50% ~ 20%
  70. 70. Non-Conforming MBS Origination Process Individual Mortgages Average Balance $125,000Loans that do not Gross WAC: 8.50%conform to Agency Pooled by Mortgage Banksstandards are sold in“whole loan” form or Judged for Sale by Balance Conforming (2000 cap of $275,000),structured into a Non-Conforming Documentation and Pay Historiessenior/subordinateprivate label CMO… Either Whole Loans (previous Loan Geographical locations, zip code, property type, page) Characteristics pay history, original and current LTV, Reviewed: occupancy, purpose, insurance Ability to Pay Willingness to Pay Value of Asset D e t e r m i n e d B y: Credit Underwriters GSMC Custodian - Income verification - Tape data - BPO - Asset verification - Current 12 month pay - Appraisal - Financial ratios (FICOs) history - Geography - 30,60,90, 120+ day - Zip Code delinquencies - Age Or Senior/Subordinate 96% 4% Tranche by Credit Tranche by Time AA 15% 13.1 yr Subordinated A 15% 13.5 yr Aaa BBB 12% 13.8 yr $50 mm 6 yr Tranche BB 19% 14.2 yr $30 mm 12 yr B 12% 15 yr UR 27% 16 yr
  71. 71. Who Buys Mortgages? Mortgage Security Holdings byBanks and Investor Type in 2002…Agencies driveinvestment flows Amounts in $US billions Agenciesin the mortgage 32%market, holdingnearly 60% of all Pension FundsMBS 9% Life Insurance Cos Foreign Investors 11% 15% Other Banks 8% 24%
  72. 72. Overview of the U.S. Mortgage Securities Market• Largest Sector of the U.S. Debt Market: – Aggregate current principal amount outstanding mortgage loans is over $4.9 trillion as compared to about $3.3 trillion of government securities and $4.4 trillion of Corporate bonds. – Mortgage backed securities (MBS) are an integral part of any broad portfolio exposure to the U.S. Government securities. The U.S. investment grade corporate debt market is less than 1.5 trillion in size.• MBS can enhance portfolio performance significantly – Major mortgages indices have outperformed comparable duration U.S. Treasuries by an average of more than 140 bp over the past 10 years. – The U.S. mortgage market consists of a wide array of securities to suit most investor needs. A full range of credit qualities, durations, risk profiles and yields exist in this market.• High Credit Quality – Most of the MBS market is issued by U.S. Government agencies which have an implied AAA rating: GNMA issues carry full faith and credit of the U.S. Government, Fannie Mae and Freddie Mac have the implicit backing of the U.S. Government. – Non-agency mortgage securities mostly consist of AA or better rated bonds. Lower 72 rated securities (down to single-B) are also available.
  73. 73. What’s the catch?• You are purchasing a product with an imbedded call option – Duration is very hard to determine. – Variability in Average Life can be substantial• You are purchasing an amortizing product – Reinvestment of Principal monthly can reduce yield.
  74. 74. "Duration" Deserves Special Focus in Mortgages...• Modified duration, Macaulay duration, cashflow duration: all measure a mortgages price sensitivity to rate movements, assuming the cashflows are held constant. – Usually not a good assumption in mortgage product owing to prepayments – Durations often quoted as a percentage of modified duration• Option-adjusted duration (OAD), model duration: measure price sensitivity for small rate movements, assuming constant OAS – Doesnt account for how securities actually trade – Reliant on prepayment model• Empirical duration, EOAD: regression of performance vs rates – can be price or OAS vs rates – adjusted for volatility, slope of the curve
  75. 75. Prepayment Risk• Prepayment Option – Any payments by borrower made in excess of scheduled principal payments are called prepayments – The option is defined by the borrowers right to prepay all or part of the mortgage at any given time – The uncertainty for the mortgage holder which results is termed prepayment risk• Prepayment Motivation – Prepayment may occur for one of several reasons • sale of property • default • refinancing – Motivations beyond rational economic considerations play an important roll in assessing prepayment risk• Risk for Mortgage Holder – Interest rate risk (re-investment risk): Should mortgage be fixed-rate, market risk arises as a result of prepayment if rates fall and coupons are above market – Liquidity risk: Should mortgage portfolio be securitized for debt issuance, prepayment implies the need to raise new financing 75
  76. 76. Duration and Convexity• Duration (simply): price yield• Convexity is the change in Duration as yields change Positive Convexity Negative Convexity Price Price 45 40 40 35 35 30 30 25 gain from gain from 25 convexity 20 convexity (negative) 20 15 15 10 10 5 5 0 2 3 4 5 6 7 8 2 3 4 5 6 7 8 Yield (%) Yield (%)
  77. 77. Options and Convexity• If you are long a call option – are you long gamma or short gamma?• Why is being long an MBS similar to being short a call option? Who are you short this option to?• Can you hedge this with options?

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