Bad Loans Pit Vranos Against Cayne as Hedge Funds Outbid Street
By Bradley Keoun (Bloomberg)
June 18 (Bloomberg) -- James E. ``Jimmy'' Cayne helped make Bear Stearns Cos. the mortgage
king of the securities industry by packaging home loans into bonds and selling them to clients like
Michael Vranos. Now Vranos, who manages $29 billion at Ellington Management Group LLC, is
cutting Cayne out of the middle and buying mortgages on his own.
On Wall Street, they call that disintermediation, and it's eating into almost $9 billion of fees that firms
including New York-based Bear Stearns earn from securitizing mortgages. Instead of buying such
bonds at markups of 1 percent or more, hedge funds expect to make better returns by taking over
bad debts and pressing borrowers to pay up.
The hedge funds are targeting delinquent or poorly written loans, a market JMP Securities LLC
analyst Steve DeLaney says may double this year to $150 billion as a record number of borrowers fall
behind on payments. Bad bets on mortgages have discouraged bankers from bidding, leaving industry
veterans like Vranos to snap up home loans for as little as 30 cents on the dollar.
``There are times in the past when I wouldn't have gone up against a Wall Street firm,'' said Tim
Campbell, a managing partner at Steel Mountain Capital Management LLC, the Lakewood,
Colorado-based buyer of delinquent loans that's backed by hedge fund Silver Point Capital LP. Now,
in the market for distressed loans, ``all is fair. I'll get some and they'll get some.''
Subprime Shakeout
The increased competition comes as Bear Stearns already is reeling from a six-month shakeout in the
market for subprime mortgages, loans made to borrowers with bad credit or burdensome debts.
Shares of Bear Stearns have dropped 7.8 percent this year, the worst performance in the Amex
Securities Broker/Dealer Index, and Cayne, the firm's 73-year-old chief executive officer, last week
reported the firm's first decline in quarterly earnings since 2005.
Bear Stearns also began liquidating at least $3.8 billion of holdings in one of its own hedge funds
because of money- losing bets on subprime bonds. A 10 percent drop in sales of new asset-backed
securities could cut Bear Stearns's revenue by 1.3 percent, according to Douglas Sipkin, a Wachovia
Securities analyst. Sipkin expects Bear Stearns to report $9.49 billion of revenue this year, up about 3
percent from 2006.
``There are still ways for us to make money in this,'' said Thomas Marano, head of mortgages at Bear
Stearns, pointing to opportunities for loan financings and securitizations where both securities firms
and hedge funds can profit. ``I kind of like having them here, because I always have the option to
partner with them.''
Taking Advantage
Both sides will have plenty to bid on, with the average U.S. home price headed for its first drop since
the 1930s and mortgage defaults through May up 49 percent from the same period of 2006, according
to Irvine, California-based RealtyTrac Inc. Late payments on home loans are the most in the 17 years
that the Federal Deposit Insurance Corp. has kept records and foreclosures reached a record in the
first quarter.
``As soon as there's an opportunity, people like ourselves will find ways to take advantage,'' said
Mani Sadeghi, managing partner of New York-based Equifin Capital Partners, a private- equity firm
that invests in financial-services companies.
Equifin teamed with New York-based hedge fund Och-Ziff Capital Management in January to invest
$125 million in mortgages and related assets. They also bought a home-loan billing and collections
unit from San Diego-based Accredited Home Lenders Holding Co.
At New York-based Lehman Brothers Holdings Inc., which has surpassed Bear Stearns this year to
become the biggest U.S. underwriter of mortgage bonds, fixed-income trading revenue fell 14 percent
in the second quarter. The firm said ``weakness in the U.S. residential mortgage business'' was to
blame.
Reluctant Bidders
The subprime crisis is making investment banks more reluctant to bid for new pools of distressed
loans that come to market and that's giving hedge funds ``quite a bit more clout,'' said William
Looney, an executive vice president at Boston-based Debt Exchange Inc., which brokers sales of loans
for banks and securities firms.
Hedge funds are mostly private and unregulated pools of capital where managers can buy or sell any
assets, participating substantially in the profits of the money invested.
``When the market was healthier, we found more value in securities,'' said Laurence Penn, a former
Lehman mortgage- trading executive who helped found New York-based Ellington in 1994. In today's
distressed market, the individual loans look like better deals, he said. Vranos, 45, wasn't available to
comment, Penn said.
Ellington Steps In
Ellington has bought mortgages this year with an unpaid balance of more than $3 billion, including
$170 million purchased for about $58 million from New Century Financial Corp., the bankrupt
mortgage lender based in Irvine, California. That beat an initial offer of $47.25 million by Royal Bank
of Scotland Group Plc's Greenwich Capital. Deutsche Bank AG, Countrywide Financial Corp.
and Credit-Based Asset Servicing and Securitization LLC, known as C-Bass, also bid
unsuccessfully.
New York-based Fortress Investment Group LLC's Newcastle Investment Corp. bought $1.3
billion of loans this year from an undisclosed seller. Earlier this month, Chicago-based Citadel
Investment Group LLC acquired Brea, California-based ResMae Mortgage Corp. through a
bankruptcy auction after bidding 98.5 cents on the dollar for the company's remaining $160 million of
loans. Credit Suisse Group lost with an offer of 98 cents.
``You're seeing hedge funds beating the traders to the punch,'' said Jeffrey Garfinkle, a partner of the
law firm Buchalter Nemer, who specializes in mortgage-company financing.
Gauging the Risks
Sometimes loans can't be salvaged. Franklin Credit Management Corp., a New York-based company
specializing in distressed-mortgage investing, posted a first-quarter loss of $1.95 million, citing
higher-than-expected default rates on loans bought in 2004 and lower-than-anticipated values on
foreclosed properties.
``There's a lot of volatility to the assets, so you'd better have a reasonable price to compensate for
that risk,'' said Mike Dubeck, co-head of the U.S. residential mortgage unit at Morgan Stanley.
``Nothing says you always make money.''
Wringing returns from bad loans may get tougher as two dozen state lawmakers consider more than
70 bills to protect homeowners, according to an analysis of data provided by the National Conference
of State Legislatures in Washington.
Distressed mortgages are handled by “scratch-and-dent'' traders, a label retailers slap on bangedup appliances that may or may not work so they can be sold at deep discounts.
Damaged Goods
In the loan business, the term denotes damaged goods whose borrowers missed payments or walked
away entirely, as well as mortgages where lenders misplaced crucial documents or applied rules too
loosely. Fixing those flaws, the theory goes, can make the loans more valuable -- and a fast profit for
hedge funds.
``Most people will tell you there's no such thing as a bad loan, just a bad price,'' said Thomas
McCarthy, co-head of loan sales at Carlton Group Ltd., a New York-based real estate investmentbanking firm.
Bear Stearns bought about $3.4 billion of scratch-and-dent mortgages last year, about 5 percent of
the $69.2 billion of loans that the firm's EMC Mortgage Corp. acquired or made to borrowers. EMC is
the firm's loan-servicing company, based in Lewisville, Texas, with about 2,000 employees.
Some hedge fund managers learned the trade by sorting through the $500 billion of loans sold by the
government-backed Resolution Trust Corp. in the early 1990s as part of the bailout of failed U.S.
thrifts.
Douglas Goodman, one of Sadeghi's Equifin partners, is a former First Boston Corp. investment banker
who once invested in loans purchased from RTC. Fortress CEO Wesley Edens and a principal at the
firm, Robert Kauffman, were traders together at Lehman in the late 1980s and early 1990s.
Earnings Welch's Praise
Steel Mountain's Campbell said he met his company's three other co-founders when they were
executives together at Matrix Capital Bank in Denver, which bought loans through RTC.
``Some got lucky and some were better than others,'' said Alexandria, Virginia-based consultant Bert
Ely, who wrote a paper comparing the RTC era with the Great Depression. ``Those who made a lot of
money talked about it and those who didn't probably kept their mouths shut.''
Vranos was paid $15 million in 1993 when he ran Kidder, Peabody & Co.'s mortgage trading desk.
That was almost four times the amount earned that year by Jack Welch, CEO of Kidder's parent
company at the time, General Electric Co. Welch said in 1994 that Vranos ``has done a better job
than 99 percent of the managers at GE at managing a cycle.''
Do-It-Yourself Bonds
For now, bids from hedge funds may be helping Wall Street by preventing a deeper swoon, said Steve
Moyer, a director at Santa Monica, California-based Tennenbaum Capital Partners LLC, which has
about $7 billion under management. Markets for subprime home loans came almost to a standstill
during the first quarter as buyers fretted about the surge in delinquencies.
Some hedge funds may be willing to outbid investment banks for mortgages because they plan to
increase profit by bundling repaired loans into securities themselves, a direct challenge to firms like
Bear Stearns and Lehman. Hedge funds are already asking bond ratings services about the procedure,
said Dan Tegen, a Standard & Poor's analyst who rates scratch-and-dent securities.
``We're actually seeing a lot more smaller parties interested in doing one, maybe two deals a year,''
Tegen said. ``There's going to be more competition coming into this product.''
Transactions backed by scratch-and-dent loans climbed to 40 last year from nine in 2002, according to
data compiled by Fitch Ratings. Securities firms began making money by pooling those mortgages into
bonds early in this decade, once they figured out how to mix them with enough better-performing
mortgages to make investors comfortable with the risk, said Michele Patterson, a New York-based
analyst for Fitch.
`Big Boys'
The biggest underwriters of such bonds include Bear Stearns, Lehman and Morgan Stanley.
Others are Calabasas, California-based Countrywide, the biggest U.S. mortgage lender, and C-
Bass, a New York-based joint venture of mortgage-insurers MGIC Investment Corp. and Radian
Group Inc.
``These are big boys and they're going to defend themselves as best they can,'' said Brad Hintz, an
analyst in New York at Sanford C. Bernstein & Co.
Wall Street firms including New York-based Merrill Lynch & Co. and Morgan Stanley spent at least $2.5
billion last year buying home lenders to assure a supply of mortgages to package into bonds.
Securities firms got about $27.4 billion worldwide in revenue last year from underwriting, trading and
holding bonds backed by mortgages and other assets, according to a June 4 report by Kian
Abouhossein, a London-based analyst at JPMorgan Chase & Co.
Most hedge funds waited until this year to follow suit, buying lenders and firms that handle billing and
collections.
Debt Collection
``In this latest wave, these are opportunistic purchasers,'' buying mortgage lenders and collections
businesses for little or no premium, said Jeff Levine of Washington-based Milestone Advisors LLC,
which advises mortgage companies on mergers and acquisitions.
When Ellington bought loans from Fremont General Corp. in April, it also signed a letter of intent to
buy the subprime lender's residential-mortgage business, including employees responsible for
collecting on the loans. Terms weren't disclosed.
Carrington Capital Management LLC, led by former Salomon Brothers mortgage trader Bruce
Rose, paid $188 million last month in a bankruptcy auction for New Century's servicing unit. The
fund raised its bid from $139 million after Morgan Stanley and two other firms joined in the auction.
Peeking Inside
Having employees to oversee mortgage collections makes it easier for owners of the loans to decide
whether to delay a foreclosure for homeowners who might be able to resume payments. Servicers also
may get more intimate knowledge of the property values underlying individual loans.
If hedge funds can get a borrower to make four consecutive payments, the mortgage can be tagged
as ``reperforming'' and sold for a gain of 15 percentage points or more, said Jeffrey Kirsch, CEO of
Miami-based American Residential Equities, which invests in distressed home loans.
Fair-housing advocates like the Association of Community Organizations for Reform Now, or Acorn,
say some borrowers simply can't pay because of illness or job losses, and firms like Franklin Credit,
the distressed-mortgage specialist, report that foreclosure doesn't always yield the expected profit.
Franklin Credit executives said on a conference call last month that a home thought to be worth
$100,000 may turn out to have $20,000 of damage by the time a lender gets possession.
Missing Sinks
``The sinks are pulled or the refrigerators are taken and plumbing gets pulled,'' said Franklin Credit
CEO Thomas Axon, who got his start investing in loans sold through RTC.
Hedge funds also may find themselves ensnared in the patchwork of federal and state regulations
governing mortgage lending, especially on loans that may have been touched by fraud, said Louis
Pizante, CEO of Irvine, California-based Mavent Inc., which offers an automated system that checks
loans to see if they comply with lending laws.
``The hedge fund industry right now is awash with capital, and when you're awash with capital, you
have a lot of novices come in,'' Pizante said.
To contact the reporter on this story: Bradley Keoun in New York at bkeoun@bloomberg.net