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To the outside world, hedge funds have historically been seen as closed organisations that seem to make a lot of money – though, granted, most people haven’t the foggiest how they do it. Well now could be the time for more clarity.

Hedge funds are increasingly coming in for scrutiny, and nowhere more so than in the mortgage industry.

Having enjoyed considerable regulatory freedom, these investment funds, which are frequently perceived as secretive and open to a limited range of investors, have traditionally undertaken a wide range of activities often not open to other investment funds.

Frequently operating on the fringes of the market, they have become synonymous with high risk and large profit.

Active in many markets, they are found investing in a broad range of assets, from shares, art and commodities and increasingly mortgage portfolios.

Contrary to the implication that hedge funds lay off or hedge risk they often do the reverse.

They will enter into transactions which are highly geared or use such techniques as short selling shares where they borrow someone else’s shares relying on an ability to buy them back and return them at a lower price hence making a profit.

As we have now seen, apart from possible impacts on the market prices, this doesn’t always have the desired effect for the hedge fund.

Hedge funds have also been big investors in mortgage backed securities. They would raise a fund from private investors and then raise debt against this from a bank to enable them to buy mortgage backed securities.

The funding line would be secured on the securities they buy. One fund I was speaking to recently told me that until the credit crunch it would leverage itself 99 times.

This means that for every £1 invested, it would borrow another £99 allowing it to invest in a £100 of mortgage backed securities in total.

This leveraging has now fallen out of the system post credit crunch which explains why hedge funds have dropped out of the primary issuance investment market for mortgage backed securities.

Why has this happened? Two reasons: firstly raising any sort of debt is now pretty much impossible and secondly hedge funds have caught a cold both from investing in US mortgage backed securities that defaulted.

Perhaps more importantly, a number of them have failed because they were required to put up cash against falling secondary market values of the mortgage backed securities they had invested in.

This is important since this perceived problem with mortgage backed securities is not always to do with poor performance of the underlying mortgage backed securities themselves but they get tarred with the same brush.

Although investment in new mortgage backed securities issues has waned, a new market opportunity has arisen for these trading driven businesses.

With so many investors in mortgage backed securities strapped for cash and capital, mortgage backed securities paper has been dumped in the market at significant discounts to its real value.

A good example of supply and demand at work. For example, if a hedge fund can buy a security at say 50p in the pound simply because someone is desperate to liquidate their holding (and where the real value if held and worked out over time is probably nearly double that), why would a hedge fund want to invest in new issues where he has to pay 100p in the pound?

The same is true of mortgage portfolios themselves where existing lenders are exiting their businesses at significant discounts.

This is all well and good but there is a potential problem here. When mortgage regulation was implemented four years ago a loophole was unwittingly allowed to exist. What is this?

Lending to borrowers to buy their homes became a regulated activity but once the loan has been made, ownership can be transferred to a non-regulated entity.

This allowed securitisation to proceed without hinder and in that context was a good thing. Nothing wrong in that.

But it also allows loans to be transferred to unregulated hedge funds and this could be a problem.

Hedge funds, not unreasonably will want to get their money back as soon as possible and make a profit. If they have purchased a mortgage for 50p in the pound then anything they receive in excess of this when the loan is repaid is a profit.

Realistically, with many of these portfolios being non-performing mortgages and no active sub-prime market for the borrower to refinance to, this will probably mean a repossession.

Could the hedge fund be more aggressive and heavy handed than a conventional lender?

Probably. All is not lost though as these loans are administered by regulated third party administrators such as Homeloan Management who have to meet the demands of regulation.

Will this loophole be left to exist? Probably not but let’s hope that in the haste to close it the government and the Financial Services Authority do not impair the ability to transfer loans to a SPV for the purposes of a securitisation.

I’m not sure the securitisation market can take too many more knocks at the moment.


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