Brownstein’s MBS Investment Philosophy

Don Brownstein, founder of the $2 billion hedge fund Structured Portfolio Management, appeared on Bloomberg Television’s “Inside Track” with Erik Schatzker this morning. Brownstein has just been named Bloomberg Markets’ Best Performing Hedge Fund Manager of this year. He talks about his investment philosophy in mortgage-backed securities and believes that the “Fed is on target with respect to its dual mandate” in regards to QE2.

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Here are the key highlights from the interview, courtesy of Bloomberg Television:

On why prepayments so important to investing in mortgage-backed securities:
For the most part, mortgage backed securities, until 2007, were regarded as being pretty safe in terms of defaults. There were low default rates and that was pretty uniform across the board. The real question that arose was when would people be paying their loans off. Most mortgages give the homeowner the right to pay their loan off early, at any time. So predicting when they would be paying their loan off becomes crucial to understanding what the yields would be on your security.

On why the default industry has been so benign:
When I first got into the business in 1988-1989, prepayments were pretty low. And what happened is in 1990, when the Fed began to move rates, prepayments picked up dramatically. When the 10 year bottomed in October 1993, at that point there had been three plateaus of rates and prepayments had accelerated way beyond what anyone had thought, for each of those drops in rates. That’s one of the questions that interested me: why and why there was so much variability in the response of mortgagors to a given rate environment.

I was actually more interested in the intellectual question of why it was that people who you would imagine would behave pretty much alike, were behaving so differently when it came to exercising their prepayment options, and I tried to understand why that was the case.

On his investing philosophy:
We tend to think about–there’s an old saying–it’s better to be lucky than good. I disagree about that. I think it’s important to be good at what you do, and the way you become good at what you do is through my opinion, understanding deeply what drives things, what makes things work. So for us, what we looked at, were the structures that were present in the residential mortgage backed security market and we tried to understand the differences in prepayments amongst mortgagors in terms of those different market structures, which are not ephemeral–they tend to be longer lasting.

On QE2:
I think it’s important to think about it in those terms as a grand experiment. Today we heard that former Chairman of the Fed Paul Volcker is leaving the President’s service. In 1980, we had what I described as a Volcker moment. I believe that the QE policy that was announced in November is going to be regarded down the road as the Bernanke moment. What Volcker demonstrated was that it is possible to whip inflation by the use of monetary policy. What I think is on Bernanke’s mind is to demonstrate that we can avoid deflation and the liquidity trap that the companies have by whipping deflation.

I think that the Fed is on target with respect to its dual mandate. As they stated, the dual mandate under the Humphrey Hawkins act is full employment and price stability. I think at this point it’s probably more difficult to explain to the public what price stability really mines. On the other hand, I think it’s a lot easier to explain what full employment means. I know the Fed has done a study recently to characterize what used to be called NARU, the non-accelerating inflationary rate of unemployment.

On what he thinks the Fed would look like today had quantitative easing and QE2 not been introduced:
Before Copernicus, there was the view that earth stood still and the sun moved around it. That was the view that told basically that the universe was static. That’s turned out not to be true. I think people who believe that policy is somehow or other exogenous to the behavior of fixed-income markets are just deluded. The Copernican Revolution took place a long time ago in physics and it’s about time that something like that took place in finance.

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