The Diverging Fortunes Between Bond and Borrower

SKIING AND TRADING

Deer Park Road has 14 employees who work in offices steps from the slopes of the Steamboat ski resort. Poles and skis hang from the walls. The only sign that it’s a hedge fund operation are trading terminals. Its main offering is the STS Partners Fund.

Fund founder Michael Craig-Scheckman, 61, has an advanced physics degree from Columbia University. The native of Queens, New York, got his start in finance in the late 1970s, when cousin Asher Edelman – a 1980s corporate raider and partial model for Gordon Gekko in the movie “Wall Street”- introduced him to a firm that traded metals.

In the 1990s, as Monzione was trying to kick his drug habit, Craig-Scheckman was working at a hedge fund called Millennium Partners. There, he traded asset-backed securities – bundles of real-estate loans, credit-card debt or aircraft leases which then could be bundled into even more complex pools. By 2010, he was running Deer Park full time, where he hired Scott Burg, an expert in mortgage bonds.

They began assembling a portfolio that would lead to their banner 2012. The main goal: Hunt for beaten-down bonds that have loans yielding cash.

In August 2011, Deer Park bought a subprime security called Citigroup Mortgage Loan Trust 2006-SHL1. They paid 25.5 cents on the dollar for the bond at a cost of $1.2 million.

Last summer, Burg was searching for securities yielding 20 percent or more. A rally in mortgage bonds made the hunt a bit more difficult. “It did require us to turn over more rocks,” the fund manager told clients in an investor letter.

On August 3, Burg was pitched a potential deal by a small Florida broker. A middle piece of the MABS 2006-FRE1 bond, the broker said, was available for 15.75 cents on the dollar.

On the surface, the bond looked ugly. Some 57 percent of the loans underpinning it were 60 days or more delinquent.

But Burg liked the fact that the bond had some protection against losses: 27 percent of the loans would have to be valued as completely worthless, and the homes backing those loans would have to be worth zero, before Burg would lose a penny. Additionally, a further $300,000 in losses would have to emerge.

He calculated that enough borrowers were making payments to produce a steady stream of cash – some $5,000 a month, equal to about $60,000 annually on the $1.7 million purchase price for 21 years. “It had a very attractive profile,” Burg recalled. He bought it.

Some of the most famous trades of the financial crisis involved investors, such as U.S. hedge fund manager John Paulson, betting on a fall in housing prices or a rise in defaults. Deer Park’s play was different. It was attempting a simple act of bargain-hunting and would profit if housing rebounded.

“If homeowners do better, so do we,” Craig-Scheckman said.

“FEROCIOUS”

Thanks to the Fed, however, Deer Park did well even as many homeowners didn’t.

The Fed announced its third round of QE on September 13, 2012. Prices of the subprime mortgage bonds held by Deer Park jumped in tandem with the Fed’s target asset, mortgages guaranteed by government-sponsored enterprises Fannie Mae and Freddie Mac. Subprime paper, the supply of which had been falling as the underlying borrowers either repaid their loans or went bust, suddenly looked more attractive because of its much higher yields.

“I don’t think anyone saw it coming,” Burg, 34, said of the reaction. “I don’t think anyone saw how ferocious it was.”

Deer Park began finding buyers willing to pay top dollar. Six days after the Fed announced QE3, Burg sold the Citigroup bond for 39 cents on the dollar, or $1.8 million, a profit of 50 percent. By February, the value soared to about 65 cents on the dollar.

“This is one I wish we never sold,” Burg said.

But other opportunities abounded. On November 30, a broker in New York reached out to inquire about buying the MABS 2006-FRE1 bond on behalf of a client.

Burg negotiated briefly – about an hour – before striking a deal at 11:08 a.m. Mountain time: $4.2 million for a security he’d paid $1.7 million for four months earlier. “Given the level that they were talking, there was too much of a profit to walk away from,” Burg said.

Deer Park’s fund ended the year up 27.43 percent. By comparison, the Standard & Poor’s 500 Index was up 16 percent. As its holdings gained value and new client money flowed in, assets under management at Deer Park sextupled to nearly $1 billion this March from $148.5 million at the end of 2011.

Burg and Craig-Scheckman believe the rally in the subprime bond market can continue if the housing market improves. But they also are hunting for beaten-up securities linked to commercial property.

CASH FOR KEYS

In October 2008, as Craig-Scheckman was setting up Deer Park’s main fund, Monzione was in deep trouble. The bank that acts as a trustee for MABS 2006-FRE1 investors initiated foreclosure on his home.

With the help of his brother Paul and sister Ann Marie, both lawyers, Monzione filed for bankruptcy. He then sued the bond trustee, alleging that Fremont had engaged in predatory lending.

But Monzione made a “lousy client,” said Paul. At one point, Paul and Anne Marie told their brother to park $500 a month in escrow to build a pool of cash. That would have shown a history of payments to buttress his case, or provided a lump sum payment if he lost. Instead he bought more home wares from estate sales so he could sell them on eBay, hoping that he could persuade a judge to order a refinancing of his loan.

Paul tried to work out a new loan with the creditors. The problem, as many troubled borrowers have found amid the housing crisis, is that because the loan was included in a pool sold to investors, it was impossible to find one lender to negotiate with.

In January, a judge dismissed Monzione’s last remaining claim. Monzione recently reached a “cash for keys” settlement in which he will be paid a sum of money in exchange for leaving the home. Paul declined to specify the amount.

Monzione is preparing to move out, rent an apartment and find storage for his figurines and antiques. The house remains cluttered with them. A porcelain Pinocchio doll recently was listed at $70.51 on his eBay page.

Asked how he felt that a bond containing his loan was such a bonanza for Deer Park, Monzione tried to be philosophical.

“That’s amazing. And I mean, even after the fact that it’s already crashed the entire United States economy,” he said. “My paper is in there. It’s not worth two cents.”

(Edited by Paritosh Bansal and Michael Williams)

Courtesy of Reuters

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