Sunday, July 22, 2007

Mr. Vranos Has a Deal for You

Published: July 22, 2007

HEDGE fund managers are not short on chutzpah, as a rule. But it takes a special kind of cheek to ask investors at this very tender moment in the housing market for $750 million to fund a new company specializing in subprime residential mortgage loans.

Michael W. Vranos, celebrity bond trader and founder of Ellington Management, has that audacity. And then some.

Mr. Vranos oversees $5.4 billion in hedge funds and private accounts, and an additional $1.2 billion in a managed account, while also managing almost $23 billion in collateralized debt obligations (pools of loans backed by assets like home loans or credit card debt).

That might be enough to keep others busy. But Mr. Vranos is also peddling shares in a new entity called Ellington Financial LLC. An offering statement, dated July 12, began circulating on Wall Street last week; it is a private placement aimed solely at institutional investors, like pension funds and insurance companies. Friedman Billings Ramsey is the underwriter.

On its face, it may sound like a promising deal for speculators. Subprime loans are in the tank, as everyone knows. Surely there is money to be made picking up distressed properties for pennies on the dollar.

And isn’t Mr. Vranos one of the world’s leading experts on mortgage securities? The Ellington prospectus certainly confirms this. “He was praised during the difficult bear market of 1994 by Jack Welch, chairman of Kidder Peabody’s parent company, General Electric,” it noted, “who said that Mr. Vranos ‘has done a better job than 99 percent of the managers at G.E. at managing a cycle.’ ”

When Mr. Vranos was head of the mortgage securities trading desk at Kidder Peabody back in the early 1990s, Fortune magazine called him “one of the best bond traders on Wall Street,” the filing boasts.

The filing is silent, however, on a near calamity Mr. Vranos had with his fund during the financial crisis of 1998. When Long Term Capital Management imploded that fall, credit markets seized. Three hedge funds run by Mr. Vranos lost about 25 percent of their value but stabilized after he auctioned $2 billion in securities to meet margin calls.

ELLINGTON MANAGEMENT has obviously thrived since then. The filing shows that since 2000, Mr. Vranos has handily beaten the fixed-income average, producing double-digit gains in all those years but two.

His performance so far this year is not as stellar. At the end of May, his mortgage-backed credit funds were up 1.8 percent; his “composite” hedge fund return for the period is 3.81 percent.

But is now the time to raise $750 million in permanent capital on a subprime spending spree?

Subprime mortgage loans are certainly far cheaper now than they were just a few months ago. Still, the shakeout in the industry may have only just begun. Last week, major lenders like Washington Mutual and Countrywide Financial said they would no longer offer the most popular subprime loans, those carrying low two- or three-year fixed rates that then reset to much higher levels. As access to those loans is cut off, subprime borrowers will have greater difficulty refinancing billions in mortgages whose rates are shooting up right now. Defaults are likely to rise, even from today’s high levels.

Granted, timing is everything in market matters — and Mr. Vranos certainly has been through his share of up and down cycles.

Yet the timing of Ellington Financial’s hoped-for debut is intriguing because it appears to be a way for Mr. Vranos to unload subprime assets he bought a few months ago at higher prices than they would likely fetch today on investors.

Some $70 million of the offering’s proceeds is expected to go toward buying equity in something called Spyridon Holdings, which owns a real estate investment trust that Mr. Vranos’s management company formed in May 2007. It bought $345 million of the riskiest portions of mortgage pools, known as equity residuals, issued by the New Century Financial Corporation, a subprime lender that declared bankruptcy in April. New Century made the loans from 2003 to 2006, the filing said.

The $70 million earmarked from Ellington Financial’s investors to buy those assets will cover about 40 percent of the roughly $170 million Spyridon put up to buy them — it borrowed the rest. In return, Ellington Financial investors will receive 40 percent of Spyridon.

But what inquiring Ellington investors should want to know is exactly how those New Century residuals are being valued and whether that amount reflects reality or fantasy.

The Ellington prospectus says that the amount to be paid, estimated at $70 million, will be based “on fair market valuations of the New Century residuals provided at the time of purchase by one or more independent third parties.” But Ellington goes on to say that it expects any difference between those valuations and the $345 million purchase price to reflect only whatever cash the assets have distributed to Spyridon since they were bought and “any changes in interest rates over the course of such period.” Some $50 million in cash has been distributed by the New Century residuals, the filing said.

No mention is made about the decline since May in the values of subprime loans over all and in New Century loans in particular. Even the lender’s high-grade paper is taking a hit — last week, Standard & Poor’s downgraded by one notch several AAA-rated New Century securities consisting of second lien assets.

The problem, traders say, is that residual interests in New Century mortgage securities are not trading, so any valuation of the $345 million stake will likely be based on a model, not a true market. Besides, if the assets were such a good trade for Mr. Vranos, investors might be wondering, why is he sharing that largess?

Asked Friday whether the offering is a way to dump poorly performing securities onto investors for a higher-than-market price, Mr. Vranos first said that I should not have obtained a copy of the prospectus because it is a private placement. All he would say about the New Century residuals is: “I don’t know if they’ve declined. I’m not responsible for pricing them — we use third-party pricing. That’s obviously a question that potential limiteds ask all the time. Obviously we have an answer.”

Josh Rosner, an authority on mortgage-backed securities at Graham-Fisher, an independent research firm in New York, looked at the Ellington Financial filing details that I forwarded to him. He said: “If you are exposed to significant losses on a mark-to-market basis, your goal is, within the legal framework, to avoid having to take that mark. One of the ways that people are starting to avoid that is to resecuritize assets and put them into other vehicles at par. I think there is a strong chance that may be what’s happening here.”

So in addition to jettisoning some of the New Century residuals, the transaction with Ellington Financial may allow Mr. Vranos to value those that he owns elsewhere in his financial empire at a higher price than he otherwise could.

Hedge funds are unregulated entities and they want to remain that way. That is fine with me. But transactions like this one seem almost certain to draw scrutiny. And hedge fund managers as smart as Mr. Vranos should know that.