They are known as the major culprits behind the precipitous collapse of investment banking firms Bear Stearns and Lehman Brothers in 2008. Debt securities backed by subprime mortgages managed to bring down lenders like GMAC Mortgage, major banks like Washington Mutual and even foreign financial institutions like Northern Rock. In 2012, however, subprime mortgages did not look too toxic to hedge fund managers.
According to recent reports from financial research firms, 2012 may not have been the greatest year for hedge funds. The S&P 500 outperformed average hedge funds by more than 5 percent in 2012, but they still came out ahead by 5.5 percent thanks to investing in subprime mortgage-backed securities.
Survivors of the Mortgage Meltdown
The eye of the storm passed over subprime mortgage from about 2007 to 2010. The high foreclosure activity during those years contributed to the labeling of mortgage-backed securities as toxic assets. By late 2010, however, hedge fund managers noticed that the remaining debt securities backed by subprime mortgages in the United States were performing remarkably well.
The best performing hedge funds currently investing in subprime mortgages are managed by individuals who were instrumental in the development of these securities. The difference now is that the secondary mortgage market is not in a frenzy, which means that these managers have time to pick the best subprime mortgage-backed securities to invest in. They are looking closely at those lenders that are making a serious effort in helping borrowers climb out of negative equity situations.
Stopping the Flow of Defaults
Debt securities backed by subprime mortgages are very risky financial instruments. Their damaging effect on the secondary mortgage market scared investors off and caused a huge capital void. In 2010, hedge fund managers noticed that number of defaults on subprime mortgages had significantly decreased.
Hedge fund managers focused their investments on subprime mortgages serviced by banks that actually cared about stopping the flow of loan defaults. The returns on these investments in 2012 were impressive; between 20 and 35 percent in many cases. One of the main reasons behind these comeback is that several hedge funds moved in at once and provided sorely needed capital to this market.
Nevertheless, hedge fund managers know that this rebound can't last forever. In fact, many believe that it may already be over and are already looking at different opportunities. With the housing market in the middle of a recovery, hedge fund manager will probably look at the greener grass of home builders and burgeoning real estate investment trusts (REITs) instead of subprime mortgages.