The 25% loss recently reported by hedge fund manager Beacon Hill Asset Management was a result of a series of duration bets gone awry, according to several mortgage-backed securities professionals who have traded with the hedge fund. In short, the fund had structured a leveraged bet that interest rates would not continue to drop; when rates continued to decline, the fund was stuck with a large short position in the 10-year note, the primary beneficiary of the rate rally. Beacon Hill's CIO, Tom Daniels, referred questions to Wallach and Associates, who did not provide comments by press time.
The basis for the loss was a series of trades put on in inverse floaters carved from the support tranches of collateralized mortgage obligations, according to two individuals who sold the securities to Beacon Hill. These inverse floaters are highly negatively convex and structured to drastically shorten in duration in a falling rate environment. Against this, the fund had shorted a large number of 10-year U.S.Treasuries, which have a fixed duration.
The fund, in a prepared statement released two weeks ago to the Wall Street Journal, says its losses were due to "accelerated mortgage prepayments" and an increase in the price of U.S. Treasuries. This prompted reactions of scorn and incredulity from Beacon Hill's peers in the fixed-income arbitrage community, most of whom had spent the last several months positioning their portfolios to cope with historically low morgage rates and Treasury yields. "It is beyond preposterous, and speaks to the issue of credibility, to argue that any professional, let alone those guys, could have been surprised by [MBS] prepays at any level," said a manager at a large New York hedge fund.
The trade could have been much less painful, argue several mortgage derivatives pros who count Beacon Hill as a client, had the fund simply decided to spend a little more money up front and buy the optionality needed to hedge the negative convexity of their portfolio. "I don't think their thinking was de facto inappropriate, in terms of thinking rates wouldn't move lower. What was inconceivable was that they simply bet the ranch on their hunch."
For now, Beacon Hill is said to be continuously reducing its positions, under order's from one of its largest customers, Société Générale, which had given the fund $100 million to manage in a separate account, according to a filing made last Thursday with the Irish Stock Exchange. The filing said SocGen has removed Beacon Hill from the management of its funds.