Financial News (FN) — Hollywood has created the perfect David vs. Goliath theme upon its release of The Big Short based on Michael Lewis’ best selling book. Wall Street professionals know that reality underlying Hollywood’s streamlined version of events is often far more nuanced.
In the summer of 2006 Steve Eisman, Vincent Daniel, Porter Collins and Danny Moses had become convinced that Sub-Prime Mortgage market was rotten to the core. At the time, the four were overseeing the FrontPoint Financial Strategies Fund. The issue they faced was that their fund was an equity long short hedge fund, a portfolio approach that did not include an allocation to bonds. While they could enter into short positions on the equity of companies involved in the U.S. mortgage market, the team felt that shorting mortgage bonds directly offered the best risk-return proposition. The team came up with a plan for a second fund named the Financial Horizons Fund. This fund would have a broader mandate that included both stocks and bonds and would short sub-prime mortgages, the homebuilder value chain, and low quality consumer credit instruments.
However, the team faced two additional challenges. Despite FrontPoint Partners having strong sales and marketing capabilities, investors were initially hesitant to allocate money to Financial Horizons. Investors were piling capital into structured credit funds that were utilizing leverage to purchase mortgage securities, including the sub-prime variety. Further, there was some resistance from a few Partners within FrontPoint to a long-short equity team trading in complex fixed income securities.
At the same time, the Co-Portfolio managers of the FrontPoint Multi-Strategy Fund were becoming concerned about the increasing levels of risk in the broader credit markets. Gil Caffray and Michael Litt oversaw an active allocation amongst all of FrontPoint strategies within this fund. Despite the Multi-Strategy Funds diversification, the two felt that exposure to credit risk was becoming increasingly important to nearly every strategy. Caffray had been observing extremely high rates of home price appreciation in places such as San Bernadino, Naples, and Las Vegas. Litt had written an in-depth research piece entitled “The Great Compression” highlighting how fundamentals in the credit market had become disconnected from credit pricing due to leverage embedded in structured credit products. The two portfolio managers were seeking a means of hedging out this growing risk to the credit markets in the Multi-Strategy allocation.
Eisman, Daniel, Moses, and Collins made their pitch on Financial Horizons being an ideal solution to hedging out portfolio credit risk. At the same time, the FrontPoint Fixed Income Opportunities Fund managers came forward with a second hedging idea for Multi-Strategy. The portfolio managers Dan Donovan, Richard Grindon, Eric Grannan, and Tom Felgner pointed out that by the summer of 2006 implied volatility across capital markets had reached historic low levels. They petitioned Caffray and Litt on launching the FrontPoint Financial Opportunities Fund. This would create a second hedge by establishing net long volatility positions across equity, credit, currency, and commodity markets.
After spending a few months doing work on each of the strategies, Caffray and Litt decided to fund both teams from Multi-Strategy with between $75 and $125 million. In making the allocations they were not so much trying to earn large profits but rather hedge risk in the larger Multi-Strategy Fund. This was not without controversy as some partners at FrontPoint were very much against funding the strategies given the bright outlook prevalent in the summer of 2006. In the end, the perseverance of each of the portfolio managers ultimately saved FrontPoint’s investors a great deal of money. Within a year there were a handful of institutional investors that made direct allocations in each of the new fund strategies. Those investors profited greatly from those investments. Underwriting contrarian strategies during low volatility periods similar to 2006 gets left on the cutting room floor in Hollywood, but on Wall Street, it is the stuff out of which movies are made.