Brevan Howard Buying CMBS Sees 60% Gains for Teachers: Mortgages

Brevan Howard Buying CMBS Sees 60% Gains for Teachers
A security guard stands outside the building housing the offices of Brevan Howard Asset Management LP in London. Photographer: Chris Ratcliffe/Bloomberg

Brevan Howard Asset Management LLP is seeking returns of as much as 60 percent within two years by buying some of the riskiest commercial mortgage backed securities as Europe’s debt crisis pushes down prices.

The $36 billion investment firm is purchasing bonds created during the real-estate boom leading up to 2007, according to people with knowledge of the strategy, who declined to be identified because it’s private. Brevan Howard created a CMBS fund that may be as large as $1 billion, probably lasting through 2014, and will return 20 percent to 60 percent, the Pennsylvania Public School Employees’ Retirement System said in an April memorandum on its website, recommending a $200 million investment with the hedge-fund manager.

Brevan Howard, whose main fund hasn’t had a down year since it was started in 2003, is wagering on debt that’s plunged about 22 percent since May 2011, after Greece’s sovereign fiscal crisis spread to Spain and roiled credit markets globally. Values of securities linked to skyscrapers and shopping malls have tumbled even as U.S. commercial-property prices rose 4.3 percent in the first quarter from the same period last year, according to Washington-based research firm CoStar Group Inc.

“Given the broad-based market selloff, prices have returned back to levels where projected yields in the mid teens are once again possible, attracting the attention of hedge funds,” said Harris Trifon, head of commercial-mortgage bond research at Deutsche Bank AG in New York.

Never Down

The Brevan Howard Master Fund has gained every year since former Credit Suisse Group AG trader Alan Howard started it in 2003. The fund returned 12 percent in 2011 after it made a bullish bet on U.S. Treasuries and U.K. gilts, wagering that increasing market risk would cause investors to flock to the safest assets. By contrast, hedge funds fell 5.8 percent on average in 2011, posting their second-worst year ever, according to data compiled by Bloomberg.

Brevan Howard spokesman Anthony Payne declined to comment.

The pension system, which had about $48 billion in assets at the end of 2011, first allocated to the investment firm in May 2010 with $350 million, Evelyn Tatkovski, a spokeswoman for the Pennsylvania teachers’ retirement plan, said in an e-mail. This is its first CMBS-only manager, she said, declining to comment beyond the publicly available memorandum from James Grossman, deputy chief investment officer, to board members.

Fallen Angels

The CMBS fund will mostly buy so-called AJ commercial mortgage bonds, many of which have been cut to junk after being assigned AAA grades at issuance, said the people. While it will invest in securities created from 2005 to 2007, when underwriting standards slipped and issuance soared, it can buy from other years, one of the people said.

The investment firm is wagering prices of the securities are factoring in too high a level of economic malaise, the person said. Moderate improvements in the economy or additional central bank intervention in bond markets would lift the prices closer to par, he said. The fund has the option of closing before the end of 2014 or extending by an extra year, according to Grossman’s memo.

A benchmark gauge of AJ prices has declined to 57.8 cents on the dollar from 73.8 cents in May 2011, according to Markit Group Ltd. data. It dropped to 54 cents last month, the lowest level this year, as investor concern grew about potential losses in the Spanish banking system.

CMBS deals from 2005 to 2007 helped inflate property values by channeling cheap financing to landlords until sales dried up after losses from U.S. home loans froze credit markets. That year, banks sold a record $232 billion of CMBS, financing deals including Tishman Speyer Properties LP and BlackRock Inc.’s $5.4 billion acquisition of Stuyvesant Town-Peter Cooper Village. The owners of Manhattan’s biggest apartment complex defaulted in January 2010.

Delinquencies Rise

Commercial property prices have dropped more than 34 percent from the 2007 peak, CoStar said last month. The delinquency rate on U.S. commercial mortgages packaged and sold as bonds rose to 11.9 percent in May as borrowers struggled to pay off maturing loans from the boom era, according to a Morgan Stanley report last month. The surge marks “the third sizable consecutive month-over-month increase,” analysts led by Richard Parkus in New York said.

The rate of increase had shown signs of slowing prior to the recent jump, said Nick Levidy, an analyst at Moody’s Investors Service.

“We are at or close to the bottom” in the commercial real estate market, Levidy said last month. There are risks though to buying lower-rated bonds, which absorb losses first as defaults climb. They can be damaged if a single building loses a tenant and can’t cover debt service on its mortgage as a result, said Levidy.

Higher Returns

Hedge funds, money managers and insurers, including American International Group Inc., have been investing this year in the $553 billion CMBS market to gain higher returns as the U.S. central bank holds interest rates near zero through at least 2014.

Brevan Howard was among investors that bought property debt held by the New York Federal Reserve in April, according to a statement from BH Credit Catalysts Ltd., a publicly-traded company that feeds money it raises from investors into a fund run by the investment firm.

Brevan Howard’s credit fund is headed by David Warren, the former head of structured credit trading at Morgan Stanley. In 2010, Brevan Howard hired Morgan Stanley mortgage trader Ahsim Khan, 30.

Picking Bonds

The New York Fed acquired the bonds as part of the 2008 bailout of AIG, with the securities parceled inside collateralized debt obligations. Barclays Plc and Deutsche Bank paid an estimated 67 cents on the dollar, JPMorgan Chase & Co. analysts said in an April report. The banks broke apart the CDOs and sold underlying bonds to investors.

The Catalyst fund “successfully participated in the first Maiden Lane III CDO of CMBS liquidation, purchasing underlying CMBS bonds at prices lower than the levels at which CMBS had been trading earlier in the year,” it said in a statement.

“If you’ve got the right commercial real estate skill set, it’s a great way to pick up yield,” said Lisa Pendergast, a debt strategist at Jefferies Group Inc. in Stamford, Connecticut. “It’s extremely important you pick the right bond. You can get 100 percent of your money back on the right bond, or you can lose all your money. Your potential 60 percent return could evaporate pretty quickly.”

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