The Hot Zone of Subprime Contagion

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There’s been a lot of talk around these parts of late about the “best” way to tell someone who’s given you money for your hedge fund that the money went away and isn’t ever coming back. There’s the James Cayne-method, which involves lies, deceptions and distractions via use of funds with 10 words in their name. The “I’m sorry, I’m sorry, stop yelling at me”-autistic rocking/crying way, made famous by Jeff Larson. And if Third Point ever sends such a note, we imagine it’ll be something along the lines of, “Jesus fuck, people, we lost your money. Quit your bitching and move on.” (And if it’s not, consider us disillusioned).
Hayman Capital Management is in the singular position of not losing money, folding, or being reduced to tears and cutting at the hands of subprime, like so many of its hedge fundy brethren. Having had the foresight to realize that subprime may be sub-optimal, HCM is now enjoying gains of 240% thanks to a little technique called shorting. So they’re in no position to write an “our b” letter to investors. If they did, its sheer magnificence probably could’ve prevented this morning’s apocalypse. We make this prediction based on the cancer-curing letter managing partner J. Kyle Bass sent to investors on July 30, explicating why subprime is here, queer, and everyone should get used to it.
Here are some of our favorite passages, but if you do anything today besides stand under the dryer in the men’s room, read this thing in full.

I recently spent some time with a senior executive in the structured product marketing group (Collateralized Debt Obligations, Collateralized Loan Obligations, Etc.) of one of the largest brokerage firms in the world…This individual proceeded to tell me how and why the Subprime Mezzanine CDO business existed. Subprime Mezzanine CDOs are 10-20X levered vehicles that contain only the BBB and BBB- tranches of Subprime debt. He told me that the “real money” (US insurance companies, pension funds, etc) accounts had stopped purchasing mezzanine tranches of US Subprime debt in late 2003 and that they needed a mechanism that could enable them to “mark up” these loans, package them opaquely, and EXPORT THE NEWLY PACKAGED RISK TO UNWITTING BUYERS IN ASIA AND CENTRAL EUROPE!!!! He told me with a straight face that these CDOs were the only way to get rid of the riskiest tranches of Subprime debt. Interestingly enough, these buyers (mainland Chinese Banks, the Chinese Government, Taiwanese banks, Korean banks, German banks, French banks, UK banks) possess the “excess” pools of liquidity around the globe.
These pools are basically derived from two sources: 1) massive trade surpluses with the US in USD, 2) petrodollar recyclers. These two pools of excess capital are US dollar denominated and have had a virtually insatiable demand for US dollar denominated debt…until now. They have had orders on the various desks of Wall St. to buy any US debt rated “AAA” by the rating agencies in the US. How do BBB and BBB-tranches become AAA? Through the alchemy of Mezzanine-CDOs. With the help of the ratings agencies the Mezzanine CDO managers collect a series of BBB and BBB- tranches and repackage them with a cascading cash waterfall so that the top tiers are paid out first on all the tranches – thus allowing them to be rated AAA. Well, when you lever ONLY mezzanine tranches of Subprime RMBS 10-20X, POOF…you magically have 80% of the structure rated “AAA” by the ratings agencies, despite the underlying collateral being a collection of BBB and BBB- rated assets…The ensuing HORROR SHOW will be worth the price of admission and some popcorn.

I met with various mortgage lenders, originators, economists, and capital markets professionals. The overriding theme that I got from them was that “Everyone committed fraud and everyone is responsible for the problem”. They told me that they believe that 90% of all Subprime loans that were made contained some kind of fraud.

…Not to mention the downfall of the poster child of the levered “positive carry” industry, United Capital Market’s Horizon Fund – managed by John Devaney, owner of the aptly titled 142ft yacht, the Postive Carry (which is incidentally now for sale, all enquiries can be directed to

Hayman Letter