(Bloomberg) — Deer Park Road Management Co.’s flagship hedge fund posted the biggest loss since its 2008 debut after wrong-way bets on a recession and mortgage bonds dented an otherwise stellar record of returns.
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The firm’s STS Master fund lost 23.4% in 2023, according people familiar with the matter. Most of the declines happened in January, when it suffered its worst ever monthly drop of of 11.7%, and during the second quarter, according to an investor letter seen by Bloomberg News.
“Coming out of 2022, the assets in our long book were priced for a recession that never happened,” Deer Park Chief Investment Officer Scott Burg told Bloomberg News in an interview. Last year, the fund “maintained a defensive positioning given the economic data and our outlook, but the damage had been done,” he said.
The fund also lost ground by shorting the high yield index, which unexpectedly rallied hard toward the end of the year on optimism that interest-rate cuts were on the horizon, boosting other credit hedge funds.
The Steamboat Springs, Colorado-based money manager is known for its wildly lucrative wagers on deeply discounted mortgage- and asset-backed securities in the wake of the 2008 financial crisis. Following the US Federal Reserve’s most aggressive tightening cycle in a generation, yields on securities tied to mortgages have surged, while a turmoil at regional banks added to volatility.
“The hedges performed well during the banking crisis in March, which helped protect the book during that market drawdown,” Burg said.
The STS Master fund manages $1.81 billion and mostly holds legacy residential mortgage-backed bonds, and also holds some commercial mortgage positions that it’s been accumulating since 2020, according to Burg.
Deer Park’s founder Michael Craig-Scheckman, who pursued a doctorate in X-ray astrophysics in the 1970s before turning his talents to finance, was one of the first employees at Izzy Englander’s Millennium Management. He founded Deer Park Road in 2003 and set up the STS Master fund during the 2008 financial crisis. The company, which also trades corporate debt, had generated mostly double-digit returns yearly since 2008.
Over the years, the firm has been known for taking bold swings. In 2022, Burg put on a sizable stock options wager that Elon Musk’s Tesla Inc. would be “squashed like a bug.” The Tesla position represented a short-term hedge in the portfolio at that time.
“This was a low cost, out-of-the-money, long put position representing a short-term hedge almost two years ago,” a spokesperson for Deer Park said.
As markets prepare for the Federal Reserve to start cutting interest rates this year, the money manager is expecting its bets, of which the vast majority include legacy residential mortgage-backed securities (RMBS), to gain momentum in 2024.
Policymakers in the US have recently suggested they’re ready to begin discussing the broad parameters for lowering rates after giving the subject only a passing nod at a meeting in December. Several have also indicated a willingness to entertain rate cuts in the first half of the year if inflation falls faster than expected.
Deer Park said its RMBS positions have 16 years and longer of seasoning, which means the underlying mortgage loans existed prior to 2007, and that the loan-to-value ratios are around 30-40%, implying that there’s around 60-70% of home equity.
“The assets we have will perform extremely well, particularly factoring in any rate cuts this year,” Scheckman said in the same interview. “We think it’s about getting back to basics with our core long book.”
Such is his conviction on a rebound in mortgage bonds that Deer Park is planning to launch its debut mortgage opportunity fund this year, and is targeting as much as $200 million for a strategy that offers a 12% hurdle rate, with a three-year lock-in.
(Updates with AUM in seventh paragraph, Deer Park comment in 10th.)
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