“I believe investors should take a slightly more charitable view to the hedge fund structure.“
Michael Vranos is the Founder & Chief Executive Officer of Ellington Management Group, a firm founded in December of 1994 to capitalize on distressed conditions in the MBS derivatives market. Michael’s Wall Street career began in 1983 at a time when the Federal Reserve was opaque in its actions and long-term plans.
“Keep more cash on hand to anticipate the panic of others.” Michael has taken this learning from the Crisis of 1998, coupled with best practices from the economic downturn in 2008, to prevent losses during the COVID-19 pandemic. As a result, the firm was able to put $3 billion to work when others experienced sell-offs.
Where are today’s opportunities? Simply put: fundamental value investments and relative value trades. Mortgages were not the source of the 2020 economic crisis, and selling them isn’t going to solve anything. With the Federal Reserve now owning $2 trillion worth of mortgages, they will have tremendous impact on that market going forward.
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SPEAKER
Michael Vranos
Founder & Chief Executive Officer
Ellington Management Group
MODERATOR
Anthony Scaramucci
Founder & Managing Partner
SkyBridge
EPISODE TRANSCRIPT
John Darsie: (00:08)
Hello, everyone, welcome back to SALT Talks. My name is John Darsie, I'm the managing director of SALT, which is a global thought leadership forum at the intersection of finance, technology, and public policy. SALT Talks are a digital interview series we started during this work from home period. Where we're interviewing leading investors, creators and thinkers. And what we're really trying to do during the SALT Talk series, is to provide our audience a window into the minds of subject matter experts as well as provide a platform for what we think are ideas that are shaping the future, as well as interesting investment opportunities. And today, we're very excited to welcome Michael Vranos to SALT Talks. Mike founded Ellington Management in December of 1994, to capitalize on distressed conditions in the mortgage backed securities derivatives market, and he was involved in that market even before it was considered sort of a hedge fund asset class.
John Darsie: (01:00)
Until December of 1994, Mike was the Senior Managing Director of Kidder Peabody, in charge of the RMBS trading division. When Mike was the head trader and the senior manager at Kidder Peabody, the mortgage backed securities' department became a leader on Wall Street in CML underwriting for each of the three years between 1991 and 1993. Mike began his wall street career in 1983. After graduating magna cum laude, Phi Beta Kappa with a Bachelor of Arts in Mathematics from Harvard University. He currently serves on the board of directors of the Boys and Girls Club, Hedge Fund Cares or now called Help For Children, as well as the Waterside School and he's an emeritus member of the board of the Stanford Shelter For The Homeless. So he's very involved in the charitable side of the hedge fund industry as well.
John Darsie: (01:50)
A reminder to our audience today. If you have any questions for Mike during today's talk, you can enter them in the Q&A box at the bottom of your video screen and conducting today's interview is Troy Gayeski who is the co-Chief Investment Officer and Senior Portfolio Manager at SkyBridge Capital, which is a global alternative investment firm. And Troy is also a contributor to salt. So Troy, thank you for joining us today. And I'll turn it over to you for the interview.
Troy Gayeski: (02:14)
Yes, thanks John. And Mike, it's really great to have you on here. And obviously, before we dive into market opportunities, which I know you're chomping at the bit to discuss. Just wanted to get a little more color on your background. I mean it's a fascinating story, how you came from relatively humble roots. Like many of us that have been on the screen, to running one of the longest, or successfully running a hedge fund that's been in business just about as long as any. And so we can take us through where you're born, how your schooling progressed, and then how you made your way to Wall Street, it'd be fantastic.
Micheal Vranos: (02:49)
Oh, thanks. Okay, thank you Troy. Sure, so I was born in Worcester Mass, and when I was young, our family moved to a town called Ellington, Connecticut. Hence, the eponymously named firm. And Ellington was and still to some extent still is a farm town. They grow shade tobacco there, which is tobacco that wraps cigars, corn, and there was a lot of dairy back then too dairy farming. My father was an engineer, and my mother was a nurse. And when I was young, I just spent a lot of time outside. And I played a lot of sports, I was a decent athlete, and I got involved in bodybuilding in my late teen years.
Micheal Vranos: (03:32)
When I got into Harvard, I was okay in math, and I spent a lot of time even at Harvard, in the gym at school. And this is important because it had some bearing on my decision to go into business because I kind of like being around people. And studying and being isolated was not exactly that. So I had written an undergraduate thesis and was given a grant by the NSF to go to graduate school in math, in Stanford. And at the very last minute, which is last minute meaning, let's say April of my senior year before graduation. I decided that it would be better to quote unquote, go into business. But I didn't know what go into business meant. I used to train with a fellow from the gym, from Harvard Business School. And he told me if I applied to jobs at Kidder Peabody, it would be great because the lunches were free, and they were very good. And if I was in sales and trading, I could be out by five o'clock and I could get to the gym. That sounded-
Troy Gayeski: (04:33)
Mike did they have protein shakes back then? And all the things they have today?
Micheal Vranos: (04:38)
Yeah, it was down at 10 Hanover square. And you could order out at the various places and things like that. It was good 80s food back then. So I decided to do it. And I was offered two jobs at Kidder Peabody, the two openings. And one was in sales and trading, and the other one was in project and lease finance. But the latter was one where I'd have to work more hours, but it was 24,000 instead of 22,000 a year. So I went for the lower salary job because I could get out at five. This was my brilliant logic back then. Anyway, so I started at the Chicago Board of Trade, and I ended up in New York by the fall of 1983.
Micheal Vranos: (05:17)
And I was supposed to be doing research in mortgages, but the traders stopped showing up to work. And they just kind of threw me in the seat. There I am 22 years old, having to figure out everything myself. There was no research group, it was pre-OAS. So the ideas of coupon compression and negative convexity, one had to sort of infer from the markets. Now, it's also important to realize back then, that rates were very, very high extraordinarily high. The current coupon mortgage rates had just dropped from 15% to 13 and a half percent, and rates have been more or less dropping for the last 40 years. And Kidder Peabody wasn't exactly Salomon Brothers, they ran the market back then. But we built our group up slowly over time. And as John mentioned, by the early 90s we became the largest CMO issuer on Wall Street and our group became the firm's profit leaders.
Micheal Vranos: (06:20)
We also produced back that a tremendous amount of mortgage backed derivatives. And in the early 90s, we developed agent based prepayment models that we still use today at Ellington to help us value these securities and these models. They consider each borrower as an individual agent who makes an economic decision to prepay or default based on certain factors, economic factors, and these agents comprise a distribution that we track over time, and that's the basis for the model. Anyway, so leaving Wall Street at the end of 94. And I'll get to the crisis of 94 later.
Micheal Vranos: (07:00)
It was a very good time, because the Fed had been raising rates precipitously, and mortgage backed securities, especially derivatives were highly undervalued. So as John mentioned, we formed Ellington in the last days of 1994. Although, it's important to say that the seeds of the partnership were planted almost 50 years ago. Larry Penn, who's our vice chairman and chief operating officer was a fellow that as a freshman I met at Harvard. And John Geanakoplos our head of research. The well known mathematical economist, and James Tobin, professor of economics at Yale is my cousin. The five of the six regional partners of Ellington... I'm sorry, of the six original partners of Ellington five are still with us today 25 years later.
Micheal Vranos: (07:51)
So we're now a firm of 155 people. We manage about 11 billion dollars across hedge funds, private debt, some long only, and permanent capital vehicles in the forms of REITs that traded in the New York Stock Exchange EFC and earn are the tickers. We write and use our own interest rate prepayment in default models for RMBS, CMBS. And corporates and as I mentioned, develop these models over decades. So that's, a little bit of my background. I can talk a little bit about some of the crises I saw back then, and how it applies to what we're seeing now if you're interested.
Troy Gayeski: (08:38)
Yeah, of course Mike. But before we get into that the question everyone's dying to ask is, how much can you bench press back in the day?
Micheal Vranos: (08:45)
Oh, that's an interesting question. You know-
Troy Gayeski: (08:47)
Don't take too long answer, though [inaudible 00:08:50] my man.
Micheal Vranos: (08:51)
Okay, I'm going to be very honest with you. 395.
Troy Gayeski: (08:55)
Not bad-
Micheal Vranos: (08:56)
It was okay.
Troy Gayeski: (08:56)
It's not bad for a man of your stature. I'll give you credit.
Micheal Vranos: (08:59)
I never got the 400 it was one of my worst lifts by the way the bench press it wasn't-
Troy Gayeski: (09:05)
Yeah, what was your best one the squat and the deadlift.
Micheal Vranos: (09:09)
Probably the squat, yeah.
Troy Gayeski: (09:10)
Squat, yeah. Same here man. That was always my most powerful movement. So, good for you.
Micheal Vranos: (09:16)
I don't know that it's done me a lot of good now at this point. But thanks for asking anyway. So-
Troy Gayeski: (09:24)
But segwaying back to business, because I know you've obviously been a huge lifter your whole life. In terms of the crises you went through, you've touched upon the 94 crisis with asking which is rate driven. You've obviously managed to long term capital, manage to the financial crisis. Just touch upon a few highlights and lessons learned or some of the keys that allowed you to survive. And then once we get through that I want to touch upon the longevity of your firm, because that's something that we feel people don't appreciate enough how difficult it is just to stay in business over time.
Micheal Vranos: (09:59)
Yeah.
Troy Gayeski: (10:00)
So shoot on the crises lessons and some of the experiences there. And then we'll get into some of your keys to longevity.
Micheal Vranos: (10:07)
Okay yeah, sure. So with all these crises, we've tried every possible way to get out of business, and it hasn't happened yet. But there's plenty of mistakes made, and there's a lot to learn. And I think the first real stark sort of learning experience and example, was the crisis of 94. To which you alluded, which is the precipitous rise in rates starting in the early spring of 94, and it's really important to realize back then. The Fed was secretive about their plans. They prided themselves in being sort of opaque with their plans, and they tightened and raised rates seven times, pushing libor from three to 6% over the course of the year in less than a year.
Micheal Vranos: (10:48)
And this was a total disaster for MBS derivatives, which were these highly leveraged securities that carry durations of at least 20 years, sometimes 30 years with negative convexity as well. So a lot of real money accounts lost money back then like mutual funds and things like that. But there was one hedge fund in particular, and there weren't many back then by the name of Asking Capital that had these securities levered as well. And that was my first experience in seeing the deadly effects of the combination of leverage and miscalculation of risk. And the two sort of work together they conspired to create a disaster. And also sort of the rapaciousness of lenders at the time, where there was not a big idea of forbearance back then. And I think, in the COVID crisis now, I can see anecdotally, I thought lenders acted more nobly than they had back then in the 90s. That's been my observation.
Micheal Vranos: (11:50)
Anyway, and then there was as you alluded to the crisis of 1998 the LTCM crisis. And that was also very interesting. And that was a crisis of leverage. And that was rather specific to hedge funds unlike the great financial crisis. And if I recall correctly, and someone in the audience might know better than I, and can check my memory. But they sent out long term capital sent out a letter on July 31 of 1998 stating that they were down 51%, and I think that was the number. So I found that to be incredibly odd, because it being down 50% given that kind of leverage, was akin to saying, "Okay, I've got the edge of his dime, and I'm going to put it on the edge of this razor blade, and it's going to balance."
Micheal Vranos: (12:45)
And that's just not an equilibrium point for a leveraged fund. And so something was going to have to... Either you're going to recover or blow up. And we know what happened, but the aftermath of that was an unnamed prime broker was making very aggressive margin calls to Ellington, and other hedge funds at the time trying to break term financing even before maturity. And we had a lot of term financing out. And I think they just made the calculation they'd rather take legal risk than market risk. And they were just looking for margin just to blow out all their borrowers.
Micheal Vranos: (13:25)
So from that, I learned three important lessons. One is not to trust anybody, two is to keep more cash on hand than you otherwise would think to anticipate the panic of others. And three is don't let your prime broker hold your money. A prime broker can hold up your trades and cause fails to others. So you can use prime brokers and we use prime brokers, but they shouldn't control your money. You should be your own prime broker. And that's not easy. That's why at Ellington we have so much infrastructure, because you need to develop great systems in risk management to hold your cash. But I think it's crucial.
Troy Gayeski: (14:10)
Yeah. And it would also be fair to say having low leverage, right? That was a lesson from both 94, and 98 correct?
Micheal Vranos: (14:15)
Absolutely, but that becomes sort of a follow on from your work backwards from there. You have to figure out how much cash you need in these scenarios, and that governs your leverage. So it's a sort of that's the flow of logic.
Troy Gayeski: (14:33)
And obviously, many of those lessons help you survive the financial crisis, and then also help mitigate losses in March as well, so-
Micheal Vranos: (14:41)
Yeah.
Troy Gayeski: (14:41)
... there's been much discussion on the financial crisis. I thought you touching upon LTCM in 94, which seems like eons ago was very informative. Why don't we segue to March and how you're able to mitigate losses compared to many of your peers.
Micheal Vranos: (15:00)
Okay, so March was interesting. So that, was a time where there was obviously a crisis of leveraging cash as well. And it has to do with managing, again left tail risk. So what we've done internally as we had, and have a lot of what if scenarios? For example, what if high yield goes down 10%? What if high yield goes down 15%? What happens to RMBS, CMBS in corporates. Particularly mezzanine tranches that carry a little extra interest rate, but whose delta will expand tremendously. So negative credit convexity, if you will, in scenarios that I've described to you. And then on top of that, what happens when that happens to haircuts?
Micheal Vranos: (15:55)
And those are the sort of what if's and scenarios that we had run. Starting actually since 2008. And even before that helped us sort of survive and actually put money to work after the March crisis of this year. I also think it's you can't underestimate the importance of having the right kind of investors so that when you call them, they come alongside. Because, the amount of money that you might husband for this sort of situation isn't nearly as impactful, as if you have investors that are willing to come along with you. And so if you could indulge me for a second, I need to get on my soapbox about this one issue with investors because although we had Ellington managed both hedge fund ENP style capital. I believe investors should perhaps take a slightly more charitable view toward the hedge fund structure. We should all keep in mind that hedge fund investors own a put. They can take the cash and put the securities back to the manager at any time oftentimes in inopportune times.
Micheal Vranos: (17:11)
And they can do this because they may have their own liquidity needs, or see better opportunities elsewhere. So as a hedge fund manager, you need to manage that put as well. And that's a drag on returns, quite frankly. Alternatively private equity, they have a call on cash, that's a drag on investor returns, and that accrues positively to them. So we are actually here at Ellington in active discussions with some pension allocators. You know that we sort of like, "Who owns that put, and what's the value of that worth PE versus, versus hedge fund." And I think it's an interesting, separate topic of discussion. But anyway, I'm digressing a bit but the point is that if you have clients that you can call even if you're a hedge fund in a crisis you can ameliorate this problem. And that's one of the ways that we put about three billion to work in April in May once the crisis hit.
Micheal Vranos: (18:13)
But again you're forced to be really fastidious about managing this left tail risk, and the liquidity so that you can buy and not sell in a crisis. And that includes not just putting aside capital, but effectively credit hedging, effectively having robust models that will tell you more or less where you think your assets will be in a big move. I mean keep in mind, the high of the index move 20% in a very short amount of time. So even in our risk scenarios, we needed to extrapolate a bit where we had down 10 and down 15 to some degree. So-
Troy Gayeski: (18:50)
Mike before we get into the key opportunities today. I think you touched upon two key points that have led to your longevity one is obviously a culture of risk management. Two is having a client base that knows when there's a buying opportunity, and isn't selling bottoms repeatedly, which is a recipe for disaster in any strategy. So those are two keys that I think that have led to your success. Are there several others that you'd like to mention that it led to just the longevity?
Micheal Vranos: (19:21)
Well, I do think modeling risk is very important. I can't emphasize that enough, because you really have to fly the plan. You're going to at times, it's like you're a pilot on instrument reading at times, because we've seen times where certain mezzanine CLO tranches for example, that we thought had the risk of let's say, of a high yield index, when it was at 108. Going to have maybe four times the risk of the high yield index, when the high yield index was 15 points lower. I don't even know that the PM believed it, but it was true. And so you need to, because modeling is really, really important to get the risks right at various times, not just now. Because, it's one thing to model risks, local risks, it's another thing to model risks for big moves. And it's not so easy, especially with moves that you haven't seen before. There's no way to know that you're going to be exactly right.
Micheal Vranos: (20:26)
Another thing I think, is it's obviously no small feat to get investors to come along with you. Investors have their own stresses at these times A. And B I think, even when an investor is looking to invest with you. And we've been around for 25 years and we're easy to check out and all that. Sometimes it takes months or even years and then the opportunity's gone. I think it's almost a little crazy sometimes. I understand how we got to that point in this industry, but I think it can hamstring investors at times too. That's a separate issue. Anyway, so-
Troy Gayeski: (21:04)
So definitely a culture of strong risk management, having clients that will stick with you in draw downs and actually add capital are very key. And it's very interesting you bring up the point of doing your in house modeling, right, which I think is a key to all success for investors is that they're not relying upon third parties to provide them with information sources, they're taking the raw data, and actually compiling outputs that make rational sense for informed decision making. You'd agree with that right, Mike?
Micheal Vranos: (21:30)
I do agree with that. I also think there's some great independent research that goes on out there. And you don't want to have the hubris to think you have all the answers and things. But in the end, you need to control your own data set, you need to know what's going into the cooking, if you will. So I think it's very important. It's expensive to do that by the way, of our 155 people roughly a third, or so or more. Are so how investment professionals have a high order, right? So the way we do things Ellington, it's a very collaborative environment. So we have the PM, and the assistant PM, and the desk analyst, and the researcher all sitting together. They're all part of a team. But any breaking that chain can be tough, if you're looking at some point, if you're just relying on an outside vendor, maybe that particular chain might not be necessary. But that's just not the way that we've chosen to do things.
Troy Gayeski: (22:35)
So Mike, let's segue into today's opportunities. Obviously, there's still areas of dislocation and structured credit. There's a lot of discussion on where pre-payments means are going to be on a go forward basis. So touch upon some of the favorite areas that you see for opportunities the next 6, 12, 18 months.
Micheal Vranos: (22:54)
Okay, sure yeah. So basically, there's two general sets of opportunities. And this is a very, almost a dumb statement. But there are the fundamental value investments. And then there's relative value trades, let's say. And the Fed has really engineered a broad tightening of almost all assets, right? So I think going blindly long is probably not the best prescription right now. And it is harder to find fundamental value investments, but they do exist. And I think one is in non agency mortgages still. And I can go into a little bit of detail about that if you'd like. But if you look and see, so what was the provenance and the opportunity. Was again, this massive selling of these assets on Sunday, basically on March 22nd by REITS.
Micheal Vranos: (23:54)
Leading up to that you would seen a lot of same day selling from really well known, long only managers leading up to that week, looking to raise cash. So this was a cash grab. And the selling by the time that week ended was rather indiscriminate. It was a selling of all structured products, but mostly legacy non agency mortgages, and later on NPL and RPL mortgages, but unlike 2008, like I said, mortgages were not the cause of this problem, and then selling them was not going to be the solution. I believe that was a big technical move, and that there's a lot of value. So what's happened since then? And why do I think that?
Micheal Vranos: (24:38)
Well, there's technical and fundamental reasons why I think that, first of all, is in response to what happened. And maybe everyone knows this, but it's really important to say nonetheless, that the Fed has had tremendous impact on the mortgage market and structured products. They've increased their holdings, net of pay downs, and you mentioned prepayments Troy, so net of pay downs, that's not a small step fee of 600 billion. And so they'll they own two trillion of mortgages, which is like 30% of the $6.7 trillion pasture market. Okay, and to think that-
Troy Gayeski: (25:12)
Yeah, all agency pastures right, Mike?
Micheal Vranos: (25:14)
Yeah.
Troy Gayeski: (25:14)
I [inaudible 00:25:15] to specify for people.
Micheal Vranos: (25:16)
Yeah, agency pastures exactly. And their balance sheet has increased 2.7 trillion since March. So it's the rising tide, is that lifting almost all boats at this point. And this is a substantially faster increase in balance sheet than other of the QE programs. So there's a lot of technical support, let's say for this market. And so what's going on right now, in non agency RMBS. So first of all, from a fundamental standpoint the housing market right now is incredibly strong, which is a positive for the securities. There's very little downside, I believe in legacy nine agency securities right now because of the low LTV. So the legacy RMBS house price appreciation, adjusted LTV is right now, are 50% or less. Meaning that for a typical borrower the outstanding loan value is only about half the value of the house itself.
Micheal Vranos: (26:22)
And these loans on average have been in existence for 15 years, and they were being paid through during the great financial crisis or have been rehabilitated and such. And we can still source that product outside of 250 basis points. Sometimes it's wide as 300, also sort of as a cousin to those securities, we saw some interesting bonds recently that have been subordinate trenches off of re-performing deals at 500 basis points to libor. In each of these types of securities are really insensitive to delinquency. And I think you'll see that the delinquencies in that market are quite high, they're probably like 18% or something like that. But even if you were to double those delinquencies and take into account what the existing defaults would be. CDR is almost at 20, and such like that, you'd still get your capital back. And you'd probably get a decent spread to libor, what we calculate in many cases 200 to libor.
Micheal Vranos: (27:24)
So it's a great risk reward. And that's with the backdrop of the Fed, and the backdrop of the strong housing. And I mean housing's just really been incredibly strong Troy. You've got house prices went up a lot in July, I think it's 25% month over month in July, and they're up eight and a half percent on-
Troy Gayeski: (27:46)
Annualized, annualized.
Micheal Vranos: (27:50)
Annualized.
Troy Gayeski: (27:50)
Yeah, that's quite a move.
Micheal Vranos: (27:51)
Right. But eight and a half percent since January, I believe.
Troy Gayeski: (27:56)
Oh, it's incredible yeah.
Micheal Vranos: (27:58)
Yeah, big jump in July. And supply is very tight also, right now we have the lowest July supply if you measure by month of inventory in housing, since it's been measured in 1982, going back to 1982. So these are really great fundamental and technical support for non agency mortgages.
Troy Gayeski: (28:29)
And so Mike, that's a great summary of opportunity and legacy RMBS, you want to talk briefly about the non QM market, because that's another area of opportunity you're saying?
Micheal Vranos: (28:36)
Sure. So the non QM market and this ties into REITs because I think the non QM it is an investible market. It's not as nearly as big as these other markets. But I do believe there's an indirect way to get exposure to these markets also through REITs. But nonetheless, let me talk about non QM and then tell you about different ways to access that market. Because, a lot of the value in non QM goes through the securitization from origination through the securitization chain. But the non QM market consists of borrowers who have over 700, FICO that are making healthy down payment. So these are 75 LTV borrowers who are paying coupons close to 6% right now, which is double that of an agency mortgage, and more than 500 basis points over the 10 year treasury. So, you can imagine that there's an incredible value in that chain.
Troy Gayeski: (29:41)
In amortizing securities too, right Mike.
Micheal Vranos: (29:43)
Yeah, amortizing 30 year secure... So it's almost a little crazy. So anyway, and what's interesting to me is that if you look at REITs in particular REITs, that house originators. They seem to be the ones to me that seems to be the most undervalued. So they're owning that supply chain and those securitization profits, and they're being valued in many cases at 60% price to book. And I think if you look at the REIT market in general, and that's why I think it's an indirect exposure, if you will. But I still think it's something to talk about because the backdrop is what just happened with Rocket and you'll ever know where did Rocket come in, 20 times earnings or something like that. And most REITs are owning their own originators about one time margin. And I understand these originators aren't Rocket, but there's a big chasm there, if you will.
Micheal Vranos: (30:40)
So if you look at the $1 billion REIT ETF REM right now that's down 40%, almost year to date, but almost like 62% of the constituents of that REIT are RMBS type hybrid RMBS REITS. So you've got these REITS that have mostly exposure to residential mortgages that are comprising this index that's down a lot on the year. Okay, so you can say should it be or shouldn't be. But the average price to book that we find of the 10 hybrid REITs that we follow is around 70%. So I believe you can buy today's assets at last month's prices or two months ago's prices, by getting into some of these REITs. And again, with the REITs with the originator arms, the price to book is even lower. And you want to look for these REITs that are functioning now like Ellington financial, for example that are taking advantage of this origination and refinancing boom that's going on right now.
Troy Gayeski: (31:49)
And then Mike, really quick before we turn over to John, for questions from the audience. Sort of get your thoughts really quick on CMBS, as well as CLOs because that's another area-
Micheal Vranos: (31:56)
Yeah.
Troy Gayeski: (31:57)
Both of those sectors, you're very active in.
Micheal Vranos: (31:59)
Sure. So that's actually dovetails with what I think is the second set of opportunities, which is more relative value. Because there are some headwinds in the corporate and CMBS market, that's obvious. But there's also some very good news, like in CMBS for example. Troy it's important to realize that that markets blessed with great hedging indices. There's substantial relative value opportunities with CMBS hedges that exist right now. And there's some pretty wide bases just between cash and the index itself. Sometimes as wide as 250 basis points, also a lot of the marginal dollars left that market, a lot of hedge funds can't participate anymore.
Micheal Vranos: (32:43)
And so we recently committed to buying a first class B strip at a very attractive levels were 300 basis points wider than pre-COVID. And we were also able to shape the collateral pool which is really important, and that brought it that strip to us it meaningfully wide spreads outside of 17% no loss, those are generally zero to eight or zero to seven and a half scripts. So it was we see opportunity there in the basis, in-
Troy Gayeski: (33:14)
Mike what do you think that is loss adjusted with the cleaner collateral 12, 15?
Micheal Vranos: (33:19)
So that's, a complicated question because generally, it's not a question of... I don't know, ultimately what the losses will be. It's the timing of the losses that matter most, we generally look to sell off the mezzanine tranches and own equity in those particular cases. And so knowing that we don't value the principal part of the equity very high, but that we value the interest payments rather high because we feel that there'll be an attenuation of losses, but ultimately it's very possible to have these high single digit losses. I do think it's possible without a doubt. But that's why again, I espouse more of a relative value approach to these markets. The same thing in CLOs for example. Do you have any other questions about CMBS?
Troy Gayeski: (34:14)
No, I think it's great if we jump to CLOs.
Micheal Vranos: (34:17)
Yeah, so for CLOs again, it's the same idea. The Legacy CLO market right now is all over the place. Tier one managers with on the run bonds are really enjoying some pretty good execution on their collateral but for other managers, especially where you've got shorter to maturity de-leveraged structures out of the reinvestment period. Sometimes the price discovery is horrible and there's a lot of negative price pressure there, I think. Some for selling and we're able to buy de-levering post reinvestment CLOs like 20, attach 40 detached at 750 to libor unlevered and these things have 115% NVOC. So they're covered for now, it would take an extreme stress for the high yield index for that tranche to take loss, tranche like that.
Micheal Vranos: (35:08)
So hedging with the high index on a sort of a collection of those types of securities. We think that's a great relative value trade.
Troy Gayeski: (35:17)
Yeah. So that's a great way to end our segment and turn over to John. I got a new nickname for you, though Mike. It's 395 Mike, you like the sound of that? I like that.
Micheal Vranos: (35:27)
400 sounds better, but-
Troy Gayeski: (35:29)
It's sort of come on, man. I like how you kept it real and kept it honest-
Micheal Vranos: (35:36)
Yeah, I'm going to be honest-
Troy Gayeski: (35:36)
Didn't squeeze in that extra five pounds.
Micheal Vranos: (35:36)
Not going to round up, no.
Troy Gayeski: (35:37)
Good man. John, why don't you take it away with questions from the audience? Okay.
John Darsie: (35:41)
All right. We have a few in the queue here. If you have additional questions, please submit them in the Q&A box at the bottom of your screen and we'll try to get them in before we let Mike go. The first question is just about technicals in the mortgage backed securities market, and whether you think there will continue to be a recovery through the end of the year, or what risk factors you're looking at are for a potential pause in the recovery in those markets?
Micheal Vranos: (36:03)
So the latter part of the question is the best part, and there are things that one needs to be concerned about, as you see this slow recovery in residential non agency. I assumed the questions about non agency. With agency, you've had a massive recovery because the Feds bought everything right.
John Darsie: (36:24)
Yeah.
Micheal Vranos: (36:25)
So, you know that the Cares Act, which is providing for this enhanced income. Sorry, I'm moving around has really basically expired on July 31st. And only a few states I think have adopted taking up these payments. So you will see, I think rising delinquencies, which will cause people to stop. Investors to pause and we're sort of counterintuitive but lower balance loans have a better pay stream track record over since the COVID crisis than higher balance precisely because of the enhanced income benefits from the government. And when that goes away, you're going to see that reversal and our extrapolation is that you will see much higher delinquencies. Nonetheless, it shouldn't affect the ultimate prepayment of principal to the securities.
Micheal Vranos: (37:25)
But that will cause applause, no doubt. The other thing is that there hasn't been a real back filling of collateral to the marginal dollar like say, in hedge funds that normally buy these. And I'm thinking that real and long only managers real money and long only managers will pick up the slack a bit, but that that could take time and it might not happen, might not happen at all or right away.
John Darsie: (37:53)
Thank you for that. The next question is given your experience firsthand with the CLO, CTO and CMO dislocation in 94 and 98, as you explained earlier. What lessons are you taking from the first quarter and second quarter of this year in 2020, of how certain large credit shops, ran their models ran their leverage or ran their business platforms.
Micheal Vranos: (38:18)
History just tends to repeat itself when it comes to leverage, it's just amazing. And I do believe that what led up to it was... I mean I wouldn't say excusable, but somewhat understandable. What happened is that there was just such a fight for yield for so many years. And credit had almost monotonically gotten better, since 08 and there have been some hiccups without a doubt 2018 and late 2015. But every time that that happened, those hiccups happened. You were rewarded, to take more risk and it's just added to it. And then you saw volatility go down, as people started to look for yield that way by selling covered calls and all that. And when you sell volatility to somebody who has nothing to do with it, you actually make volatility go down more.
Micheal Vranos: (39:13)
And so the market kept grinding into this pick up pennies in front of the steamroller thing. And it was just bound to happen at some point who knew would be this something else. So you just really do need to keep that cash aside. I guess that's it. It's a sort of a repeat of what I said.
John Darsie: (39:30)
Yeah. What are your thoughts on inflation on the RMBS market? And are you modeling any inflation risk into your models?
Micheal Vranos: (39:38)
We don't right now model anything other than what would be I would say is rather benign inflation. I do understand that things have changed recently. I haven't reviewed any models recently. In terms of what the Fed has mentioned, I haven't really reviewed any models would take into account any significant difference from what we've had recently. I mean inflation in general does tend to help a lot of these assets that we're talking about.
John Darsie: (40:11)
Do you see an opportunity in a hotel CMBS and similar types of asset classes?
Micheal Vranos: (40:17)
I don't know. I'd have to talk to my PM. I don't have a strong opinion about that. I will say one thing, that a lot of people... The market is tends to be somewhat backward looking and even someone in your audience asked a question about what could cause a pause or a problem. I think all of us here need to acknowledge that the more subtle in one drawn out disaster scenario is that real returns go negative. And you're sort of alluding to that in your question, and that when the Fed has bought so much paper, and with inflation on the other end, outpacing the yield of the securities that it could be a slow death. And it's tough, especially for pensions and others. And that's a big concern.
John Darsie: (41:05)
I want to finish with a question about your philanthropic work, which I know is near and dear to your heart. You're one of the most active philanthropists on Wall Street you help lead the Help For Children Organization used to be called Hedge Fund Cares. Could you talk about a few other causes that are most important to you and the most satisfying part of all that philanthropy that you do?
Micheal Vranos: (41:24)
Sure, so there's a there's an intersection of philanthropy and science that for me, that's very interesting. I believe that we're going through a sort of a renaissance in the life sciences right now akin to what we went through in tech many years ago. And that you're seeing this happening now with different forms of stem cell research for example, I'm a big supporter of different kinds of stem cell research initiatives. Also, certain neurological diseases that may or may not have to do with stem cell research, the effect of the gut microbiome on diseases too. What we eat, things like that I think are really important. And it's more important to me personally than whether my phone works better or 5G or something like that. It's how are we going to live healthy for the rest of our lives? And I think it's very important. And I think we're going to see great strides, probably after I die, of course, but like I see great strides in that area. I'm very excited about that.
John Darsie: (42:34)
Well, you look great. You said your girlfriend gave you your haircut, but she did a fantastic job. So thanks so much for joining us, Mike. It was great to have sort of this long form format to be able to talk to you about all your experience, which I think is fascinating. Troy, do you have a final word for Mike?
Troy Gayeski: (42:50)
No, Mike it was great to have you on and again, I think compliments to just the breadth and depth of experience. And again, I keep saying the word longevity, but having invested in hedge funds for close to 20 years now, it's hard to stay in business over a long period of time and some of the most well known managers as recently as five years ago are no longer in business so compliments to you and your team for doing that for so long.
Micheal Vranos: (43:14)
Thank you, Troy. And thanks for the opportunity to speak today.