"The Circle of Life"

Location Date: 
February 7, 2013

There is an old adage in the investment business that you ride your winners and sell your losers. That adage applies equally well to the hedge fund industry. One of Arrow’s winning managers in our Diversified Fund has been Rose Grove Capital Management LLC based in Boston. Their expertise is in US and global financials – particularly preferred shares. We have been invested with them for over four years now and their most recent investment letter is such a good read that I thought I would select a few choice bits for you.

"We opened for business here in December of 2006. Amongst other trade ideas, we were constantly pitched by our counterparties to get short mortgage insurers via the CDS market. The names were MBIA , MGIC (MTG), PMI and Radian (RDN). They were all trading below 100 basis points in yield, and over the course of the next few years, they all ballooned out by thousands of basis points. PMI went out of business. As we know, bank stocks also got decimated during that time period, and the ones with the highest mortgage exposure got hurt the most. Hence the fate of mortgage insurers and many large financial institutions seem to be tied, particularly the banks that received the most TARP (BAC and C). Why do we bring this up? It is called the circle of life. As you know we try to keep things simple at Rose Grove. In the last two weeks there has been a resurgence in the stocks of the surviving mortgage insurers. MBIA, MTG and RDN are up approximately 70%, 110% and 65% respectively YTD. The CDS of all three names has rallied significantly (MTG 25 upfront points in a week), and both RDN and MTG have raised equity. The amazing thing about MTG (in our opinion) is that these events have happened on no news, but rather on the desire of secondary investors to recapitalize the company in an equity and convertible offering. A few positive opinions on the MTG equity seriously changed the financial lives of CDS trading desks, the dreaded correlation world, and some happy stockholders. We still do not trade mortgage insurers, but we do trade the large financial institutions that were hugely affected by the former’s demise. Will the largest financial institutions subsequently benefit from the MI's rise from the ashes? Could their suspected maladies be as over-hyped as the seemingly incorrect CDS and stock levels of MIs two short weeks ago? We think so. We like BAC, Citi, JPM, WFC, GS and MS a lot at Rose Grove."

Could it be that Ben Bernanke and Co. are winning the war of confidence and that the "animal spirits" are finally awakening? We are seeing M&A starting to accelerate along with equity financings (no longer just in the credit markets). VZ/VOD, DELL, HTZ, BRY, CPNO etc. etc. The bankers look set to coin it again albeit without all the leverage of the glory years. Let's hope so – we need the growth to offset the fiscal drag that is inevitably on its way. As Rose Grove concludes, "being short ideas, stocks and credit does not make sense here."

Jim McGovern