Hedge-fund investors betting on the riskiest home-mortgage loans are learning a difficult lesson: The higher they fly, the further they fall.
Consider the volatility at Second Curve Capital -- a hedge-fund firm run by Thomas Brown, a former Wall Street research analyst -- which recently has been hammered betting on the stocks of "subprime" lenders, which cater to high-risk borrowers.
The two main funds at Second Curve were down 8% and 10% in January -- and at least as much last month. Hedge-fund databases show the funds' losses for February at 12.5% and 14%, though Mr. Brown contends that the performance was comparable to January.
In any case, it is a significant turnabout from 2006, when the Second Curve funds rose nearly 55%. In 2005, Mr. Brown's funds were down 2%, after soaring 60% in 2004. With $600 million under management, Mr. Brown tends to invest in highly concentrated areas of the financial world, accentuating the bumps.
Live by the subprime, die by the subprime.
Seriously, this highlights an interesting and perhaps difficult problem in the market. Hedge funds don't make any disclosure reports to the SEC. Therefore, we don't know what they are investing in. We also don't know how many hedge funds are investing in the subprime mortgage area or in what concentration.
This means there could be a few more hedge funds out there reeling from the subprime shakeout. This could lead to a wave of redemptions and a ton of problems in the market.