Deer Park Road Corp founder Michael Craig-Scheckman and md Will Bashan answer SCI's questions

Q: How and when did Deer Park Road become involved in structured finance?
M: I founded Deer Park Road in 2003 when I moved to Colorado, with the aim of continuing the relationships I had built in previous roles at hedge funds. Initially I was managing money for a very large New York-based hedge fund. By May 2008, we were running a portfolio for this other hedge fund and had launched our own fund - the STS Partners Fund.

Q: What are your key areas of focus today?
M: I've been trading distressed securities since 1993 and before 2007 had been focusing on MBS and other ABS, such as manufactured housing, home equity loan and aircraft lease. At that time, we were finding opportunities in situations where structures were getting more aggressive or complicated, or where underwriting standards had slipped. Those sorts of situations appear to be on the rise once again.

In 2008 and 2009, it was much easier to make money on the basis of minimal analysis, but now you have to do the homework and pick your spots. In 2008 you could look at a subprime RMBS tranche with 30% delinquencies and assume that it would be liquidated in one year - although intellectually you knew the assumptions couldn't be correct, you could buy it there anyway. Now, it's clear that delinquent loans can't be liquidated at this pace and you have to be more selective.

The composition of our portfolio is dictated by the market: we're an opportunistic, deep-value buyer. At the moment, it comprises about 80% MBS and the remainder ABS. The largest positions are mezzanine subprime deals, but there's aircraft, CMBS, franchise and manufactured housing in the portfolio too.

We typically avoid senior bonds and focus on the lower parts of the capital structure and on older transactions. About 70% of our subprime holdings, for example, is in the 2004 and pre-2004 vintages. These vintages aren't as volatile as the later ones.

Q: How do you differentiate yourself from your competitors?
M: We have an unusual fee structure: we charge 60% on the first 40% of ROI and 20% on the remainder. But we receive no fees if we don't make money for our investors.

We originally created this fee structure as an alternative structure, but the feedback was so positive that we made it our only fee structure. We believe this fee structure aligns us better with our investors.

W: The other differentiators are that we focus on high cashflow, generating 3%-5% a month, and keep the duration of the portfolio short (between 2-4 years). In addition, we don't use leverage because we're targeting high yielding ABS.

M: There is a simple reason for not using leverage: we're getting good enough returns without it. There is a certain amount of leverage inherent in securitisations anyway and it's easier to sleep at night without it.

W: Another edge that we have other funds is our dealer network. Michael's been in the business since 1993 and Scott since 2001, cultivating a network of 80 dealers from the major players down to the niche players. The ability to have the first look at an asset is a significant driver of our strategy.

M: Some of our competitors tend to only do business with the larger dealers. We don't use a prime broker either: we have a custody account with a large bank, which means we're not at risk of being on a bank's balance sheet.

Q: What is your strategy going forward?
M: We began raising outside investment in June 2010 and have been successful in attracting inflows every month since then. The firm has grown beyond our year-end target of US$100m AUM and so we are aiming for US$200m AUM by the spring. Another recent milestone was achieving a three-year track record.

On the staffing side, we hired Scott Burg as a portfolio manager last August (SCI 18 August 2010), Amy Charity in investor relations in June and Hao Li as a research analyst last month (SCI 22 July). We plan to hire another operations person in the autumn, bringing the number of employees at the firm to 10.

We continue to see a broad spectrum of opportunities in the ABS market.

Q: What major development do you need/expect from the market in the future?
M: The US RMBS and CMBS markets have been beaten up over the last couple of months. Loan modifications are having a significant impact on 2006-2007 subprime bonds, with cashflows seeing severe disruptions.

Losses flowing through the structure speed up repayments, but then modifications hit and the cashflows dry up. This is being reflected in bonds that were once trading at 80c now being worth 40c.

There could be months where the situation improves, but then it worsens again. The disruption is most obvious in older deals with fewer loans: when one loan is liquidated, it looks like a giant blip.

What trips you up are loans that aren't being processed traditionally; for example, where a deal is behaving like it has a 100% loss severity but is only being reported with a 50% loss. In these cases, it is necessary to reverse-engineer the position. While servicer reporting is improving, it's usually after the fact.

Nevertheless, there are greater opportunities in RMBS. It remains quite difficult to source attractively-priced CMBS: interest in the underlying properties is growing, which has held the lower part of the market in. We're not willing to be as speculative as others perhaps are.

What I'd really like to see is the private label RMBS market return. At present, the GSEs are the only game in town, but clearly they have to shrink. The unwinding of the GSEs will help drive the yields needed to justify new private label issuance.

CS