It's Back to the Future for Next Stark Vehicle

Stark Investments is teeing up a hedge fund that would use credit-default swaps to short subprime mortgage-backed securities.

The vehicle is noteworthy for a couple of reasons, starting with the fact that it represents Stark's first launch since the financial crisis. The strategy, too, is a throwback, similar to the play John Paulson, Steve Eisman and a few other prescient portfolio managers made just before the implosion of the subprime-mortgage market in 2007.

But Stark is making it clear that its planned RMBS CDS Opportunity fund doesn't represent a bet against the housing market or subprime mortgages per se. The St. Francis, Wis., fund operator sees a narrow window of only a few months to short the subordinate tranches of particular MBS issues suffering from severe loss rates.

Since marketing began in February, Stark has lined up $150 million of verbal commitments for the vehicle. No launch date has been set. But given the fund's strategy, Stark is expected to begin investing any day now.

Stark designed the strategy to capitalize on two trends. First is the apparent weakness of mortgage-backed securities issued just before the credit crisis. As an example, the fund's marketing documents cite a 2006 deal where 51% of the loans backing the bonds are delinquent and another 31% are in some stage of foreclosure. The fund will buy credit protection against the subordinate tranches of deals like this, “where we think the level of delinquencies and severities will completely wipe out any value of underlying cash positions,” according to the marketing documents.

The other trend has to do with the supply of attractively priced swaps contracts. Specifically, the Bank for International Settlements' pending “Basel 3” rules are prompting banks to reduce their CDS exposure to avoid increased risk-based-capital requirements. As the banks dump their swaps contracts, Stark expects the cost of purchasing credit protection to drop.

Stark, founded in 1992 by Brian Stark and Mike Roth, has fallen from about $13 billion under management before the financial crisis to around $3 billion today. The firm manages assets in two main multi-strategy vehicles, Stark Investment and an offshore companion, Shepherd Investment, as well as a series of special-purpose vehicles set up to hold illiquid assets during the 2008 market crash. The Shepherd fund was up 6.9% in the first quarter.

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