Leveraged funds use statistical models to make themselves feel better about taking risky bets. While the bad news in Q1 could be accounted for in their models, the market swings resulting from fear and panic could not. As a result many firms were forced to sell assets into a markets with few buyers, further depressing prices.

The collapse of Carlyle Capital was a textbook example of this phenomenon, providing excellent buying opportunities in its wake. Carlyle Capital borrowed money to buy agency backed mortgage bonds. With the help of generous lenders, the fund ended up with leverage of 32:1 ($700 million in equity vs. $21.7 billion in assets), which is the equivalent of buying of buying a $1,000,000 house with a $32,250 down payment. On March 6, 2008 Carlyle Capital got a public call from their lender saying they wanted a larger down payment. Carlyle had to sell assets to raise capital, but with the news the agency markets liquidity dried up; there were too fewer buyers even at reasonable valuations. As a result, prices dropped further, which in turn caused the banks to push harder, leading to more forced sales and lower prices.

Why is this interesting to investors in the Wanger Long Term Opportunity Fund (WLTOF)?

WLTOF invests in firms with small market capitalizations. From a risk management perspective, we take great care to ensure liquidity for our investors, but small stocks tend to be less liquid than larger ones. The upside is that our investors capture the higher expected returns demanded for investing in less liquid securities. The downside is that when there is a liquidity crisis, such as the market has been experiencing, these small stocks are disproportionally affected. The short term decline in prices may affect the WLTOF’s month to month returns, but in the long term WLTOF benefits from these forced sales by buying equities in good companies at better than reasonable prices. During the first quarter we hunted for value.

Regional banks appeared to offer an opportunity. Regional banks have been particularly hit by the liquidity crisis and will likely offer investors substantial opportunity for capital appreciation as we return to a more “normal” liquidity environment. Picking regional bank stocks, however, is like picking used cars; it’s difficult to know which one is going to be the lemon. To gain exposure to financials WLTOF invested in two public firms: MFA Mortgage (MFA) and Anworth Mortgage (ANH), whose strategies are similar to Carlyle Capital, but with greater discipline on the use of leverage. MFA and ANH, like banks, offered the opportunity for capital appreciation from the normalization of the liquidity environment and a steepening yield curve (i.e. borrow for the short term, lend for the long term and collect the spread), but with fewer murky questions on credit and solvency.

Prior to Carlyle Capital’s collapse, ANH and MFA were unattractively priced based on price/book and dividend yield metrics. As Carlyle Capital neared collapse the agency-treasury spreads jumped 10%, and speculation circulated that haircuts (i.e. down payments) would be raised, the result was that the prices of MFA and ANH collapsed; for instance, ANH market value fell 39% from March 4th to March 14th. WLTOF began building a position once the prices had fallen meaningfully below book and we had confirmed with many of lenders to Mortgage REITs that haircuts were not jumping to 10%, but being more reasonable adjusted to the top end of the 4%-5% range.

Between March 14th and March 20th the panic passed and liquidity returned to the market; the agency-treasury spread declined more than 25% from the peak and the share price of ANH rose 44%.The WLTOF continues to hold both ANH and MFA and believes investors will benefit from additional capital appreciation as short term rates continue to fall and spreads revert back to more normal levels.

Investment managers are paid to intelligently take risk. Over the long term, investors in WLTOF will benefit from being a buyer of illiquid securities during times of panic when others are forced to sell.

James L. Cahn