"Empire a family tribute" [EDIT: pump that Annaly (NLY)]
Sunday, November 3, 2002
columns.scmp.com
JON OGDEN
Mike Farrell is a man who believes in honouring his family roots. He has done it in spectacular style by building a US$17 billion fund management empire based in the Big Apple.
Mr Farrell's father, an Irishman, emigrated to the United States after serving in World War II.
His son went into the financial world and after 20 years of working for corporate employers, decided he had enough money and contacts to build his own shop.
Mr Farrell set up New York-based Fidac, short for Fixed Income Discount Advisory Company, in 1991. Today, Fidac has US$7 billion under management, while New York-listed sister company Annaly, named after the ancestral hometown in Ireland, has US$10 billion.
Mr Farrell considers the companies as a tribute to his family. Annaly uses the family crest for its logo and the family motto: prodecce non nocere, or proceed without fear.
Both firms have Mr Farrell as chairman and chief executive and follow a similar strategy of capturing the interest rate spread between interbank rates and mortgage-backed securities.
"We consider ourselves to be a manufacturer of yield," Mr Farrell said.
"What we have done is really give people the opportunity to exploit the spread that they wouldn't have access to as individuals.
"We just package it up in different forms for different geographic areas that we are executing in."
Locally, Sun Hung Kai Fund Management has chosen Fidac to manage one of its funds.
The strategy works with each US$1 invested by a client buying a US mortgage-backed bond. Then Fidac or Annaly will borrow another, say, US$8 at Libor (London interbank offered rate), which closely follows the Fed funds rate. That money goes on buying more mortgage backed securities, largely ones which have floating rates which adjust every 30 days.
In an example trade, Libor would be at 1.81 per cent and the US mortgage-backed security would yield 2.72 per cent, giving a spread of 91 basis points. The annualised return equals the 2.72 per cent for the bond the investor has bought plus eight times his 91 basis point spread, giving a total return of 10 per cent.
"It's boring but today boring is good," said Mr Farrell, referring to the collapse in equity markets. "We make it sound simple. But there is a lot of work that goes into achieving this strategy."
He likes to tell clients it is like investing in "a bank without walls and tellers".
"The strategy really replicates the strategy that banks used to do [before] the 1980s," Mr Farrell said.
"In my parents' generation, you would go to a loan officer in a bank. He would approve it, then use his deposit base as a way to fund that mortgage and would manage that spread over time."
Nowadays, the banks sell their mortgages to government agencies Freddie Mac, Fannie Mae and Ginnie Mae. They package pools of the mortgages and issue bonds backed against them, which investors like Mr Farrell can buy.
"That in effect gives the average home owner in the United States the same credit quality as the US government, AAA, by putting an insurance wrapper on his mortgage," said Mr Farrell.
"Cashflows come from US home owners and borrowers through the structure to us."
Using borrowed money to help generate returns can raise warning signals for investors but Mr Farrell does not see it that way.
"The average home owner in the States puts 10 per cent down on his house and borrows 90 per cent," he said.
"What we are doing is putting 10 per cent down on the securities and borrowing up to 90 per cent. Leverage is something that is a fact of life in everybody's life."
Effectively, Freddie Mac and its sister agencies were carrying out the same strategy at a leverage rate of 77 to one, he said, while banks did it at 30 to one.
Mr Farrell said his maximum leverage ratio, by comparison, was 12 to one.
"Let's say you own Citibank stock. They do this strategy but they also do corporate lending, they have credit risk, counterparty risk, currency risk all embedded into that 30 to one level," he said.
"We have one risk that we share with Citibank and that is interest-rate risk. They are taking all these other risks and they are embedding it into their leverage."
These days, investors are paying attention to Mr Farrell's story, whereas in the Internet bubble heyday a couple of years ago they used to tell him: "A double digit return is great but I can do that in Yahoo! in 25 minutes."
Mr Farrell keeps at least 85 per cent of his portfolio in floating rate mortgage backed securities. That way, he is covered when interest rates rise or fall. The change in his borrowing costs should be matched by a change in the yield on his mortgage bonds.
US mortgage-backed securities have grown into the largest debt market in the world with US$4.5 trillion outstanding. That means Mr Farrell's companies can offer clients the ability to buy in or cash out within a week.
"We are able to give the liquidity because the numbers of people and size of the market is so great. There's a lot of cash chasing these assets," Mr Farrell said.
He considers his products mid-range - a step up in risk and return from cash holdings but far more conservative than equity funds.
The numbers bear him out. Between August 1984 and this July, his strategy produced an annualised return of 10.69 per cent per year, beating the 9.2 per cent from US stocks benchmark S&P 500 and the 8.09 per cent from the Lehman Aggregate Bond Index. That period has seen some stormy weather in bond markets, including aggressive Fed rate-raising campaigns in 1994 and 1999, the Asian financial crisis and the collapse of giant hedge fund LTCM, which Mr Farrell said all stress-tested his strategy.
For someone investing in mortgage-backed securities, Mr Farrell is frank in declaring his worries that the US housing market may be overheating with low interest rates and robust price rises producing a buying stampede.
"I personally believe that we are in a housing bubble," he said. "The evidence I would point to is that despite the lowest interest rates in 40 years we're experiencing record defaults and delinquencies on mortgages in the United States.
"In addition to that, mortgage insurers are all underperforming the market. Some of them have had their stocks slashed in half in the past few weeks."
Nevertheless, even if the housing market ends in tears, Mr Farrell believes the US government housing agencies will stand by their investors.
"Regardless of whether a mortgage repays, prepays or defaults, we are always going to get 100 cents back from the government agencies," he said. "It is up to them to cure their operations by going in, repossessing a property and liquidating it.
"We look our investors in the eye and say these entities are too big to fail. They are run by the US government and have a credit line to the US Treasury."
FACT FILE
Mike Farrell
1971:Graduated from the Univer sity of New Mexico.
1971:Began work for EF Hutton in New York.
1978:Senior executive working with Cantor Fitzgerald.
1985:Trader with Morgan Stanley.
1987:President of mortgage deal ing desk with LF Rothschild.
1989:Head of fixed income with Schroders.
1991:Set up private company Fidac to invest in mortgage- backed bonds. |
