Back during the Asian credit crisis in the 1990s, MIT-trained economist and hedge fund manager Nandu Narayanan took a close look at the ratio of a country’s credit to its gross domestic product, BusinessWeek Online reports. In Malaysia, for instance, it was 220%, meaning $2.20 worth of debt for every dollar of economic output.
Looking at the U.S. market late last year, Narayanan, manager of the $100 million Trident Investment Management fund, found that the ratio was between 370% and 440%, which he called “well north of anything ever seen in most countries of the world.”
Sensing that any increase in interest rates in the U.S. could create severe problems in the credit market, Narayanan foresaw that subprime mortgages would crash and default, so he began shorting insurance policies on debt issued by subprime lenders and mortgage insurers, boosting his fund’s return to 35% so far this year.
Sensing that the market has much lower to go, Narayanan believes his fund can deliver even high returns for 2007. “If everything that we shorted goes to zero, we have the opportunity for a 200% return,” he said. “While that is unlikely to happen, we are hoping to end up with returns in the 60% to 80% range.”
Likewise, John Paulson, a veteran of Bear Stearns who now runs an eponymous hedge fund of his own that is up a stunning 300% this year, began tracing the declining subprime mortgage index last winter and decided to short that the market.