A Hedge Fund Makes Billions Off Americans’ Underwater Mortgages

Fortunes were made on Wall Street betting against sketchy mortgages before the housing bust a decade ago. In its aftermath, one firm has made billions taking the other side of that trade, scooping up battered home loans in a wager that plenty of Americans would keep paying them.

The payoff, years in the making for hedge-fund firm Fir Tree, is $2.6 billion and counting, according to an investor letter reviewed by The Wall Street Journal.

Fir Tree has reached the final stages of collecting on its gambit at a time when the housing market is at a crossroads following five years of sharp gains. In many cities, surging prices have strained affordability, while rising interest rates and high student-loan debt have made it difficult for the generation starting families to buy homes.

Fir Tree, which manages about $8 billion, favors complex trades that often involve legal action. It is a creditor in the decade-old battle over what is left of failed investment bank Lehman Brothers, has spent years trying to wring cash from Puerto Rico’s defaulted bonds and, during the recent oil bust, emerged from bankruptcy court holding the reins of energy producers.

Its mortgage wager was two-pronged: The firm relied on human nature—a belief that homeowners would stick with their mortgages, even if their houses were no longer worth what they owed—while it also took legal action to force banks to pay up for flawed loans that did default. So far, about half of the firm’s $2.6 billion profit is attributable to homeowners paying underwater mortgages. The rest has been redress for loans that defaulted, according to people familiar with the matter.

In 2010, at the depths of the crash, more than 12 million U.S. houses were worth less than the debt on them. In places like Las Vegas and Miami, about two of every three mortgaged homes were underwater.

Many investors feared homeowners who had paid top dollar before the bust or borrowed against properties at inflated values would soon default. It wasn’t hard to see why. Academics and lawyers argued many underwater homeowners should strategically default, especially if staying put imperiled their long-term financial health.

At the time, Fir Tree was looking to play the crash. It had been among those who bet on a mortgage meltdown and profited when the market imploded.

The firm noticed that panicked investors were dumping bonds packed with second mortgages. Those debts have secondary claims to properties that are collateral for first mortgages. If a property has lost value when the borrower defaults, there may be no value left once the first mortgage is paid.

Clinton Biondo, one of Fir Tree’s managing partners, said the firm figured the securities selling for cents on the dollar were so cheap, it could still break even if most of the loans defaulted.

It probably wouldn’t come to that, though. Fir Tree believed many Americans would pay regardless of the value of their house. “Even highly distressed borrowers pay off their obligations since they care about their credit,” Mr. Biondo said in an interview.

By 2013 Fir Tree, at a cost of about $1 billion, had acquired second-lien bonds with a face value of roughly $9 billion, according to people familiar with the matter.