February 29 2008: 11:39 AM EST
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Mortgage mess socks ex-Goldman Sachs stars

A smart bet on the collapse of the subprime housing market comes back to bite Geoff Grant and Ron Beller.

By Roddy Boyd, writer

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NEW YORK (Fortune) -- Not long ago, Goldman Sachs alums Geoff Grant and Ron Beller looked like superstars. A prescient wager on the collapse of the subprime mortgage bond market generated last year a whopping 87 percent return for one of their hedge funds.

The twosome, who run London-based Peloton Partners, aren't looking so shrewd these days. They've been forced to liquidate their once high-flying ABS fund after gambling big on a mortgage bond rebound that didn't materialize. The $1.8 billion fund's collapse comes after a series of recent trades dropped sharply in value, leading to margin calls from creditors that the firm was unable to meet.

The ABS fund's implosion, coming just three years after Peloton Partners was formed, highlights the steep challenges that hedge funds face amid the credit crisis gripping Wall Street. Last week D.B. Zwirn & Co shut down its two biggest hedge funds amid investor defections. Citigroup halted earlier this month withdrawals from one of its hedge funds.

Also on Thursday, Grant and Beller told investors that they were suspending redemptions in a second Peloton portfolio, a $1.6 billion multi-strategy fund that finished 2007 up 27 percent. According to a letter sent to clients this week, the multi-strategy fund had a very large position in the ABS fund, whose bust has had a "serious negative impact" on the multi-strategy fund.

Grant and Beller said in the letter that they were assessing their options. But depending on the assets left in the ABS fund, the multi-strategy fund's investment could be almost worthless.

A spokesman for Grant and Beller did not respond to a request for comment.

The story of the ABS fund's demise began last year when Peloton took short positions on investments backed by pools of subprime mortgages, meaning it bet that their values would fall. While other hedge funds like Paulson & Co. also bet short on mortgage bonds, Peloton did something more complicated: It wagered that slices of the same bond portfolio with different ratings would diverge sharply in price - a strategy known as capital structure arbitrage.

For instance, the fund was long on AAA-rated mortgage bonds and gambled that BBB-rated subprime bonds would fall in value. That calculation paid off big when, according to ABS investors who spoke to Fortune.com on the condition of anonymity, the fund's short position fell 75 percent, from an average of nearly $100 to $25. Meanwhile, the price of the fund's AAA-rated long position declined much less.

The price differential between the short and long positions led to the 87 percent return. Trade publication EuroHedge Magazine subsequently named the Peloton ABS fund as 2007's best fixed-income fund.

Everything changed this year. The fund had about $16 billion in long positions versus $3.2 billion in shorts, according to a hedge fund manager who has seen Peloton's portfolio. The short positions - which were so profitable in 2007 - declined modestly in value, while the credit crisis drove the value of the massive long positions down an average of between $15 and $25 per bond in about a month. The fund suffered massive losses as a result.

What's worse, the fund's investment bank creditors - whose balance sheets have been brutalized in the credit crisis - did not have the resources to absorb the hit on behalf of the fund and demanded additional collateral. Peloton was unable to meet those demands.

In turn, a consortium of Peloton's lenders - its prime broker Goldman Sachs, Citadel Group and Och-Ziff Capital Management - declined to buy the portfolio. Grant and Beller are now trying to sell pieces of Peloton's portfolio, according to U.S.-based mortgage hedge fund managers who have been approached.

Founded in 2005, Peloton's collapse has caught the hedge fund community off-guard. Unlike Amaranth Advisors, which teetered on the brink of collapse for several weeks before finally selling its assets and winding down operations in 2006, Peloton's hedge fund rivals and prospective investors told Fortune.com they had little inkling of serious trouble.

The trade publication Hedge Fund Alert recently noted that Peloton's multi-strategy fund was hiring. Earlier this month, the Financial Times published a fawning profile of Grant and Beller, noting that Peloton had an unusually large risk-management staff.  To top of page

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