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By Eric Jacobson | 12-30-2009 10:41 AM

Barach: Why Mortgages

DoubleLine president and former TCW Total Return manager Philip Barach on why he and colleague Jeffrey Gundlach were attracted to the mortgage-backed securities market.

Eric Jacobson: Hi, I'm Eric Jacobson with Morningstar. I'm the director of fixed-income research, and I'm here today with Phil Barach. Phil is the president of a new firm called DoubleLine. He and the team that he comes over here from TCW is one of the co-founders of the mortgage securities group at TCW, before he left, and he ran the mortgage securities group there along with Jeffrey Gundlach, who is the CIO. Phil, thanks so much for joining us today.

Phil Barach: Thank you, Eric.

Jacobson: So, Phil, one of the reasons that I wanted to do this interview with you is because I think a lot of people who have invested in the past with TCW, and potentially, maybe again with DoubleLine, perhaps aren't as familiar with you as some of the other folks, but you're an important piece to that. So, if I could just start off with some basic things, tell us a little bit about your history in the industry.

Barach: OK. Well, I have a long history in the industry. I started in this industry in 1977, working for National City Bank in Cleveland, Ohio, and started there in the bond department. At the time, I didn't really know much about the bond department, but I found it very, very interesting.

Smart enough to realize that the weather in Cleveland wasn't very attractive, I moved out to California and actually got a job as the assistant city treasurer for the city of Sacramento, running the retirement system, being involved in financing for the city. That was an interesting position, but through that position, I got to know people at CalSTRS and eventually moved over to CalPERS, where I became the principal investment officer of that fund. That was in the mid '80s.

Jacobson: For people not from California or knowledgeable about that, that's a very large pension organization.

Barach: Yes, I think that's the largest retirement system in the United States. It, at the time, was all internally managed. I think it's mostly still internally managed.

When I was at CalPERS, I realized, at that point in time, that there were a lot of inefficiencies and value in the mortgage-backed securities market. At that time, in fact, most corporate bond spreads were very, very tight--10, 15, 20 basis points over. The mortgage market was just growing, and effectively took most of the fixed-income portfolio from CalSTRS and put it into mortgage-backed securities, selling corporate bonds. Remember, this is just before the leveraging of credit in the United States, and all the securities were consequently downgraded.

Also, when I was at CalPERS, I saw an opportunity in the CMO market and, using their portfolios and working on behalf of CalSTRS, their sister portfolio, created the first private-label CMOs, Salomon Brothers Trust One and Trust Two at that time, because there was huge arbitrage at that point in time.

Afterwards, I was recruited to SunAmerica, working for Eli Broad. I worked there for a couple years and joined TCW in 1987. Then, in 1987, Jeffrey and I spun off and created that MBS group, which has since grown to quite a bit. Obviously, this year, in December, I left with Jeffrey and the entire team to manage money at DoubleLine, so fulfilling a wish of my own, a long-term wish to control my destiny and be a major owner in my own firm, with teams and people that I've worked with for a long time that I respect and have the highest regard for.

Jacobson: So tell us, then, what are your responsibilities going to be like with the new firm, in terms of day-to-day?

Barach: Well, my primary responsibility will be mostly that of managing money, dealing with clients, managing money, buying securities, setting strategy, investing in portfolios, determining what sectors to be in. There'll be other administrative duties, and obviously, at TCW I had other administrative duties.

But I think, if you look at the sectors that I love--and people who are really good in this field are people who love doing it, love doing it even when they're on vacation. I find a tremendous draw and feel towards the markets, always following them, always have ideas on them. Jeffrey and I and the other members of the team will sit around and discuss those at all times.

I think and I'm hoping that the position will be mostly one of that of managing portfolios, interfacing with clients, talking to the clients, giving them information about it, with some other duties that are important, but we expect to have a large enough team so that the principals of this group, the people with the real love and ability for money management, will be able to concentrate on doing that. We have no interest in moving out to some other area, some other field. What we love to do is to manage money as efficiently and as best as possible.

Jacobson: As you said, your history and sort of bailiwick, if you will, is in mortgages. Have you specialized? You mentioned private-label before, but when you talk about the sectors that you like to be involved with, is that primarily the agency mortgage space, or do you have a lot of history with non-agency mortgages yourself as well?

Barach: Well, I have a lot of history with non-agency mortgages. One of the things that's interesting is, for a long period of time, we thought the non-agency mortgage just wasn't that attractive. The difference in yield between an agency and non-agency mortgage, up until a couple years ago, was 10, 15 basis points, and they had worse convexity and faster prepayments. So there was really no reason to own them. We were aware and cognizant of it, but there wasn't much to do in the sector.

When the opportunities came about, we had a lot of experience, a lot of expertise in it and morphed over into that sector. It might be temporary; it might be for a period of time, but let it be known, we all have experience in other sectors. When I was at CalPERS, I was head of all fixed income, including corporate bonds, high-yield, and Treasuries--same thing as when I was at SunAmerica and ran an entire portfolio.

One of the reasons why Jeffrey and I decided to focus on mortgage-backed securities is because we realized, in the area of corporate bonds, there were many unknown factors that just couldn't be predetermined. One of the interesting points in my career that I remember, the anniversary just happened just recently.

There was a 25-year anniversary of Bhopal, India, where Union Carbide blew up a plant and killed hundreds of thousands of people. Huge amount of people died. I remember going into work, when I was working at CalPERS. We had a huge position in Union Carbide bonds, and they were very good bonds. Suddenly that position was decimated, and I realized, "There's no way I could forecast that, no way I could do anything about that. Let's look at a sector where we can understand the variables and dynamics."

We looked at mortgage-backed securities. We looked at agency and Ginnie Mae, with the assumption that the agencies would essentially be government-guaranteed, which they were, and said, "Look, the variables we have to understand are prepayments, convexity, things along those lines. We might be wrong, but if we're wrong, it's not a principal-loser; it's an underperformance. So let's focus on areas that we truly understand and we can add value, and let's try to minimize the risk."

By doing that, if you look at the returns, I think that we've had much, much less volatility over the years, because there are just certain events that happen that you have no control of, Long-Term Capital, Russian crisis, 9/11, all those events out there that occur, but in the mortgage area, you can have more control of your destiny.

So we realized that in the area of mortgage-backed securities, there were two big positives. The positive was higher incremental yield versus Treasuries. The other positive is a yield almost equivalent to a Treasury. The negative, of course, is that they had that issue of prepayments, and you were sort of hostage to the prepayments. So we realized that if we could develop the systems and model and expertise in security selection to minimize or mitigate the impact of prepayments, we'd be stuck with a higher yield and a better credit quality.

In fact, if we look at TGLMX, for most of the history of TGLMX, which I have been co-managing with Jeffrey Gundlach since 1993, for the great majority of the time period, there was very little allocation to non-agencies. We exceeded our alpha in incremental returns through managing and mitigating those prepayments and buying those sectors of the agency mortgage market which gave us better alpha and less volatility.

Jacobson: Well, that's really helpful. Thank you so much for your time.

Barach: OK, Eric. Thank you very much.

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