From the Economist: Distressed Debt Funds / Cashing in on the Crash

[Guy Berger]

Honestly, if I had the money and the cojones, I would pour money into illiquid-and-undervalued-but-highly-rated assets too.

The Buffett quote near the bottom is hilarious, IMHO.

Distressed-debt funds

Cashing in on the crash

Aug 23rd 2007 | NEW YORK

From The Economist print edition

Tempting morsels for strong stomachs

AP

Is there a pair in Buffett's size?

THE past few years have been lean ones for those who feed off corporate carrion. Now, as credit markets creak, distressed-debt investors—known less kindly as vulture funds—are confident that their time has come at last.

Many can claim to have seen the rout coming. Private Equity Intelligence, a research firm, calculates that vulture funds raised $15.6 billion in the first seven months of this year, more than the $13.9 billion they garnered in all of 2006, itself a record. A further $30 billion is in the works, including a giant $20 billion fund being pieced together by Goldman Sachs.

Nothing gets vultures squawking louder with delight than a wave of forced selling. This week Thornburg, a property firm facing funding difficulties, sold an array of top-notch securities worth over $20 billion at a 5-10% discount. Highly leveraged, computer-driven “quant” funds are having to liquidate shares, bonds and anything else they can sell in order to meet margin calls from their prime brokers. As markets tighten, creditors will also be less willing to refinance wobbling companies. That could mean an imminent end to the bankruptcy drought.

While some hedge funds suffer, others are poised to snaffle up bargains. Citadel, Ellington and Marathon Asset Management, among others, have both the ready cash and the inclination. Citadel traditionally keeps more than a third of its assets in cash or liquid securities, allowing it to pounce when opportunities arise. It recently took over a chunk of Sowood Capital, a rival that buckled under bad bets.

If the past is any guide, spectacular returns beckon for some. John Mauldin, publisher of an investment newsletter, points out that during America's 1980s savings-and-loan crisis, bottom-fishers could net perfectly good mortgages for 15 cents on the dollar.

Two skills will be particularly useful: spotting the gems in the rubble, and timing. An investor who pays 90 cents on the dollar for debt that is almost certain to be repaid can make mouth-watering returns with minimal leverage. But after WorldCom's collapse, many would-be vultures swooped too early, tearing into the discounted bonds of cable and telecoms firms, only to see them tumble further.

Ironically, the very firms that helped to inflate the credit bubble are now among the keenest to profit from its bursting. Blackstone and TPG, two of the biggest sponsors of leveraged buy-outs, both have distressed-debt funds, and Blackstone has expanded its already big restructuring unit. Private-equity firms are even looking to buy debt in each other's deals at a discount, says Martin Fridson, an independent credit analyst.

Experience counts for more in busts than in booms. So no one was surprised when Wilbur Ross, who earned a fortune buying up failed steelmakers, made an “initial foray” into subprime mortgages this month, offering $50m to a bust lender. Warren Buffett is also sniffing around, armed with a cash pile approaching $50 billion. When the price is right, he told the Wall Street Journal this week, “I can spend money faster than Imelda Marcos.” Unlike the Philippines' former first lady, however, he will be looking for weather-beaten shoes in need of a shine.

[The Magnificent Goldberg]

There seems little doubt that a bust is coming. I've been warning my son-in-law that he's investing in a new self-build house at the wrong time.

The big difficulty with busts is noting when the bottom arrives. The Great Crash of 1929, 1930, 1931, was just that - it didnt just happen in October 1929; it was a series of falls, lasting for years, each of which swept up the bottom-feeders who thought they were picking up bargains. This bust looks to me as if it might go the same way. Too many things look as if they could go wrong within the same broad timescale, producing a feedback loop.

MG

[Guy Berger]

There seems little doubt that a bust is coming. I've been warning my son-in-law that he's investing in a new self-build house at the wrong time.

The big difficulty with busts is noting when the bottom arrives. The Great Crash of 1929, 1930, 1931, was just that - it didnt just happen in October 1929; it was a series of falls, lasting for years, each of which swept up the bottom-feeders who thought they were picking up bargains. This bust looks to me as if it might go the same way. Too many things look as if they could go wrong within the same broad timescale, producing a feedback loop.

MG

Well... the thing is, we are mostly talking about assets that, while difficult to sell at face value, are very unlikely to default. (Even subprime-based ones.) So it seems to me that at worst, these vulture funds will be able to redeem them at maturity. That is, assuming that the vultures aren't financing the purchases through heavy borrowing.

On the other hand, you are right -- these vultures could find that in the short term prices will continue to fall, making them wish they had waited longer before buying.

Guy

[Dan Gould]

The Buffett quote near the bottom is hilarious, IMHO.

And who said economists have no sense of humor?

[The Magnificent Goldberg]

There seems little doubt that a bust is coming. I've been warning my son-in-law that he's investing in a new self-build house at the wrong time.

The big difficulty with busts is noting when the bottom arrives. The Great Crash of 1929, 1930, 1931, was just that - it didnt just happen in October 1929; it was a series of falls, lasting for years, each of which swept up the bottom-feeders who thought they were picking up bargains. This bust looks to me as if it might go the same way. Too many things look as if they could go wrong within the same broad timescale, producing a feedback loop.

MG

Well... the thing is, we are mostly talking about assets that, while difficult to sell at face value, are very unlikely to default. (Even subprime-based ones.) So it seems to me that at worst, these vulture funds will be able to redeem them at maturity. That is, assuming that the vultures aren't financing the purchases through heavy borrowing.

On the other hand, you are right -- these vultures could find that in the short term prices will continue to fall, making them wish they had waited longer before buying.

Guy

The feeling I get is that the bust is going to come with defaulted mortgages, as the silly deals that people were offered to get them to buy what they couldn't afford reach the stage of the more realistic conditions that should have been attached from the start and there ain't enough profit in the price rises to take out another silly mortgage to cover the debt. In that sort of scenario, and I gather it's huge, there seem to be few hiding places.

MG

[Guy Berger]

Well... the thing is, we are mostly talking about assets that, while difficult to sell at face value, are very unlikely to default. (Even subprime-based ones.) So it seems to me that at worst, these vulture funds will be able to redeem them at maturity. That is, assuming that the vultures aren't financing the purchases through heavy borrowing.

On the other hand, you are right -- these vultures could find that in the short term prices will continue to fall, making them wish they had waited longer before buying.

Guy

The feeling I get is that the bust is going to come with defaulted mortgages, as the silly deals that people were offered to get them to buy what they couldn't afford reach the stage of the more realistic conditions that should have been attached from the start and there ain't enough profit in the price rises to take out another silly mortgage to cover the debt. In that sort of scenario, and I gather it's huge, there seem to be few hiding places.

MG

But the truth is that the mortgage problem is not that big.* Adjustable-rate subprime mortgages are only a small fraction of the overall US mortgage market, and while the delinquency rates have jumped up, they aren't astronomical. (I think they are in the 10-15% range.) For other parts of the mortgage market -- fixed-rate subprime, alt-A, jumbo, and conforming -- delinquency rates are much, much lower.**

Guy

*Obviously if you are a family that can't cover such a mortgage, or a firm that relies on brokering them, you have a big problem. I mean the macro sense.

**Some of these sectors (alt-A, fixed-rate subprime) have "died" in the sense that few if any new loans are being issued, but there are no mass deliquencies.

Edited September 2, 2007 by Guy