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An article in last week’s Slate ponders this very notion, which is especially relevant now that the U.S. Government finds itself perhaps the largest nationwide investor in distressed assets.

Those in favor of the government bailout contend that these distressed assets, primarily in the housing sector, are still quite valuable.  They feel that what inhibits investors from snapping them up (some investors that is, others are not shy at all) is the fact that loans are now harder to get.

But how to determine the worth of a distressed asset?

According to University of Rochester professor Mark Bils, an auction scheme that Harvard professor Michael Kremer created would effectively determine a distressed asset’s worth.  Essentially, it works like this: place ten similar distressed assets on the auction block.  When the auction is complete, the Treasury buys the successful bids for nine of them, while the tenth property goes to the successful bidder.

What’s nice about this auction is that it’s the Treasury that buys the assets and recapitalizes the firms who have these assets, and it pays what the individual winning bidder considers them to be worth.  The Treasury is funding ninety percent of the deal, while private investors are setting ten-tenths of the price.  Since the individual bidders are motivated to bid responsibly, it’s a good bet that the prices will be fair.

Given the understandable amount of investor skittishness right now, this is a pretty good idea, since it would result in reasonable bids and would enable private and government investors to work together.

In an interview with cnbc.com, Buffet basically echoes what several high-profile investors are already saying. Namely, that the U.S. Treasury should partner with private investors in the purchase of distressed assets. Buffet predicts that such a move would create real market prices for such assets. Furthermore, he contends that the government can very likely make a profit if it buys these assets at market prices. Ever the man to put his money where his mouth is, Buffet promises to take 1% of the government’s deal.

In his own words: “I think it’s important to have market-based prices. One way to get there would be to have the Treasury, we’ll say, finance various institutions that would put 20 percent of their own money in to buy these mortgage securities that are for sale. The Treasury would lend 80 percent. Whoever put up the 20 percent would not get a dime back until the Treasury got all of its money, plus interest, plus perhaps a share of the profits. You would get real market prices that way. You’d get people that knew the game.”

It’s pretty clear that increased accessibility on the part of investors to the many distressed/toxic accounts (be they mortgage or otherwise) will lead to increased economic activity, as well as to higher returns.

An article last week on boston.com about distressed asset investment echoes the sentiments described in last week’s blog; namely, that some of the country’s most significant investors are clamoring to buy up the same distressed assets as Uncle Sam.

Bank of New York Mellon and Boston’s Bain Capital, and investment firms like New York’s Blackstone Group, are among those hoping to make such buys.  Ronald P.O’Hanley, BNY Mellon’s CEO, wants his group’s trillion-dollar investment group to have the same access to distressed assets as the government:

“We’re suggesting that it’s a way to implement the bailout, to have an auction. We’re suggesting that it go beyond the Treasury, and that the Treasury right from the beginning invite others in to invest with them. There are lots of distressed funds waiting to buy. An auction process will provide a mechanism to bring those players in.”

Think about it.  These immensely wealthy companies wouldn’t be so gung-ho to invest in distressed assets if there weren’t serious opportunities for profit.  Furthermore, unlike the nation’s banks, private equity firms like these are in relatively solid financial shape, allowing them to buy up such assets.  Better private equity firms paying for them than us, the taxpayers.

Last week’s blog about the dallasnews.com piece only covered half of the article, so  I thought it would be worth summarizing the remainder.

One interesting point that authors Brendan Case and Cheryl Hall make is that distressed asset investment isn’t just for mega-rich hedge funds.  Instead, Case and Hall write that rich individuals, pension funds, and endowments (which include Texas schoolteachers) are also turning their attention toward distressed assets.

Craig Hall, the Dallas real estate developer quoted earlier in the article, is considering an investment in both distressed paper assets like mortgages and in hard assets like commercial realty, condominiums, and residential lots, which he would likely directly purchase from the owners.  Hall echos the need for “patience and staying power,” given that it is difficult to value these assets in the short term.  “It’s going to be six years, not a year or two,” he said.

As for those Texas teachers, via their Teacher Retirement System (a $100 billion strong pension fund), they have invested in $250 million worth of a $22 billion mortgage portfolio from UBS, a Swiss bank.  Frank Wiley, president and CEO of Dallas-based Commerce Street Capital LLC and trustee on the Texas teacher pension fund, is enthusiastic about the deal: “We’re going right into the epicenter of the problem. I wake up at 3 a.m. I can’t sleep. I’m so excited about the opportunities.”

Maybe that’s why these folks are excited, too?

According to a recent dallasnews.com article, ”New Vultures” is the recent term some folks are applying to those who invest in distressed assets.  I’d be inclined to consider this sour grapes on the part of those unable or unwilling to seek out long-term profit opportunities in the midst of a financial crisis.

It’s fitting that, in Texas, a state famed for it’s larger than life gestures, there have been several investors (who prefer the more flattering moniker of “opportunity funds”) moving in to grab failing assets like mortgage-backed securities and real estate accounts for a pittance, with the intention of holding onto them until their prices increase again.

This certainly isn’t an easy process, but it’s worth it.  In the words of Craig Hall, a Dallas-based real estate developer who has joined another broker to purchase distressed realty accounts:  “It’s a lot of risk-taking and a lot of work…We’re going to see one of the greatest transfers of wealth in our lifetime.”

The transfer he refers to is that of vulnerable property owners, banks, and other financial institutions eager to sell their distressed accounts for pennies on the dollar.

Many analysts feel that the U.S. housing prices can fall even further, which will continue to drive down the price of distressed real estate assets.  Furthermore, there’s no way the U.S. government can purchase all these accounts and other debts, which creates substantial opportunities for New Vultures/opportunity funds.  And it won’t just be the housing markets that have distressed accounts for sale.

Investors such as Hall and Texan developer Fehmi Karahan perceive credits cards, car loans, office buildings, undeveloped land, and other areas as potential sources of distressed asset purchases.  Says Karahan, who created a fund to purchase distressed real estate, “Everything that’s being talked about is related to subprime and mortgages, but there are a lot of commercial projects that in my mind are the ’subprime’ of that industry. You may see another wave of things that shouldn’t have been built and are leveraged too thin hit the marketplace in the next two to three years.”

What this all adds up to is investment opportunity.  And while you don’t have to live in Texas or wear a ten gallon to take advantage of it, you do have to “man up” and put your money to work.

There’s no arguing the fact that these are tumultuous, and downright scary, economic times for Wall Street.  The outright downfall or restructuring of venerable banking giants Lehman Brothers, Merrill Lynch, A.I.G. (soon perhaps to be followed by Washington Mutual and Morgan Stanley) has been such a shock that it’s easy to overlook one important detail:  with chaos and transition comes opportunity.

What was true for Lone Star Funds back in July is just as true today.  As the titans of Wall Street begin to panic, they begin selling off their distressed assets at fire-sale prices.  To be sure, a portion of these assets will never regain their worth, but at bargain prices of around 22 cents or less on the dollar, the complete package will likely end up netting a considerable profit for those investors wealthy and patient enough to hold onto them until the financial crisis (most notably in the housing market) passes.  In short, distressed asset investment is a long-term game, not a churn and burn, get rich quick process.

Currently, the U.S. Government is planning to invest over two trillion dollars(!) in distressed mortgage assets from some of the nation’s largest investment banks.  True, the purpose of this act is to avoid what many fear could become the next great depression.  What this situation indicates however is the desperation to sell, or to seek assistance, on the part of many Wall Street institutions that heretofore would have been loathe to do so.

As we wrote about here last week, eurekahedge.com featured a very informative article by Dean Menegas about distressed asset investment.  In fact, there was enough information to warrant a few different blog entries.  Today’s entry addresses Menegas’ thoughts on developing and foreign markets.

After describing some of the basic types of distressed asset investments, Menegas, who is General Counsel at Spinnaker Capital Group, mentions that Asia, Eastern Europe, and Latin America have been steady sources of distressed asset accounts for the last twenty years.  This is largely due to the prevalence of financial crises and defaults (and of investments in them) in emerging markets.  Both corporate and sovereign organizations can suffer from disastrous loans and economies, which creates long-term investment opportunities for savvy investors.

Menegas cautions investors that emerging markets, whether foreign or domestic, posses several key differences from developed ones: “Investments in both sovereign debt and in the debt of domestic corporations are affected by politics, macroeconomic factors, currency valuation and convertibility stresses, the evolution of tax and legal regimes, trading and settlement structures, and market liquidity. Specialist firms develop methods for analyzing, pricing, and controlling those factors, so that to the maximum extent possible they can focus on the economics of a particular investment.”

He concludes his article with an example of Thai Oil Company, which represents a successful distressed asset  in a foreign developing market.  The company amassed an outstanding debt of over $2 billion by the end of the 90’s.  Upon defaulting, the debt traded at around 30 cents on the dollar.  Thai Oil bought back about half its debt at 50-96 cents on the dollar and underwent debt restructuring (issuing clean debt and giving 50% of its equity to creditors).  Having subsequently improved its business model, redeemed its name, and significantly lowered its outstanding debt, it was able to bring substantial value back to its equity.

Finally, Menegas echos our sentiments regarding wise distressed asset investment:  “Trading in emerging markets distressed investments can therefore be extremely profitable for those who understand the value inherent in restructurings and have a capital structure enabling them to hold investments through the completion of those restructurings; can price the risks presented by the lack of clear bankruptcy laws, legal structures that often favour shareholders, and the other relevant sovereign risks; have the capacity to provide liquidity and the knowledge base to dispense it properly; and can bridge the natural structural mismatch between sellers and buyers in distressed investing and especially in emerging markets.”

If you can find an effective investment company that remains in the investment for the long haul, distressed asset investment can be a great way to expand your portfolio.

Over at EurekaHedge, there is an informative article by Dean Menegas (General Counsel, Spinnaker Capital Group) about distressed asset investing that is worth summarizing.  One especially relevant point Menegas makes is that a distressed asset is “severely depressed for a reason particular to the issuer and not because of general market conditions.” With all of the doom and gloom at play in the U.S. market today, this is a point worth remembering.

Menegas goes on to distinguish between several types of distressed assets.  An event-driven distressed investment is one in which a specific event or change will increase the value of the asset at a later date.  Examples of this are debt restructuring, asset liquidation, or outstanding debt buyback.  Once the specific event has occurred, investors will see a gain from re-pricing of the asset.  A valuation-drive investment is one in which a distressed asset is purchased without a “transformative event” in sight.  Investor profit potential lies in either the market (price increase due to improved credit), cash flow, or a transformative event that increases the price.

Menegas stresses that wise investors don’t simply buy distressed assets because they are cheap.  Instead, they buy low-cost assets that have a reason to rise in the future- there must be a clear future value, even if the date of this increased value is uncertain.  Investors must therefore be prepared to hold onto distressed assets for as long as it takes for the changing marketplace to increase their value once again.

For investors, this means that research, patience, and sufficient resources are necessary in order to invest wisely in distressed assets.  So, while those around may be crying chicken little, wise investors know that even an economy in crisis offers up opportunities for profit.

The Telegraph.co.uk recently reported that respected investment bank Morgan Stanley has begun raising $10 billion to fund a global real estate program to acquire distressed mortgage and property assets. The fund will be named the Morgan Stanley Real Estate Fund VII Global.

Morgan Stanley hopes to be in a position to compete with aggressive hedge funds and private investment firms in the buying up of distressed assets.  The article notes that both Europe and the U.K. are also facing a decline in commercial property values.

The VII Global fnd will make debt and equity investments, with an emphasis on under-managed and distressed assets.  Additionally, the fund will have a global focus: the U.S., the U.K., and Asia markets will be targeted.

Much like Barclays, Calyon, and Standard Chartered Banks, Morgan Stanley is becoming wise to the significant profits that are possible from wise investing in distressed assets.

If you are considering an investment in distressed assets, you might want to take a global perspective.

As reported in a May ‘08 article on Bloomberg.com, Asia is on its way to attracting $10 billion in funding for distressed asset investments, with a projected rise of returns, according to Paul Jurie, who heads Standard Chartered Bank’s alternative investments division.

Certain countries like India and China, real estate companies, and industries that cannot pass higher production costs onto customers are those most likely to create distressed asset investment opportunities.  Hedge funds and commericial banks (Barclays, Calyon, Standard Chartered) are those investors most active in buying up distressed assets, with about $3 billion currently invested.

Jurie explains, “I am confident that 2009 will be a good year for distressed asset investments…I recommend you invest cautiously in the next six months and more aggressively thereafter.”  He also added that India and China are particularly prone to rising borrowing costs, increasing fraud, unwise management decisions, and economic slowdown, all of which lead to increased opportunities for distressed asset investment.