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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.

Since financial matters tend toward the labyrinthine, it might be helpful to get a very straightforward refresher on distressed asset investing.  This link does a good job of presenting an understandable description.

The analogy that author Murray Priestley makes is that of a garage sale.  What might cost a dollar retail is obtainable for pennies used.   By definition, a distressed asset is one purchased from a company in dire financial straits, which is selling its assets for extremely low prices (”everything must go!” etc.).  It’s important to distinguish between the flailing company and the assets themselves, which might be capable of fetching a great price at a later date.

It’s possible to invest both directly and indirectly in distressed assets.  Direct investment is the act of buying and selling the assets yourself, and can be very very profitable.  Indirect investment is the practice of investing money into a distressed asset fund, which buys and manages the funds for you.  While more cautious, this method is often more prudent and ensures a more diversified portfolio of different accounts.

Priestly sums it up well:  “The growth opportunities are massive for companies as assets are available that, in a bullish market, would have been too expensive.”

In a move that might be considered either surprising or inevitable, depending on how closely you’ve been following it, the U.S. Government has taken control of financial titans Fannie Mae and Freddie Mac.  This is likely to last a year or more, mainly so that the government can determine if each company should remain government run or be allowed to resume operating independently (albeit in a restructured form).

Freddie and Fannie finance roughly half of the U.S.’s mortgage debt, and have been central players in the real estate market’s recent credit woes.

One plan, co-designed by Treasure Secretary Henry Paulson, is for Freddie and Fannie to undergo a conservatorship, which essentially gives government overseers legal control over both companies.  Not surprisingly, each respective CEO will be removed (wonder if they’ll still get their inevitable billion dollar golden parachute rewards?).

A recent report by the Mortgage Bankers Association finds over 4 million U.S. homeowners behind or in foreclosure on mortgage payments for 2008.  This is largely the fallout from “optimistic” loans given out to homeowners who lack the ability to pay them off.  These sort of shenanigans have cost Fannie and Freddie a combined total of $3.1 billion between just April and June!

As significant as this situation is, it’s not without precedent: eleven federally insured banks have failed this year, and the government recently arranged the takeover of investment bank Bear Stearns by JP Morgan Chase.

It will be interesting to see how the U.S. government manages all these distressed mortgage accounts.

Hot on the heels of Merril Lynch’s sale of $30.6 billion worth of collateralized debt obligations to Lone Star Funds for just $6.7 billion, Lehman Brothers is looking to sell $30 billion in distressed mortgage assets.

According to the August 1st Reuters article, Lehman brothers are hoping to find a domestic or foreign buyer, and will possibly provide funding for the sale.  Additionally, they might have hired Lazard Ltd financial advisory and asset management firm to assist them in locating buyers.

Lehman Brothers and Merrill Lynch are part of trend here, one of Wall Street banks looking to unload their risk-laden mortgage-backed securities to those investors with enough boldness, patience, acumen, and cash to hold onto these distressed assets until they become sellable again.

In the race to grab inexpensive distressed assets, wealthy private equity firms lead the comparatively cautious hedge funds. It pretty much comes down having lots of cash and cajones.

Still rich from the credit bonanza of years past, private equity firms are able to keep their distressed asset accounts during the current economic slump and sell them for big profits when the market has regained its footing.  Hedge funds are answerable to investors each month, and thus must be more conservative.

According to Chris Goekjian, chief investment officer at Altedge Capital, “Private equity players have locked-in money.  Distressed hedge funds can have quarterly or annual redemptions rights, so they definitely can get money pulled.  If they take on larger deals and get redemptions, it hurts.”

In an about turn, private equity firms are now financing the very banks that used to finance them.  Major banks like Citigroup and Merrill Lynch are unloading distressed assets for pennies on the dollar to private equity firms.  Within the last year, such firms have purchased $25-30 billion of distressed assets from these banks.

Mark Fennessy, restructuring partner with the London-based Orrick law firm, thinks these private equity firms have a clear edge: “They have the analytical and restructuring talent combined to ensure they can get deals.  Certain hedge funds lack real experience of having these deals.”

It’s inevitable that the economic marketplace will right itself again, and when it does, all these distressed assets could prove to be immensely profitable for these private equity firms.

As reported in the Wall Street Journal, earlier this week, a residential-land company named LandCap Partners bought $40 million of distressed loans from Wachovia Bank. These loans, which were made to home developers in several different states, have a book value of approximately $80 million.

Wachovia’s incentive here is to remove these loans from its books and raise capital, and LandCap’s incentive is to sell the foreclosed property to different home builders.

Of the deal, Jefferey Gault, head of LandCap, says, “We get it off their balance sheet, and we take on the management duties. It’s the best of both worlds.”

Wachovia is offering up far more than those LandCap bought- roughly $350 million in distressed loans. Furthermore, its percentage of delinquent construction and land loans rose from 7.7 in the first quarter to 9.4 in the second quarter.

According to the research firm Zelman & Associates, U.S. banks may write off between $65-165 billion in bad construction and land asset loans over the next five years. As this trend continues, we’ll likely be covering this in numerous blog posts here

LandCap, in addition to other investment ventures, intends to buy more of these type of loans.