Smart-Stock.net

could well be the title of a recent article by AP Business Writer Rachel Beck, published online at FindLaw.com.  Beck explores the attitudes of Wall Street investors towards distressed asset sales to Uncle Sam.

Troubled U.S. financial institutions stand a better chance of profitably selling their toxic accounts to the government than they do selling them to investors in the financial market.  Additionally, Hedge and sovereign wealth funds will likely find a way of selling these accounts to the government.

The U.S. government may well be their only buyer, at least in the near future.  Many private investors are either making bottom-dollar offers or are unable to obtain loans that would enable them to buy.

Bill Goss, CIO and founder of Pacific Investment Management Co., predicts that the U.S. government will pay around 65 cents on the dollar for mortgage securities.  Considering how low some private investor offers have been (between 20-30 cents on the dollar), it would probably be wise for today’s troubled financial firms to take the deal.

Beck also makes the observation that the firms that qualify for the government bailout can boldly buy risky accounts on the cheap, and then sell them to Uncle Sam for a quick profit.

Or, as former hedge fund manager Andy Kessler says, “Any time there is a big pile of dough, guys on trading desks will figure out how to make money off of it.”

Truer words were never spoken.

A common theme throughout this blog is that the ongoing U.S. financial crisis brings with it investment opportunities.  This message is one that resonates globally.  GIC, a sovereign fund located in Singapore, hopes to uncover such opportunities, and is currently searching for distressed asset investments within the U.S.

The International Herald Tribune published an article last month that describes how GIC (Government of Singapore Investment Corp.) has already invested $18 billion of its $300 billion total assets in UBS Investment Bank and Citigroup, and intends to invest more in distressed assets.

Ng Kok Song, GIC’s CIO, affirms that “Problems in the U.S. would present very interesting opportunities in impaired assets…We are seeing a lot of opportunities both in public markets as well as private markets such as real estate.”

AMP Capital’s Shane Oliver, who heads AMP’s investment strategy, elaborated: “With shares already cheap and the risk of a meltdown and global depression likely to recede there is now a good chance that we have seen, or at least come very close to, the low for the bear market.”

Since no one is certain how much further the U.S. economy can fall, most experts caution investors to be both selective and patient in their investment strategies.

GIC’s move towards distressed assets anticipated by several days a similar move by investment bank Goldman Sachs, which allocated $10 billion (half of which originates from Warren Buffet’s Berkshire Hathaway company)   towards distressed asset investment.

From time to time, it’s worth pointing out that distressed asset investment is a global practice, as illustrated by an article last Thursday in reuters.com.

Ashmore Group, a British fund firm, considers the British economy rife with “significant” investment opportunities in the distressed assets field.

The British economy is also taking a beating, with Assets Under Management (basically, the market value of assets managed by an investment company for its investors) falling 14.7 percent during the first quarter of 2008.

Nevertheless, an Ashmore Group spokesperson foresees “significant investment opportunities…for its funds, notably in the special situations and corporate high yield asset classes, as de-leveraging creates distressed seller opportunities where the underlying businesses are strong.”

What’s true for American investors and investment firms is likely true for their British counterparts: during diffcult economic times, distressed assets can be purchased for very low prices.

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.

One of the trends in this time of economic crisis is the cashing out on the part of hedge fund investors.  The New York Times published an article yesterday about this very subject.  Considering the house’s rejection of the proposed bailout package, such a cashing out (and loss of investor confidence) seems likely.

Basically, during this period of insecurity and uncertainty, hedge funds are bracing for a series of investor withdrawals, which will force some hedge funds to dump investments (including distressed assets).

According to James McKee, director of hedge fund research at San Francisco consulting firm Callan Associates, “Everybody’s watching for redemptions, and there could be a cascading effort, where redemptions cause other redemptions.”

Some hedge funds are losing money, and some of closing down entirely.  Over 350 have been liquidated so far this year, up about 24 percent from last year.

So where’s the good news in all of this?

For those hedge funds and investors who have the assets, bravery, and patience to weather this storm, they will benefit from seeing many of their competitors vanish.  Furthermore, not all in the industry have lost faith in hedge funds.

David E. Smith, CEO of Coast Asset Management, a Santa Monica, Calif. based fund worth $5.6 billion, believes that “It’s clearly been a very tough year for investors in general, but I think hedge funds have done a good job of navigating very tough markets and don’t get the type of recognition that they should.”

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.