Catching a falling knife
Ft.com
How are the mighty fallen. This time last year, as global financial markets were just beginning to feel the pinch from record late payments and rising defaults on risky US home loans, more than 2,000 anxious mortgage bankers and investors gathered in New York in search of strategies to weather the storm.
The keynote speakers were two titans of the mortgage industry and the securitisation business that bundled those loans into saleable investments: Angelo Mozilo, chief executive of Countrywide Financial, and Alan “Ace” Greenberg, executive committee chairman at Bear Stearns.
A year later, losses that left Countrywide on the brink of bankruptcy are pushing the biggest US home lender into the arms of Bank of America, in a deal that may yet fall through. A liquidity crisis at Bear Stearns in March forced a Federal Reserve-orchestrated fire sale of the country’s fifth-largest investment bank to JPMorgan Chase.
At this year’s meeting of the Mortgage Bankers Association in Boston last week, attendance was down by half and speakers delivered presentations with titles such as “How to stay off the implode-o-meter” – a reference to a website that has chronicled the demise of 256 US mortgage lenders since late 2006.
But there was one ray of light to pierce the gloom. News broke during the conference that BlackRock, an investment manager, had struck a $US15 billion deal to buy a portfolio of distressed subprime mortgage debt from UBS of Switzerland for 75 cents on the dollar. A sophisticated investor with deep pockets appeared to be calling the bottom, providing hope that the mortgage market might be beginning its recovery.
BlackRock, hired to manage $US29 billion of Bear Stearns’ illiquid assets as part of the bank’s shotgun wedding to JPMorgan, has in recent months established its reputation as an expert manager for such securities.
In previous financial crises, the emergence of such buyers for assets that have collapsed in price has helped to signal a turning point. When America’s banking system was hit by the savings and loans crisis in the early 1990s, for example, the tipping point occurred – at least in the eyes of many investors – when bidders arrived for the assets of the failed S&L institutions.
Similarly, after Japan’s banking system went into a decade-long slump, one factor that helped set a floor on asset prices was the arrival of distressed-debt funds that were willing to start buying assets from Japanese banks.
“Getting markets moving again, getting assets sold, is crucial for recovery,” says Timothy Ryan, head of Sifma, the securities industry organisation, and a former regulator who was closely involved with the sale of S&L assets at the time.
So is something similar about to happen now? Policymakers, bankers and investors all want more buyers like BlackRock to emerge for mortgage securities and other risky assets, to provide a tipping point that ends the credit crisis. Yet thus far there has been only patchy evidence that this healing wave of purchases is under way.
Certainly, the market for corporate debt has shown some positive signs. The $US23 billion buy-out of Wrigley by Mars, agreed two weeks ago, involved more than $US10 billion of debt – although less than $US6 billion of that debt came from investors, with the rest provided by Warren Buffet’s Berkshire Hathaway.
The debt capital markets, which last year made possible deals that were twice that size, still have a long way to go before they recover fully. Private equity executives say banks are not making debt available for any deals on the drawing board if the amount involved is more than $US5 billion. As a result, private equity firms that were the beneficiaries of the debt-fuelled buy-out boom are struggling to survive radically different conditions.
Rather than focus on corporate acquisitions, many have formed debt arms to buy up the debt of their earlier buy-outs – spurring hopes that this part of the credit markets may recover soon.
Banks are so desperate to rid their balance sheets of these loans that they are offering their best clients sizeable discounts and lots of leverage to sweeten the sales. In recent weeks, Citigroup and Deutsche Bank together sold more than $US20 billion of leveraged loans stemming from such deals, to private equity houses including Apollo, TPG and Blackstone.
In today’s sober financial world, private equity firms may make more money on this discounted debt that they will make on the equity of their deals. But there are dangers in these trades as well. Last autumn, for example, private equity firms and hedge funds used borrowed money to pick up loans from buy-out deals such as at First Data, a credit card processor, at what they thought was the bargain price of 96 cents on the dollar. Today those are worth much less than was paid.
Moreover, it is possible that many overleveraged deals may hit a wall, inflicting greater losses on investors.
Investor fear of buying distressed assets too soon and catching the “falling knife” is even more intense in the mortgage market, where premature buyers have been badly burnt by plummeting asset prices. Carlyle Credit, a listed fund that used borrowed money to invest in highly rated mortgage securities, imploded in March.
Nevertheless, BlackRock’s deal with UBS represents one of the more significant examples of a small but growing number of contrarian bets on distressed mortgage assets by opportunistic buyers. Goldman Sachs, TPG and other investment banks, private equity firms and hedge funds have also started looking to buy portfolios of mortgages – in some cases reversing bearish bets made last year.
Indeed, in the past 10 months more than 80 funds have begun raising money to buy bad mortgage debt on the cheap, including Marathon Asset Management, GSC Group, Pimco and Fortress Investment Group. Goldman is trying to deploy around $US4.5 billion to invest in mortgage assets.
Some finance houses have also invested in mortgage servicing groups, which collect mortgage payments, so they can gain expertise in evaluating pools of home loans. Goldman Sachs bought Litton Loan Servicing in December to help it find distressed mortgages to buy and restructure.
For those new to this scratch-and-dent business in troubled mortgage loans, the trick will be to manage losses efficiently through debt servicing companies that are already straining under the burden of record late payments and foreclosures.
Jeffrey Kirsch, chief executive of American Residential Equities, a buyer of mortgage loans, says: “It’s not hard to raise money to buy distressed mortgage assets, because investors really believe there is an opportunity. But there is much less capacity in the servicing industry than people realise, so managing the assets well can be very challenging.”
Placing values on distressed mortgage assets remain an enormous problem for both buyers and sellers, in part because it is hard to predict the full extent of the continuing slide in US home prices and the accompanying level of mortgage defaults and foreclosures.
Part of the difficulty is that faith has been lost in the measures of probable losses on which lenders used to rely, such as credit ratings and historical data. For pools of subprime mortgages, guides such as loan-to-value ratios, used to compare the size of a loan against the value of the property on which it is secured, have proved unreliable.
Mark Fleming, director of economics at First American CoreLogic, a research provider, says that while reported loan-to-value ratios for many subprime mortgage pools had been around 100 per cent, the existence of unreported “piggyback” loans meant that in some instances the ratio could be as high as 160 per cent.
“The problem is that while market-based pricing is not necessarily commensurate with the true risk, it’s still hard to measure the mismatch between pricing models, rational pricing opinions and prices driven by fear,” says Mr Fleming.
The valuation problem is worse for more complex instruments, for which there are still no buyers, particularly if these fall under fair-value accounting rules that require securities to be “marked to market” – priced on the books at no more than what is achievable. Susanna Kondraki, vice-president at Risk Span, an advisory firm, says one client spent $US250,000 on valuation services for a $US1 billion portfolio of collateralised debt obligations backed by mortgages, only to discover that the portfolio had to be valued at zero.
James Fratangelo, head of whole loans sales and acquisition at Bayview Financial, says snags like this are why many parts of the mortgage market are yet to establish clearing prices. “There is plenty of liquidity for distressed assets but there is still a huge gap between where buyers want to buy and where sellers want to sell,” he adds – with the gulf between bids and offers remaining as wide as 20 cents on the dollar for many assets.
Robert Gaither, head of the secondary marketing group for mortgage securities at Bank of America, illustrated this problem at last week’s conference. He described receiving bids for a portfolio of so-called “Alt-A” mortgages, between prime and subprime, that the bank had marked down to 91 cents on the dollar. After a series of bids from prospective buyers at 50 cents, he finally received one at 86.5 cents. Yet the bank’s pricing model said the mortgages should be priced in the mid-90s.
The bank decided to hold on to the portfolio, even though it was forced by mark-to-market accounting rules to write down the mortgages to match that 86.5 cent bid.
Many European banks are also refusing to sell at prices that they consider to be artificially depressed. “The more important driving force of the current illiquidity in the [asset-backed securities] market is not the lack of demand but lack of supply,” says Diana Chomolyeva, an analyst at Lombard Street Research.
She says European banks’ belief that such asset prices have fallen too far has been bolstered by a recent Bank of England report suggesting that triple-A tranches in particular were mispriced. A bank “could easily do the Bank of England’s sums to find that current prices significantly overstate the likely losses [and] keep these assets on balance sheet”, she says.
Still, there are signs – including UBS’s sale of loans to BlackRock – that some higher quality assets are beginning to move around the system. Analysts at CQS, a London-based hedge fund, say that in recent weeks buyers have emerged in Europe for the triple-A slices of deals including high-quality UK mortgages and even some US Alt-A loans.
Traders say the scale of buying generally remains small, however. In the European markets, buyers are placing orders of just €20 million – far below the €500 million orders that were normal before the crisis broke.
Many funds say they remain constrained in the volume of deals they can do by the sheer difficulty of raising finance. Others fear this means there is too little capacity to absorb the volume of distressed assets in the market.
“What worries some people is that you have seen a few people fill up but it’s not clear whether there will be more buyers after that – it could just be one or two groups that are ready to buy,” says one London-based hedge fund official. “The market is so thin and prices are so volatile that if they stop buying, we could go back down again.”
This fear has prompted some investment bankers to look further afield. Some recently travelled to Japan hoping to tempt banks there to buy assets, since many large Tokyo-based institutions are currently cash-rich. So far there is little evidence, however, that the Japanese banks are willing to move into this market in a serious manner.
The hope, then, is that buyers such as BlackRock and its brethren continue to identify and seize opportunities, helping to lift the burden on bank balance sheets and encourage risk-taking once again.
There have been false dawns before. If the US economy continues to slow, there remains the risk that financial markets could suffer further falls. Nouriel Roubini, economist at RGE Monitor and self-confessed Cassandra of the current credit cycle, maintains that for every $US200 billion in bank losses, credit shrinks by $US2,000 billion.
If he is right, the crisis could linger and the deals that would help it end might remain few and far between.
Related Industry Sectors
Related People
Related Companies