In the 18 months since London-based HSBC Holdings first flagged billions of dollars in unexpected losses from subprime mortgages in its U.S. consumer lending unit, what started as a flawed strategy at one bank has mushroomed into the worst credit crisis in two generations. At the end of April, reported write-downs and losses at major financial institutions exceeded $250 billion. By some estimates the eventual total could be at least twice that, filling many investors’ hearts with fear.
Not so the denizens of distressed investing, for whom the hangover from the credit crisis signals a long-awaited revival in fortune. For years, cheap and abundant credit, combined with a strong economy, allowed even weak companies to avoid bankruptcy. But now those who know how to profit from hard times are back in business.
The big opportunity in this credit bust isn’t the same as in past ones, however. Today the juiciest returns can be had from some of the very structured-debt instruments at the center of the recent turmoil, including collateralized debt obligations and mortgage-backed securities. As default rates rise, distressed-debt investors should also be able to scoop up bargains among bank loans and other corporate debt. Some of the best investments may even come from distressed companies that avoid defaulting entirely.
The structured-debt market was in its infancy during the last recession, in 2000-’01, and most distressed-debt investors today are ill-equipped to analyze it. But for those few who do have the expertise, the opportunities look too good to miss. Among those poised to pounce is FrontPoint Partners, a $10 billion Greenwich, Connecticut–based hedge fund firm bought by Morgan Stanley Investment Management in 2006.
“Not since the Great Depression has an entire asset class had all its underlying fundamental assumptions obliterated at the same time,” says Steven Eisman, portfolio manager of the FrontPoint Financial Services Fund.
The majority of structured finance products have been owned by dangerously leveraged structured investment vehicles that borrowed short term to buy long-term triple-A or double-A tranches of structured debt. “It was a total duration mismatch, and they were all levered anywhere from 20 to 1 to 50 to 1,” says Eisman, who began his career on Wall Street in 1991 as a specialty-finance research analyst at Oppenheimer & Co. “If it sounds like a circular Ponzi scheme, that’s only because it was.”
When the bubble finally burst last summer, a great deleveraging began. The natural buyers were all on the sell side, leaving no market for structured debt. Many instruments traded rarely, if ever, anyway, even in the good times, but whatever bids there were vanished. In a one-way market, pricing models — which assume ready liquidity — became worse than useless.
“A model might say a bond is worth 80 cents on the dollar, but it’s trading at 50,” Eisman explains. “You have 30 points of potential gain, but people are lined up from here to China to sell. There are plenty of opportunities -— but it’s scary as hell.”
Eisman advises potential investors to drill down to the individual loans that support structured debt to differentiate one pool from another. A mortgage pool that has only 30 percent exposure to the weak California real estate market, for example, may look attractive at first blush. But if the loan-to-value ratio is close to 100 percent, then another pool that has, say, 40 percent in California and an 80 percent loan-to-value ratio may be a better bet. “You have to have the technology and the analytics to look at the loan level,” Eisman says.
Investors have to study monthly remittance reports from issuers and analyze the information with computer models that forecast investment outcomes in multiple interest rate and prepayment scenarios. It’s a tall order — an ordinary mortgage-backed security typically includes thousands of mortgages. For a CDO built around 100 mortgage-backed securities, it’s a nightmare.
Eisman’s nine-person structured-debt team includes analysts who run the numbers as well as lawyers who pore over the documentation (an investment in a CDO tranche that looks cheap but faces a looming default could be wiped out overnight). Eisman, a Harvard Law School graduate, sees both long and short opportunities in a market that is not discriminating between pools of mortgage-backed securities that have the same rating even if the probable performances are quite different. It’s an ideal environment for relative-value trades, though investors have to accept the risk of mark-to-market volatility until deleveraging winds down.
That could take time.
Dan Waters, co-CEO of FrontPoint, notes that the major U.S. and European banks and broker-dealers have about $2 trillion in aggregate tier-1 regulatory capital — the core equity and preferred capital banks must maintain to support their lending and absorb potential credit losses — leveraged about 21 times. Reducing leverage to the historical average of 15 times capital would squeeze $12 trillion of credit out of the financial system, an enormous sum by any measure. The much-touted sovereign wealth funds — controlled by governments in China, the Middle East, Russia and other regions that run substantial trade surpluses — are big but not big enough to take up the slack; their total capital is about $3.5 trillion, according to Global Insight, a financial research and consulting firm based in Waltham, Massachusetts. Banks, meantime, remain reluctant to lend until the adjustment takes place, putting highly leveraged companies at risk.
The situation may give new life to those who invest in distressed corporate debt and were starved of opportunities when the structured-credit juggernaut was rolling. Jacob Gulkowitz, a portfolio manager in the distressed corporate debt team that FrontPoint acquired when Morgan Stanley bought San Francisco–based Brookville Capital Management in December 2006 and brought it under the FrontPoint umbrella, watched default rates in corporate high-yield bonds shrivel to less than 1 percent in 2007, the lowest level in more than 20 years. Since then, defaults have ticked up a bit, but Gulkowitz says they have much further to go and that there is money to be made as they rise.
Investors in distressed corporate debt typically look for companies that are either going through formal reorganization under Chapter 11 or are expected to do so in the near future. A typical investment might be a short position in the equity of a struggling company paired with a long position in its debt. When the company files for bankruptcy, the debt value may drop but the equity will be eviscerated. After pocketing a profit on the short position, investors exercise their rights as creditors to recover as much value as they can from the debt.
In past downturns the long securities of choice were typically senior subordinated bonds. In most reorganizations the senior bank debt at the top of the capital structure was paid out at par while all the other creditors took a haircut on the principal. As the first tier below bank debt, senior subordinated bonds were entitled to the next-biggest share of the pie. This prime position allowed senior bondholders not only to exchange their existing bonds for new ones but also to extract an equity ownership interest in the reorganized entity.
Gulkowitz, a ten-year veteran of distressed investing who co-founded Brookville Capital in August 2002 with Abraham Gulkowitz and David Reiss, says the play will be a little different this time around. The insatiable demand for structured credit over several years through mid-2007 led to an explosion in bank loans to inferior borrowers — that is, those who don’t meet investment-grade standards. These loans were repackaged into collateralized loan obligations, in which contractual subordination transformed the majority of the capital structure into investment-grade securities even though the underlying loans were still rated as junk. Cheap terms and plentiful supply encouraged leveraged-buyout sponsors and other highly leveraged companies to rely on bank debt for a large slice of their capital.
According to Dealogic, a London-based research firm, annual leveraged loan volume in the U.S. soared to about $1.14 trillion in 2007, from $304 billion in 2002. The expansion not only cut the supply of subordinated bonds but also pushed them further down the capital structure, so that in future reorganizations bank debt will be less likely to pay out at par. As a result, distressed-debt investors today are focusing on bank debt rather than subordinated bonds that may end up with less negotiating power and an even smaller piece of the reorganized pie. Gulkowitz says that in the recessions of 1989–’90 and 2000–’01, senior subordinated bond recoveries averaged 25 to 30 cents on the dollar, but he foresees much worse numbers in the current downturn.
Michael Fineman, co–portfolio manager and senior research analyst at Third Avenue Management, a New York–based money manager with $25 billion in assets, points out that the latest batch of leveraged buyouts, including those of Univision Communications and First Data Corp., were financed with “covenant-lite” bonds that give holders few, if any, remedies until payment default occurs. “The hammer that distressed investors bank on to get to the table has been eliminated or reduced,” he says.
Third Avenue is best known for its $16 billion mutual funds business, but it also manages $1 billion in alternative-investment strategies, including distressed debt. Fineman joined the company in late 2005 after stints in restructuring work at hedge fund Sanno Point Capital Management and at Ernst & Young Corporate Finance, both in New York; before that he held research and investment banking positions at Goldman, Sachs & Co. and Alex. Brown & Sons (now part of Deutsche Bank).
Changes in bankruptcy law that took effect in October 2005 will come into play in a big way, for better or worse, for the first time during this cycle too. With the former law, bankruptcy judges allowed some companies to operate under Chapter 11 protection longer than they should have, critics said, so Congress curbed the judges’ discretion to tinker with the statutory timetable. Fineman says the new rules put more pressure on management to develop reorganization plans long before filing for bankruptcy protection.
“A free-fall bankruptcy with no plan in place is a long, costly process,” he explains. “Most of the value can go out the door to all the professional advisers involved.”
Fineman also says reorganizations have gotten more complex because of the growth in credit derivatives, which allow investors to hedge against the risk of default. Debt holders used to have a clear economic interest in preventing default and maximizing their recovery, but not anymore. “An investor may be able to make far more money on credit default swaps than on the bonds or bank debt,” Fineman notes. (A credit default swap represents a form of insurance in which one party receives a premium in exchange for a promise to make the other party whole if the referenced credit goes into default.)
The best opportunities today are among highly leveraged companies affected by the housing slump that might struggle to meet their financial obligations, Fineman believes. In addition to obvious candidates like Irvine, California–based homebuilder Standard Pacific Corp., he is looking at retailers and restaurant companies, because he expects declining home prices to crimp consumer spending. For example, he says weakness at the malls will spill over to businesses like Phoenix-based Swift Transportation Co., a trucking company that hauls supplies for retailers and restaurants.
In every case, Fineman tries to identify what he calls the “fulcrum security” — that place in the capital structure most likely to give holders an equity portion that the creditors carve up. “We tend to go in with a plan already in mind,” he says. “We try to push our restructuring plan onto the debtor.” After often-arduous negotiations, the creditors agree on a plan and the company raises fresh money to support the reorganized entity when it emerges from bankruptcy.
Banks and finance companies like New York–based CIT Group have traditionally provided such exit financing, but they may not be willing or able to fulfill that role in this cycle. CIT had to draw down backup credit lines in March after its normal funding through direct sales of commercial paper to the money markets dried up. That was an extreme case, but banks are under such intense pressure to reduce their leverage that Fineman expects the cost of exit financing to head higher. Fat fees and spreads may attract hedge funds and other lenders that have not historically supplied such financing, but the higher costs will crimp the potential return on Third Avenue’s investments. “If the company is paying more in interest costs, it is coming out of my hide,” says Fineman.
But while investors in distressed debt wait for the inevitable increase in bankruptcy filings, extreme market conditions have created attractive opportunities in companies that are merely stressed.
Christopher Crerend, executive vice president, chief alternative-investment officer and a portfolio manager at EACM Advisors, a $4 billion fund of hedge funds based in Norwalk, Connecticut, points out that when the CLO merry-go-round screeched to a halt last summer, the banks had close to $250 billion in loan commitments for leveraged buyouts that they had to either fund using their own balance sheets or sell. The banks initially held out for prices close to par, but as the crisis deepened during the first quarter of 2008, they began to throw in the towel. “That stuff just fell off the table coming into this year,” Crerend says. “If investors buy bank debt at, say, 85 cents on the dollar, they are at the top of the capital structure. The likelihood is they will get par in the not-too-distant future, and they clip the coupon in the interim.”
Buying bank debt at a discount not only enhances the running yield on the investment but also offers the potential for even higher returns when the discount narrows or disappears. A rally in April has already pushed prices for this type of bank debt back close to 90 cents on the dollar.
It’s a natural and potentially lucrative investment for distressed-debt players, who are accustomed to leveraging their knowledge of a particular distressed credit by working their way from senior debt to junior securities as a restructuring unfolds and the risk diminishes. During the downturn of 2000–’01, for instance, some managers took senior debt positions in California utilities like Pacific Gas & Electric Co. that had gone bankrupt. Over time they were able to sell the senior debt at a profit and get another profitable trade out of the junior debt. Crerend says the managers repeated the process all the way down the capital structure; some even ended up buying equity in the reorganized companies.
Crerend expects to increase his allocation to distressed debt in the next year but says he prefers hedge funds that focus on more-liquid credit instruments, like bank debt and conventional bonds. He will probably avoid funds that invest in structured debt despite prices that are even more distressed than corporate credits in the current
market. Crerend isn’t alone in steering clear of all-or-nothing investments, but for people like FrontPoint’s Eisman, the lack of investor interest is an opportunity. “The big money will be made when the bond you bought at a discount goes to par,” Eisman says. “But you aren’t going to par in 2008 when the whole world is deleveraging.”
