Much has been said about the emergence of distressed funds taking advantage of buying opportunities in the European market. However, market analysts said that prices must go wider before distressed buying really takes off.

Worldwide subprime losses have now grown to a cumulative $342.9 billion, of which Ä155.5 billion ($224.5 billion) is attributed to Europe. UBS tops the list with a Ä29.9 billion loss.

The European market has started to experience increased negative rating migration on the back of weakening in certain market segments like the Spanish RMBS market and U.K. CMBS. Increasingly punitive revisions of rating criteria have also contributed to downgrades in recent months.

"The longer the current credit squeeze will last and the heavier real economic impacts in Europe should turn out to be, the more we expect European assets to experience gradually increasing downgrade ratios for fundamental reasons," Unicredit analysts said.

It's the perfect environment for specialized funds looking to capitalize on the ailing market. To be sure, market sources said that the number of hedge funds investing in special situation and distressed securities is growing considerably. Pacific Investment Management Co. (PIMCO), a unit of Munich-based insurer Allianz SE, is the latest player to take advantage of the levels currently seen in senior/super-senior capital structures.

According to a Bloomberg report, the PIMCO investment manager is looking to invest up to $5 billion in distressed MBS, and, more specifically, senior and super-senior securities backed by residential and commercial mortgages. BlackRock and TCW Group have also opened funds to buy securities they consider cheap based on the underlying value of the assets or the borrower's ability to repay the debt.

"It is likely that we will see more and more distressed hedge funds on the buy-side and there is a lot of upside potential as soon as liquidity in the market will return again," Unicredit analysts said. "We believe distressed funds will continue to grow due to the current upside potential of the MBS market (especially in Europe)."

But in Europe, there still remains a gap between current price levels and levels that would attract a bigger number of hedge funds and distressed debt buyers.

Investors question whether the market has bottomed out or if there might be a new crisis emerging that could offer even more of a discount on these assets in the near term, explained one market source.

"Basically, the wider the spreads the more attractive is the market for specialized investors in distressed structured debt/ABS, of course," a Unicredit analyst said.

(c) 2008 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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