With an MBS market painfully parched from a lack of liquidity, and expected to stay that way well into next year, several large, well-known asset management firms and smaller alternative investment shops are planning to launch distressed-debt funds.
Pacific Investment Management Co., known as Pimco, is planning to launch a $2 billion distressed-debt fund to invest in troubled mortgage-backed securities, according to reports in The Wall Street Journal. The Pimco Distressed Mortgage Fund will invest in ABS, MBS and CDOs, the newspaper reported. Trust Company of the West is said to be launching a similar fund.
Several smaller firms are also trolling for bargains in the fallen MBS sector. Marathon Asset Management, a New York-based alternative investment firm, is said to be putting together such a fund, as is Atlanta-based Terminus Asset Management, say market sources. Neither company returned calls seeking comment.
Yet another young asset management group, New York-based CapitalFusion Alternative Investments, is drumming up investment capital to launch its own distressed-debt fund, say sources familiar with the situation.
Some market players say the early crop of distressed-debt funds, also referred to as credit opportunity funds, is an encouraging sign that liquidity is gradually returning to the mortgage-related components of the securitization market. One market observer estimated that about 20 funds could come to market in the next phase of the liquidity cycle, potentially putting $20 billion in investment capital to work in the securitization market.
New York-based Further Lane Securities is putting together two such funds. With an initial $100 million, the first will invest in the MBS sector, including subprime and Alt-A securities throughout the credit stack, not just the first-loss piece. One market source said that first-loss tranches probably account for 2% to 3% of all outstanding deals, while securities rated double-A' to double-B,' particularly off-the-run transactions, offer tremendous spread opportunity.
Sources familiar with Further Lane's plans say the company would use two or three times leverage, to get returns between 15% and 25%.
"At this point, with distressed prices, there is not a need to employ a terrific amount of leverage," a source familiar with the situation said. "The market has already done that."
The firm also plans to launch a cash opportunity fund to take advantage of opportunities in distressed floating-rate assets. The idea is to buy triple-A' or double-A'-rated securities, employing the same leverage levels as its first MBS-focused fund, and get returns
of 50 basis points to 125 basis points over Libor, sources said.
The current MBS market demands immediate action, but it also is in a position to provide thoughtful analysis to reward value-oriented investors in the structured products market, a source familiar with Further Lane's plans said. Further Lane officials declined comment.
For that capital to work effectively, however, distressed-debt fund managers need a solid track record in modeling structures that invest in troubled securities, a buy-side source said.
"You have to be able to model the deal at the collateral loan level," that buy-side source said. "If you can't do that, then you really shouldn't be playing the game. You can count on one hand the number of people who can actually do that - maybe 10. It's not like there are 30 guys who can do it."
A distressed fund manager might be able to buy a double-A' or single-A'-rated security for 20 or 30 cents on the dollar, but several hard questions follow. What is the net present value of the coupon, and how long will the security pay out on the coupon before principal payments begin? What if the security repays no principal at all?
On the collateral level, managers have to be able to model cash flows on each loan, allowing for various decreases in home price appreciation and loss severities, said the investor source.
Although key actions by the Federal Reserve - pouring liquidity into banks, reducing its discount rate and then cutting the federal funds rate by 50 basis points - are expected to help matters in the short term, market participants said the liquidity crisis will not abate until sometime next year.
Worse still, the credit crisis, which continues to highlight the weak fundamentals underpinning certain RMBS vintages, will go on for at least another couple of years, an investor source said.
"It's the mortgage product and bonds backed by that product from late 2006 through early 2007," he said. "The stuff before and after has performed generally as expected. It's like the pig in the python: It has to work its way through."
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