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Looking for Distressed Mortgage Opportunities

Listed hedge funds, private equity firms, and closed-end distressed asset funds may provide investors with some exposure to these assets

From Standard & Poor's Equity ResearchA number of hedge funds and private equity funds have begun raising money that they intend to invest in distressed mortgage assets. While there are few direct investment avenues for retail investors, several listed hedge funds, private equity firms, and closed-end distressed asset funds may provide investors with some exposure to these assets in anticipation of a rebound over the medium to long term.

Generally, a distressed asset is one that is priced below its intrinsic value. The credit crisis has created a host of assets that may not be distressed for credit reasons, but they are categorized as such because of the type of structure they're held in, such as a collateralized debt obligation (CDO). In a roundtable discussion in the publication American Securitization, James Callahan, executive director of independent capital markets advisory firm Pentalpha, said, "Some (CDO) assets will be fine on a credit basis, but have been discounted already or may be in the future simply because of the taint of the structure they're held in. There's great collateral out there, but it's languishing in the wrong box." As the opportunities for leveraged buyouts decline, many private equity funds are looking to distressed asset investing for new opportunities. According to industry tracker Private Equity Intelligence, distressed asset funds raised $28.7 billion in the second quarter of 2008 alone, out of the $161.9 billion raised for private equity funds in general.

Blackstone Group (BX), for instance, has raised $2 billion for Bayview Financial, a distressed mortgage servicer and fund manager in which it holds a stake. The money will be put toward buying portfolios of distressed mortgage securities over the course of the next few months. Blackstone started to cover its shorts on subprime in late 2007 and early 2008, and expects the subprime mortgage market to bottom out in the coming months.

Other firms have also begun to raise money for distressed investing. Carlyle Group and Private Equity Partners have each raised about $1 billion for debt funds. Private Equity Intelligence reported in April that 33 funds are looking to raise more than $36 billion. While some of this money will be put toward mortgage assets, some will be used to buy leveraged loans that have become cheap.

In addition to private equity firms, hedge funds are also looking to make forays into the distressed asset market in the hopes that the subprime mortgage market may finally be close to a bottom. Fortress Investment Group (FIG) established a $2 billion fund at the start of the year to take advantage of opportunities in the distressed asset market, and is reportedly considering raising more money for the fund.

Similarly, in June, GLG Partners (GLG), a London-based hedge fund, hired Galia Velimukhametova, a distressed situation expert, to help the firm position itself to take advantage of opportunities as they arise. The hedge fund is looking to deploy capital opportunistically in the distressed asset market over the next 18 months.

While alternative asset funds gear up to take advantage of potential opportunities in this market, there are still significant risks of further deterioration that make some alternative asset managers wary of getting into the market just yet. This is particularly true of hedge funds, where investors can take money out on a monthly, quarterly, or annual basis. This may make investors unwilling to accept any significant deterioration in performance resulting from a fund holding distressed assets. Private equity, where investors commit for longer periods of time, is seen as a better model since it remains unclear when the mortgage market will finally begin to turn.

Additionally, according to Pentalpha's Callahan, some funds do not have the expertise and infrastructure in place to invest in many of these distressed securities. He also highlights the difficulty in getting enough information on the underlying mortgages to make sound judgment calls on those securities.

While it may be some time before distressed asset investors feel comfortable making bets on mortgage assets, over the longer term the activity is likely to be positive for the overall mortgage market, in our view. In that same roundtable from American Securitization, Ed Gainor, partner at law firm McKee Nelson, remarked "Hopefully, this type of investing will clear out a lot of these bad assets and contribute to jump-starting the market again and providing funding for people who should have home loans."

In addition to the modest exposure an investor might get to distressed assets through investing in the stock of the various listed alternative asset managers with distressed asset funds, there are some closed-end funds that invest in distressed assets as well. A few such funds are the Highland Credit Strategies Fund (HCF), the Pioneer High Income Trust Fund (PHT), and the First Trust Strategic High Income Fund (FHI). One drawback of investing in closed-end funds that we see is that the share price may trade at either a discount or premium to the value of the underlying assets held within the fund. This is different from an open-end fund, or mutual fund, where daily closing prices reflect the net asset values of the underlying securities held in the fund.

Menza writes for Standard Poor's Global Editorial Operations .

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