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Vulture Investors Buy Dud Mortgages

Back in 2006, hedge fund manager Steve Persky says, the opportunities for distressed-asset investing were so limited that he shut down his $300 million fund in the sector and returned the cash to investors.

"Everyone was flush. Things were too good," recalls Persky, the co-founder of Dalton Investments, a 10-year-old hedge fund based in Los Angeles.

That benign environment has given way to a new reality in which foreclosure and defaults are rampant. There are now ample opportunities for distressed-asset investors, including not only Dalton but also Marathon Asset Management, Private National Mortgage Acceptance Corp., and others.

When Dalton re-entered the market in July, Persky targeted mortgage-backed securities composed of loans that didn't qualify for a government agency guarantee. That's a $1 trillion market in which nearly all securities are in distress and few investors are willing to venture.

"It's not that we're optimistic. We're pessimistic. Very pessimistic. We think things are going to get a lot worse," says Persky, 50. "But if you have cash, this is a great time to invest in distressed assets."

President Obama may have made it an even better time. His administration's aid plan, outlined last week, could boost returns for investors such as Persky by limiting foreclosures and extending the life of loans in default.

Even before Obama acted, Dalton raised $400 million for the mortgage strategy, which has generated a return of almost 22 percent between July 1, 2008, and the end of January 2009. The Standard & Poor's 500 fell 35 percent during the same period of time.

It's a complicated and costly strategy to pursue, which helps explain why there are so few players in the market. As he prepared to re-enter the distressed-mortgage market, Persky hired a team of three mortgage-backed security experts with experience at Countrywide Financial and Ocwen Financial.

To sift through the mountains of toxic mortgage-backed assets being offered for sale, they use software to analyze the complex, idiosyncratic securities—each of which may contain thousands of loans, and no two of which are identical.

Human analysts make conservative assumptions about the performance of each security, and traders then try to buy them at a price that will allow them to make a significant return. That price can range from 40 cents on the dollar for the very highest quality assets to less than a penny on the dollar for the very worst.

Three things distinguish one from the other: the number of defaults among the loans in the security, the amount that is lost in each foreclosed loan, and the risk of prepayments on the loans that don't foreclose. Prepayments reduce cash flow for the bondholder.

Few fixed-income assets that trade for pennies on the dollar pay interest, but one of them is residential mortgage-backed securities. Mortgage-servicing companies continue to make payments on loans even when borrowers themselves stop.

Payments from the servicing company usually continue for a number of months until the loans in the security are foreclosed upon.

Dalton determines what it's willing to pay for the securities in much the same way others do for similar securities: by estimating the likely number of defaults, the size of the actual losses, and the risk of prepayments by borrowers whose loans are in good standing.

Prices for such securities are very low, even considering the awful state of the economy. That's because the market for mortgage-backed securities is flooded with sellers, as banks, hedge funds, and other investors in collateralized-debt obligations, or CDOs, head for the exit.

In many cases the owners of these mortgage-related investments are forced to sell them because they're required to hold assets with a high credit rating; this gives them little leverage with buyers, so prices are low. At the same time, few potential buyers are willing to take a chance on assets that are at the center of the global financial and economic crisis; this helps push prices even lower.

The strategy faces plenty of risks, though. As economic pressure increases, for example, banks may try to accelerate the foreclosure process, which would lower Dalton's return.

Phil Phan, professor of strategic management at Johns Hopkins University's Carey Business School says investors "have to keep a close eye on the recovery rate"—the rate that lenders push for faster and more foreclosures—because as the crisis deepens, lenders feel more pressure to turn around assets quickly.

This, of course, not only reduces investors' returns on these failed mortgages, it pushes more families out of their homes faster.

Persky says the carnage in the housing market and the economy is likely to get worse, and remain a problem for a number of years.

"What's going on is horrible. I wouldn't gloat about making money from this," Persky says. "But this is a historic opportunity for distressed-asset investors."

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