Fools and Their Money: Value-Destroying CDO Managers Raising Distressed Mortgage Funds

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Why is it that in finance, nothing succeeds like failure? Witness LTCM’s John Meriwether’s ability to raise a new hedge fund after the biggest financial blow-up in history, or Geoff Boisi and Vikram Pandit’s ability to sell not-hugely-successful funds to banks, then perform unspectacularly in management roles (although in fairness, Boisi had been a leader in M&A in the 1980s, and it is remotely possible that Pandit might redeem himself, but I’d have more hope for him if he had abandoned Citi’s dividend).

The latest chapter in trying to trade in on a dubious track record is the efforts of mangers of CDOs (some were actively managed) to reposition themselves as experts in distressed mortgages. From Bloomberg:

Money managers including TCW Group Inc. and Harding Advisory LLC that topped the list of firms behind the most toxic mortgage securities have raised more than $4.3 billion to invest in home-loan debt.

At least half of the 20 top managers of collateralized debt obligations tied to subprime-mortgage securities have funds seeking to profit from home loans. They are targeting twice what they’ve already raised, data compiled by Bloomberg show.

“CDO managers may be seen as guys who created garbage and now want more money to sort out their own junk,” said Roy Smith, a former Goldman Sachs Group Inc. partner who now teaches finance at New York University’s Stern School of Business…

The CDO managers, who join more than 80 competitors now targeting distressed mortgage assets, tout their experience, relationships and databases to pension funds and wealthy individuals. They include firms such as Cohen & Co., GSC Group and Harding, as well as TCW, the former Trust Company of the West now owned by Paris-based Societe Generale SA, and BlackRock Inc., the largest publicly traded U.S. fund manager.

Joseph Patterson, president of Patterson Capital Corp., the Los Angeles-based bond fund manager founded in 1977, said it’s surprising that a CDO manager can maintain a reputation for being a “wonderful mortgage manager.”…

“Despite what’s been said about CDOs, having a background with the securities is a positive,” said Munish Sood, president of Princeton Advisory Group, the 12th-largest manager of CDOs composed of mortgage bonds in 2007 according to Standard & Poor’s. “We have experience managing the underlying mortgage assets, which is where we are seeing the opportunities.”…

Mortgage specialists including Cohen’s Frederick Horton compare the current round of fundraising to the aftermath of the collapse of Drexel Burnham Lambert Inc. Bankers tainted by working at Drexel, or funds that bought “junk” corporate-bonds from it, proved worth betting on after the debt helped cause hundreds of U.S. savings and loans to collapse in the 1980s. Leon Black, Drexel’s former chief of mergers, later founded Apollo Management LP. He acquired big stakes in many of the companies Drexel had helped finance by buying their junk bonds from failed thrifts.

Junk, or non-investment-grade, company bonds returned a record 39 percent in 1991, the year after Michael Milken’s Drexel filed for bankruptcy, Merrill Lynch index data show.

“The guys who were most successful at making money in that cycle were former Drexel guys or former high-yield managers,” Horton, a senior managing director at Cohen, said in a telephone interview last month. “The same thing will happen here, I think.”

Um, the Drexel guys were always specialists in junk bonds. The CDO managers were supposed to be buying good assets but it was later revealed that what they had bought was junk. So we are supposed to trust someone with demonstrably failed credit judgement as skilled in recognizing value in distressed assets?

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7 comments

  1. Independent Accountant

    YS:
    Connect this to your recent post on the KPMG paper. I contend KPMG is trying to position itself to secure business from these guys.

  2. Uncle Billy

    There are many smart guys in many rooms.

    …”were supposed to be buying good assets”

    From whose point of view? Then, as now, these “engineers” sought out the junk, often helped create the junk, then packaged it and sterilized it, knowing full well that it would blow up and they would go in buy it up again from the suckers that bought it.

    You wouldn’t want to invest with them, I’m sure, nor would I, but those who care little about the fallout will definitely want another round with the smart guys.

  3. Andy G

    http://www.ft.com/cms/s/0/98d7521c-479b-11dd-93ca-000077b07658.html

    This should set some alarm bells ringing:

    A dispute between UBS and a hedge fund that sold it protection on a complicated mortgage security highlights why banks are still having a hard time figuring out the total amount by which they will have to write down such debt.

    UBS asked Paramax Capital International to sell it protection on $1.3bn of the most highly rated slices of a CDO made up of subprime residential mortgages that the UBS investment bank underwrote.

    Paramax claims that, from the beginning, the UBS hedge was cosmetic. In May 2007, when the original agreement was signed, the terms were a fraction of the market rate. Also, Paramax had only $200m under management and its agreements with its own investors limited it to commit no more than $40m to any single deal. Thus, it could never compensate UBS fully for any meaningful loss in value of the $1.3bn UBS was trying to insure, it claims.

    Paramax also claims that UBS told it that the bank would employ “subjective valuation methodologies” that meant it would not record any loss in value that could trigger calls for additional margin from Paramax. (Because credit derivatives contracts are individually tailored agreements rather than standardised documents, in fact there is some discretion in how firms value such deals.) Paramax also claims that UBS promised that if the lender needed a “real” hedge, it would tear up the agreement.
    Now UBS is taking Paramax to court, seeking to compel it to pay up as the securities drop in value, alleging breach of contract. Paramax in turn is charging UBS with negligent misrepresentation.

  4. foesskewered

    maybe they finally found their calling; they create the distressed assets then manage them, talk about full service!

  5. Independent Accountant

    YS:
    I have an advantage over you. I spent my “obligatory” five years with the Big 87654 and got to see how they worked, from the inside.

  6. Skeptical

    Please tell me Chris Ricciardi is working at one of these firms…ex-Merrill, ex-CSFB. Think I read in the WSJ that he was with Cohen.

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