The Ways of Wall Street (Distressed Debt Edition)

The Financial Times’ John Gapper had an interesting piece today, “Patience on debt can ease distress.” I’ll give you the section that caught my eye to see if you react to it the same way I did:

Last week, I went to a dinner in Manhattan that ostensibly had nothing to do with the credit squeeze. It did, however, provide an insight into how the market’s attack of nerves will eventually be resolved and the pace at which this could occur.

The man sitting on my left was a software entrepreneur who was planning to invest some of his money in a new distressed debt fund being raised by Goldman Sachs. The fund, called GS Liquidity Partners III, will try to buy various kinds of impaired debt in the next year or two and bet on it coming good.

One sort of debt for which it will bid is finance provided by banks to private equity funds for leveraged buy-outs that they may now have trouble offloading to investors. The New York Times estimated last week that banks have committed some $330bn (£163bn, €240bn) of debt that will be offered for sale in the next few months.

As my colleague James Mackintosh wrote in the Financial Times last Thursday, Liquidity Partners III and funds such as GLG Partners and Oaktree Capital plan to buy debt currently trading at about 95 cents on the dollar, which provides a high yield, and wait out the liquidity crisis. My dinner companion is not a financial expert but likes the idea. “It seems as if this is a good time to get into it,” he remarked.

Opposite me, meanwhile, was Peter Andrews, chief executive of a small investment fund called Dreambuilder Investments that specialises in restructuring subprime mortgages. Mr Anderson’s fund buys defaulted mortgages from banks at steep discounts to their face value – it acquired a bunch of them at 7 cents on the dollar recently.

It obtains them after the homeowners have stopped making monthly payments but before the bank has foreclosed on the houses. It then persuades some borrowers to restart payments, either by giving them a discount or by marking down the mortgage enough to let them sell the house without making a loss. Finally, it resells the buffed-up mortgage portfolio at a profit.

The fund started six years ago by buying mortgages in the industrial states of the Midwest where home owners were affected by factory closures. Now it is bringing its experience to the coastal states hit by the subprime mortgage crisis. As the US housing market has deteriorated, the fund has been able to negotiate bigger discounts; its earlier deals were at 40 per cent or more to face value.

My reaction? Predicatably, Wall Street gives highest priority to solving its own problems.

Readers may recall that I highlighted another FT story last week, by John Dizard, in which he also recommended distressed investing. Dizard noted that hedge funds and other investors were making forced liquidations, and the pickings were rich. One example was a single A floating rate bond backed by home equity loans, rated singe A, paying on a current basis. It was priced to yield 35%. This is not a CDO or other insanely arcane paper. With a bit of effort one could get a crude idea of default risk.

So why was it going begging at such a cheap price? Because no institutional investor will touch it. Even if it is cheap, it may be cheaper later, not due to defaults, but due to other forced liquidations possibly driving the price of paper like that even lower. In that case, they’d have to mark the price down on their books.

So there will be fortunes made for those who can pony up the cash and have a bit of risk appetite. But what is Goldman serving up to retail investors, aka chumps? Debt at 95 cents on the dollar. A discount, but hardly a great deal when bargains abound.

And what kind of debt? LBO debt. Hhhhm, and who happens to be owning uncomfortably large amounts of LBO debt and really really needs to place it? Goldman and other major Wall Street firms.

Even if Goldman does not put a penny of its own debt into the fund, having funds like the one it is sponsoring will create more demand for the paper that Goldman and its buddies desperately need to sell, and more demand = better prices. So as usual, it’s the classic Wall Street game of retail investor as stuffee.

Now let’s consider the other distressed fund, a no-brand-name fund that buys subprime mortgages when the owner has defaulted but the bank has not foreclosed on the house (note that what constitutes “foreclosure” is defined differently by different databases, since in many states, various foreclosure notices are sent out before the house is auctioned at a foreclosure sale. Since this article is too short for such detail, the house might have entered the foreclosure process but clearly hasn’t been sold).

This is an actual functioning operation with a track record that saves troubled subprime borrowers, doesn’t require legislative fiat or taxpayer dollars, and even provides a return, and a nice one at that, to investors. You can explain it in three sentences and it works.

But as attractive as this idea is, it is successful precisely because it is small in scale and not widely known. The fund doesn’t enter the picture until the borrower is seriously on the ropes. Borrowers who had other routes out, like selling the house on their own, would have taken it. Similarly, because the bank has deemed the mortgage to be hopeless, it sells them at cheap prices. This gives the fund a great deal of latitude to do things to help the borrower yet still earn a good return.

In other words, pursing this idea on a much larger scale (say having the government buy mortgages) won’t be as successful. They would buy mortgages at an earlier stage in the default process, at much higher prices, which would give them much less room to work with distressed borrowers. And having a large scale buying program would be self-defeating. The very presence of active buying would drive the prices of the mortgages up, increasing the cost to taxpayers.

Nevertheless, the contrast in Gapper’s story is striking. Wall Street peddles a fund that has mediocre return potential and does the vendor more good than the investor, while a small independent operator has a fund that produces high returns and addresses a real world need. But the fault isn’t entirely Wall Street’s. Too many investors would rather buy a brand than do their own homework or think for themselves.