Institutional Investor's Alpha Magazine - May 2008 - (Page 43)

Strategies Distressed Debt Taking Credit By Neil O’Hara I n the 18 months since London-based HSBC Holdings first flagged billions of dollars in unexpected losses from subprime mortgages in its U.S. consumer lending unit, what started as a ﬂawed strategy at one bank has mushroomed into the worst credit crisis in two generations. At the end of April, reported writedowns and losses at major ﬁnancial institutions exceeded $250 billion. By some estimates the eventual total could be at least twice that, ﬁlling many investors’ hearts with fear. Not so the denizens of distressed investing, for whom the hangover from the credit crisis signals a long-awaited revival in fortune. For years, cheap and abundant credit, combined with a strong economy, allowed even weak companies to avoid bankruptcy. But now those who know how to proﬁt from hard times are back in business. The big opportunity in this credit bust isn’t the same as in past ones, however. Today the juiciest returns can be had from some of the very structured-debt instruments at the center of the recent turmoil, including collateralized debt obligations and mortgage-backed securities. As default rates rise, distressed-debt investors should also be able to scoop up bargains among bank loans and other corporate debt. Some of the best investments may even come from distressed companies that avoid defaulting entirely. The structured-debt market was in its infancy during the last recession, in 2000-’01, and most distressed-debt investors today are ill-equipped to analyze it. But for those few who do have the expertise, the opportunities look too good to miss. Among those poised to pounce is FrontPoint Partners, a $10 billion Greenwich, Connecticut–based hedge fund ﬁrm bought by Morgan Stanley Investment Management in 2006. “Not since the Great Depression has an entire asset class had all its underlying fundamental assumptions obliterated at the same time,” says Steven Eisman, portfolio manager of the FrontPoint Financial Services Fund. The majority of structured finance products have been owned by dangerously leveraged structured investment vehicles that borrowed short term to buy long-term triple-A Distressed-debt or double-A tranches of structured debt. “It was a investors who know how total duration mismatch, and they were all levered to proﬁt from hard times anywhere from 20 to 1 to are back in business. 50 to 1,” says Eisman, who began his career on Wall Some of the best Street in 1991 as a specialtyﬁnance research analyst at opportunities may be in Oppenheimer & Co. “If it sounds like a circular companies that entirely Ponzi scheme, that’s only avoid bankruptcy. because it was.” When the bubble finally burst last summer, a great deleveraging began. The natural buyers were all on the sell side, leaving no market for structured debt. Many instruments traded rarely, if ever, anyway, even in the good times, but whatever bids there were vanished. In a one-way market, pricing models — which assume ready liquidity — became worse than useless. “A model might say a bond is worth 80 cents on the dollar, but it’s trading at 50,” Eisman explains. “You have MAY 2008 • INSTITUTIONAL INVESTOR’S ALPHA • 43

Table of Contents Feed for the Digital Edition of Institutional Investor's Alpha Magazine - May 2008

Institutional Investor's Alpha Magazine - May 2008 Contents Letter from the Editor Longs & Shorts Pension Corner: Send in the Clones The Good Guys: Outside the Box Cover Story: Welcome to Oz Interview: The Tipping Point Regulation: When Sentinels Go Astray Strategies: Taking Credit Research Center: The Hedge Fund 100 Book Excerpt: Shoot the Messenger Alpha Bytes: VaR Enough? Unhedged: Commentary: Not Your Father's Activist

Institutional Investor's Alpha Magazine - May 2008

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