Institutional Investor's Alpha Magazine - May 2008 - (Page 44)

At FrontPoint Partners, Jacob Gulkowitz (left) and Steven Eisman see bargains in distressed bank loans and corporate debt. 30 points of potential gain, but people are lined up from here to China to sell. There are plenty of opportunities — but it’s scary as hell.” Eisman advises potential investors to drill down to the individual loans that support structured debt to differentiate one pool from another. A mortgage pool that has only 30 percent exposure to the weak California real estate market, for example, may look attractive at ﬁrst blush. But if the loan-to-value ratio is close to 100 percent, then another pool that has, say, 40 percent in California and an 80 percent loan-to-value ratio may be a better bet. “You have to have the technology and the analytics to look at the loan level,” Eisman says. Investors have to study monthly remittance reports from issuers and analyze the information with computer models that forecast investment outcomes in multiple interest rate and prepayment scenarios. It’s a tall order — an ordinary mortgage-backed security typically includes thousands of mortgages. For a CDO built around 100 mortgage-backed securities, it’s a nightmare. Eisman’s nine-person structured-debt team includes analysts who run the numbers as well as lawyers who pore over the documentation (an investment in a CDO tranche that looks cheap but faces a looming default could be wiped out overnight). Eisman, a Harvard Law School graduate, sees both long and short opportunities in a market that is not discriminating between pools of mortgage-backed securities that have the same rating even if the probable performances are quite different. It’s an ideal environment for relative-value trades, though investors have to accept the risk of mark-to-market volatility until deleveraging winds down. That could take time. Dan Waters, co-CEO of FrontPoint, notes that the major U.S. and European banks and broker-dealers have about $2 trillion in aggregate tier-1 regulatory capital — the core equity and preferred capital banks must maintain to support their lending and absorb potential credit losses — leveraged about 21 times. Reducing leverage to the historical average of 15 times capital would squeeze $12 trillion of credit out of the ﬁnancial system, an enormous sum by any measure. The much-touted sovereign wealth funds — controlled by governments in China, the Middle East, Russia and other regions that run substantial trade surpluses — are big but not big enough to take up the slack; their total capital is about $3.5 trillion, according to Global Insight, a ﬁnancial research and consulting ﬁ rm based in Waltham, Massachusetts. Banks, meantime, remain reluctant to lend until the adjustment takes place, putting highly leveraged companies at risk. The situation may give new life to those who invest in distressed corporate debt and were starved of opportunities when the structured-credit juggernaut was rolling. Jacob Gulkowitz, a portfolio manager in the distressed corporate debt team that FrontPoint acquired when Morgan Stanley bought San Francisco–based Brookville Capital Management in December 2006 and brought it under the FrontPoint umbrella, watched default rates in corporate high-yield bonds shrivel to less than 1 percent in 2007, the lowest level in more than 20 years. Since then, defaults have ticked up a bit, but Gulkowitz says they have much further to go and that there is money to be made as they rise. Investors in distressed corporate debt typically look for companies that are either going through formal reorganization under Chapter 11 or are expected to do so in the near future. A typical investment might be a short position in the equity of a struggling company paired with a long position in its debt. When the company ﬁles for bankruptcy, the debt value may drop but the equity will be eviscerated. After pocketing a proﬁt on the short position, investors exercise their rights as creditors to recover as much value as they can from the debt. In past downturns the long securities of choice were typically senior subordinated bonds. In most reorganizations the senior bank debt at the top of the capital structure was paid out at par while all the other creditors took a haircut on the principal. As the ﬁ rst tier below bank debt, senior subordinated bonds were entitled to the next-biggest share of the pie. This prime position allowed senior bondholders not only to exchange their existing bonds for new ones but also to extract an equity ownership interest in the reorganized entity. Gulkowitz, a ten-year veteran of distressed investing 44 • INSTITUTIONAL INVESTOR’S ALPHA • MAY 2008

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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