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Government's bailout could present a buying bonanza

Investor returns on mortgages could top those of the S&L rescue

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By Janet Morrissey

October 5, 2008 6:01 am ET

The government's financial-bailout plan could present a buying opportunity for savvy investors interested in buying troubled mortgages and distressed mortgage-related securities on the cheap.

In fact, some industry experts believe that returns from these investments could rival the huge profits pocketed by investors during the bailout of the government-owned Resolution Trust Corp. during the savings and loan debacle of the late 1980s and early 1990s.

"I think there will be opportunities for excellent returns," said a senior partner at an opportunity fund, who did not wish to be identified. "When you have $700 billion to $1 trillion coming into the market, there will be immediate and intermediate opportunities in the distressed debt in equities," he said. "This is going to be a good time for buyers over the next three years or so ... You will find, as there was in the RTC period, very good opportunities."

The executive expects many investors to start moving into the sector in the first quarter of 2009.

"It's very difficult to try to time the bottom of any market," said Stace Johnson, a managing director at Principal Global Investors, an asset management firm in Des Moines, Iowa, that manages $244.4 billion in assets.

However, there are signs that some of the market's savviest investors are jumping in.

"Warren Buffett's move to put $5 billion into [The] Goldman [Sachs Group Inc. of New York] demonstrates that he believes it's the right time to be putting some money back into financials," Ms. Johnson said. "I would expect others to be getting back in."

"It certainly will be a buying opportunity," said Spencer Hill, managing director of Hill Asset Management in Kingstree, S.C., which manages $20 million in assets. "Mortgage-backed securities, if they're heavily discounted enough, offer an opportunity for an above-average yield ... for the investor who is going to buy and hold on to it."

Does Mr. Hill expect returns to approach those of the RTC era?

"I would say probably even better, in some cases," he said. "It depends on how each [mortgage-backed security] was packaged, and who packaged it."

It all comes down to pricing.

"Any buying opportunities will depend on the strike prices of the mortgage securities when purchased by the Treasury," said Tom Barrack, chief executive of Colony Capital LLC, a private-equity firm in Los Angeles.

However, experts caution that there are many "moving parts" in the bailout package that need to be spelled out to ensure that those potential triple-digit returns don't wind up in the red.

While Ms. Johnson expects that the bailout will entice buyers back into the market, she speculates many may take a more cautious approach.

"There is a lot of excess wealth around the world, but some of these sovereign investors got burnt by coming into the financial institutions earlier this year," she said. "A lot of the investors who were ready before are going to be a little bit more [cautious]."

Under the legislation, Treasury Secretary Henry Paulson gets sweeping and unfettered powers to buy up bad mortgages and mortgage-related securities from U.S. and possibly foreign financial institutions. The move is aimed at removing some of the toxic assets that have been making financial institutions sick. This in turn will help restore investor confidence in the financial services sector and thaw out the frozen capital markets.

Big returns are possible — but not certain.

It's not clear who will oversee the mortgage purchases, how the securities will be assessed and how much the government will pay for them, said Alan Madian, an economist with LECG LLC, an advisory firm based in Emeryville, Calif.

Indeed, unlike during the RTC era, the troubled assets this time around are far more difficult to assess and value. It's not as simple as estimating the value of an empty or half-built office building. This time, there are various kinds of mortgages, ranging from interest-only to alt-A mortgages, and even more-arcane instruments, such as credit default swaps and collateralized debt obligations, that have been pooled together and sold as securities to investors around the world.

Basically, the cash flows from the different kinds of mortgages have been sliced and diced into different tranches and spread over different securities. Tracking down the actual collateral — the house — and then assessing the chances of the individual mortgage holders' defaulting on the loans would be a major hurdle. At the same time, the housing crisis continues to deepen, causing more mortgages to go bad daily, driving the value of the securities even lower.

All of this uncertainty caused the credit markets to seize up. Indeed, in July, Merrill Lynch & Co. Inc. of New York, in an effort to boost liquidity, raised eyebrows when it sold off $31 billion of its mortgage securities for only 22 cents on the dollar. Another firm, Citigroup Inc. of New York, values similar investments on its books at about 61 cents on the dollar.

Under Mr. Paulson's plan, Treasury officials will have to determine a fair price that's high enough to restore confidence in the market but low enough to ensure that taxpayers don't take a bath.

The government will buy the troubled assets with the intention of selling them back to the market when prices rebound. All of this has led to speculation that the government might overpay for some of the assets and wind up reselling them later at fire sale prices — a lose-lose situation reminiscent of the RTC crisis, for which the government was criticized sharply.

Observers speculate the rescue package price tag will exceed $700 billion, with some, such as Geoffrey VanderPal, a certified financial planner at Elite Financial Planning Group of America Inc. in Las Vegas, pegging the final cost as high $5 trillion. "There's still a lot of uncertainty — a lot of moving parts — and $700 billion doesn't come close to covering the actual potential losses with the mortgage crisis." VanderPal manages more than $100 million in assets.

At the very least, the bailout should move buyers off the sidelines and into the market.

"Having the government step in and provide that floor goes a very long way to bringing stability to the market and increasing liquidity overall," said Robert Cestari, managing director at Winthrop Realty Trust, a real estate investment banking firm based in New York. "By the government stepping in and catching the proverbial knife, I think it moves things forward."

It's all about restoring confidence in the financial markets, concurs Ward Dietrich, a principal at Madison Capital Management LLC, an investment management firm based in Denver that has invested more than $925 million in capital. "The purpose of the $700 billion is to take concern, to take risk and to take fear out of the equation."

E-mail Janet Morrissey at jmorrisey@investmentnews.com.

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