RMBS Opportunities in 2009: Recap from IMN's Distressed Investment Summit

Information Management Network (IMN) organized the Distressed Investment Summit: Credit Crunch Investment Strategies for Institutional Investors this week in Dana Point, CA, and the sky wasn’t the only way to get some sunshine. Between indirect (and very direct) sales pitches, the investment managers and panelists offered gated optimism about their perspective on distressed investment opportunities in 2009 and over the next few years. Interestingly, much of the optimism shared here was duplicative of presenters and panelists at the recent Wharton Hedge Fund Conference in Philadelphia.

(To provide some context, the audience was mostly comprised of pension and municipal fund managers and the panelists were mostly investment and capital managers seeking these funds as clients.)

The main highlights mostly with regard to RMBS, with details following:

• There are very good opportunities in RMBS in 2009, but at the right price.
• Mark-to-market is a major cause of illiquidity in the residential mortgage-backed securities (RMBS) markets.
• Corporate debt is too volatile to consider for any long strategies, along with CDOs and CLOs.
• It’s too early to consider Commercial MBS (CMBS).
• The government (past and present) isn’t helping the credit markets with mortgage cram-downs and a failure to develop clear “rules to the game” so far

The detailed ideas shared below are a combination of comments and presentations from a number of panelists throughout Monday and Tuesday, including:

• Dean Di Bias, Advantus Capital Management
• Larry Pokora, Paulson & Company
• Michael Pecoraro, NPM Capital Management
• Michael Clark, Meridian Development Partners
• John Pluta, Declaration Management & Research
• Michael Levitt, Stone Tower Capital
• Johnathan Morrison, Macquarie Capital Advisors
• Phil Baruch, Trust Company of the West

“Get ‘Em While Their Hot”

There was general agreement among the panelists that immediate opportunities lie in selected RMBS, with the caveat that “you need to get them on the cheap,” and those investment firms that have cash can indeed get them on the cheap. The market is ripe with opportunity, with up to 30-40% returns on RMBS trading at $0.40.

Distressed Assets Over the Next 5 Years

Managers are focusing on RMBS in 2009 because they see the returns and opportunity there in the short- and intermediate-term.

Distressed credit can be grouped over a 5-6 year timeline:

2008-09: Stressed housing market

2009-11: Stressed Consumer Credit

2010-13: Weakness in Commercial Real Estate, as CRE usually lags economic weakness.

From this vantage point, the housing correction is now two years into the cycle. This provides information to investors on the frequency and severity of loss. Corporate defaults just starting and are apt to tremendous volatility. Buying into the RMBS with short, predictable cash flows is a more effective investment that the 7+ years in a corporate debt investment. (This viewpoint on corporate debt was shared by many throughout the panels – too much volatility and too early to know where the good opportunities lie.)

Mark-to-Market

The fundamental challenge, as always, is finding a willing seller at these prices. Current asset holders are subject to the “mark-to-market” guidelines, so selling even a small portion of their loan portfolio at 40/100, down from the 60 or 70 where they are currently marked, would require the sellers to remark all remaining loans on the books. This would wreak havoc on most banks’ capital ratios, causing bank regulators to step in and shut down these banks almost immediately. The net result is an illiquid market – there’s not much activity right now because of the mark-to-market effects on the sell side.

Trades? What Trades?

So when will liquidity start to flow? One answer was - “They’ll sell when they hit the bid.” Yes, of course they will, but when will that be?

With over $1.4 trillion in RMBS currently on the market, there will be forced sale situations throughout 2009 such as today’s announcement that the Federal Reserve will purchase more mortgage-backed securities from Freddie Mac and Fannie Mae as part of its action to purchase government bonds.

Depressed ≠ Distressed

Most of the panelists agreed that the depressed prices in RMBS do not necessarily mean that assets are distressed – they are only priced as distressed and most loan portfolios are priced as non-performing when default rates mostly show otherwise. However, this requires asset analysis and modeling at the loan level, integrating property-level analysis with local real estate market trends. IRR is driven by price at acquisition, cash yields, partial recoveries from defaults, and principal aromatization. At current price levels, 17-25% IRR is realistic and RMBS offers a good “margin of safety.” The primary risk lies in government cram-downs of the sub-prime mortgages, where 60% of sub-prime loans are currently performing.

But, there’s a slightly different perspective on this - “Just because it’s cheap doesn’t mean that it’s a good investment, or that it won’t get cheaper.”

Uncle Sam

The government’s actions introduce additional liquidity constraints in the distressed credit market, particularly in RMBS. “Why would they [current RMBS holders] sell at 40 when they can wait for a government bailout and get 90?” And while the sellers view the buyers’ assumptions in developing a bid as absurd, it’s also easy to justify the absurdity. The net result? Relative market inactivity.

This spawned a conversation about the lack of “rule of law” in the credit markets. Most managers felt that the government’s action of inactivity has stalled the recovery, and their attempts to stem foreclosures will only prolong the market’s gridlock. (Of course, the government would argue that they’re probably less concerned with getting RMBS to trade at true market value than they are keeping people in their houses…)

Risk = Return

The government’s inaction with respect to the “rule of law” creates a higher risk environment, which in turn, creates the ability for higher returns. Putting some numbers to highlight these higher returns outcomes:

For a Performing Loan Portfolio with the following assumptions, ROI reaches 17% (or higher with a purchase price closer to 40):

• Default rate of 10% per year
• Prepayment rate of 5% per year
• Recovery Rate of 50%
• Eventually trades at par

Most of the panelists agreed on the assumptions and projected ROI, but this all assumes that the market price will strike at the 40 range, instead of the 50-60 range. Additionally, as stated “analysis needs to be taken at the loan level.” RMBS is a different animal – assets vary widely in a loan portfolio unlike a block of Microsoft shares that are homogeneous.

Sunshine On My Shoulder Makes Me Happy

So yes, the pitchmen on the panels offered a positive perspective, particularly in the RMBS market for 2009, all based on eventual market liquidity and prices in the 40 range, well below the 60 range where sellers have these securities marked. The assumptions are grand, but then again, so are the projected returns. Like everything, the truth is probably somewhere in the middle.

Disclosure: no positions

Comments

[J. D. Swampfox:]

The writer reports: "For a Performing Loan Portfolio with the following assumptions, ROI reaches 17% (or higher with a purchase price closer to 40):

* Default rate of 10% per year
* Prepayment rate of 5% per year
* Recovery Rate of 50%
* Eventually trades at par

Most of the panelists agreed on the assumptions and projected ROI, but this all assumes that the market price will strike at the 40 range, instead of the 50-60 range."

As said, apparently no one else will buy them at the 50-60, so the current holders are going to have to hold on to them. If the current holder's pre-write-down cost is 95, those current holders will be earning a return that is maybe 6 or 7%...but since they are enjoying almost zero cost of funds thanks to the Fed, that's not a bad spread - right? And, if they can hang on long enough they could earn a fair return, while they wait to sell the RMBS off later - right?

Mar 20 09:15 PM

[Scott Sambucci:]

Hi J.D. - Thanks for the comment. Your comment:

> As said, apparently no one else will buy them at the 50-60, so the
current holders are going to have to hold on to them. If the current holder's pre-write-down cost is 95, those current holders will be earning a return that is maybe 6 or 7%...but since they are enjoying almost zero cost of funds thanks to the Fed, that's not a bad spread - right? And, if they can hang on long enough they could earn a fair return, while they wait to sell the RMBS off later - right?

This is exactly a point that Michael Clark from Meridian Development Partners made on one of the panels - if the banks get bailed out at 90/100, why bother selling at 40? But, there are some forced sale opportunities that have brought the prices down to the 50-60 on selected portfolios. Most of the speakers/panelists are banking on these prices becoming available more broadly as 2009 progresses.

Mar 23 12:01 PM