Technicalities of the Trend
Distressed mortgage funds have become a hot trend in the hedge fund world.
A distressed mortgage is when the borrower fails to make the promised payments on a loan. When the borrower fails to make the payments, the lender has the ability to foreclose on the mortgage. Lenders often sell the distressed mortgages to hedge funds. After purchasing the mortgages, the companies rework the mortgages to either foreclose on the properties or, in some cases, allow the borrowers to remain in the homes. The marketing hype surrounding this strategy has been well marketed; however, it is yet to be seen if the results will live up to the hype.
The distressed mortgage market is extremely appealing to managers, who are looking for above-normal returns for investors. While some home prices have rebounded, there are still over 4 million loans with delinquent borrowers. Hedge fund managers are betting that after purchasing distressed mortgages at a substantial discount, the loans can be restructured in a way that allows borrowers to start payments again - which would generate sufficient cash flow and modest returns. Another reason for the appeal is the steep discount the federal government is selling loans for. Numerous institutional investors are now rushing to buy distressed mortgages.
Oaktree, Blackstone, Specializing In Troubled Assets
Some of the most prolific purchasers of distressed mortgages have been institutional investors that specialize in distressed properties and troubled assets like Oaktree Capital (NYSE:OAK) and the Blackstone Group (NYSE:BX). In the past, the Blackstone Group has been a leader when it comes to purchasing distressed mortgages. (Blackstone has also had recent success in several other regards.)
In the last few years, however the risks have begun to outweigh the benefits of purchasing distressed mortgages.
A person who had been briefed on Blackstone's strategy reported that while The Blackstone Group has bought 44,000 foreclosed homes since 2012 - which exceeds the amount of any other buyer - it has recently drastically scaled back its purchases. Today, the company's spending has changed from $35 million to $40 million a week used to buy homes, which is still a notable sum, but below from the $140 million a week that was previously being spent last summer.
A benefit of buying distressed mortgaged is that sales are at a discount. The discount pricing leads to a "no strings attached" approach. The returns on buying a discounted mortgage and reworking it can be enormous.
Another upside of an opportunistic and discounted loan purchase is that they are fairly plentiful. Banks have rebounded and are able to stand losses and are more willing to sell distressed mortgages.
Risks Coming To Light
Two of the bigger risks that are giving hedge fund buyers pause are the defenses of the borrower or the threat of bankruptcy.
Depending on the specifics of the loan agreement and the history of the loan, the borrower may have put defenses in place and have claims that might delay a foreclosure on the collateral and reduce the possible return to the loan buyer.
A bankruptcy filing by the borrower is also something that makes potential buyers wary. The bankruptcy would impose an immediate prohibition, an automatic stay, and the creditors would be unable to pursue any claims against the borrower, including any mortgage foreclosures.
It would appear that the risks are causing companies to scale back on the amount of distressed mortgages that are being purchased. This recent strategy change could be a sign that companies are becoming less willing to extend themselves without better guarantees of sufficient returns on their investments.
While investors might be concerned by the trend's apparent turn-about for firms in this market, Blackstone stands out as diversified enough to withstand the volatility.
The firm recently profited enormously from a deal with competitor KKR & Company, has beat analyst estimates consistently in the past year, and continues to pay investors increasing, healthy dividends.
The trend in troubled housing assets will be certainly be one to follow, as the housing market continues to struggle in relation to the overall economy; however, Blackstone investors should take heart that shares of this firm will likely be able to ride the waves.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.