Turning bad mortgages into assets

At best, we are in recession. At worst, spiralling somewhere worse: a slump or depression or another negatively descriptive scenario.

Gulf News

At best, we are in recession. At worst, spiralling somewhere worse: a slump or depression or another negatively descriptive scenario.

Meanwhile, professional investors will be looking for opportunity - as for them, the definition of the word 'crisis' is when wealth is handed from the fearful to the brave.

Brave but not stupid. The professional investor, starts by looking at the overall macro-economic cycle. From growth to boom, boom to retraction, retraction to recession, and from bust to recovery, the professional investor will be looking for the strategies most likely to survive in those environments.

For recession and worse, the world of opportunity starts with buying "distressed" assets. The world will see the first wave of institutional and HNW buying simply because that world recognises that to make money, you need to "buy low and sell high".

Anything likely to have a higher price during an economic recovery might fit the "distressed" tag, with fund managers adding in titles such as "opportunity fund"; "event driven" and "value-based."

Equity Bridge Capital's (EBC) Warren Mal-schinger's view is that their arbitrage and opportunity fund is an early "distressed opportunity" founded in the US housing market.

Malschinger says the fund is "ready to turn investment into rewards fairly quickly due to favour-able restructuring incentives to homeowners and the will of government to underwrite further decline in the mortgage market; philosophically, the market has already turned". So what does it do?

The "box" statistics illustrate the logic behind the "buy low, sell high" opportunity. The underlying assets are US mortgages, and the associated property. Yes, those are the very same toxic debts that nobody wants - mortgages that are not being repaid - non-performing loans.

You need to be a self-confessed experienced investor to ensure you can get your mind around the fact that loans which history will record had a major hand in crippling the banking system- now stand out as a potential opportunity.

It's precisely because nobody wants these loans that EBC's fund is able to buy "tapes" (or tranches) at a 80 to 90 per cent discount of the original loan value. The hypothetical $100,000 (Dh367,310) toxic-loan being purchased for say, $15,000.

That's some discount, but just the beginning of the story. The EBC plan is that they buy these mortgages and sell them back to the original homeowner over a two to three year period. Assuming Malschinger can find these significant discounts there are two more features to appreciate in understanding the investment opportunity.

Assumptions

Firstly, the underlying assets are Non-Performing Mortgages (NPM) - and in most cases the homeowner is still in occupation.

"We don't like the risks of other potential liens associated with mostly unoccupied properties" says Malschinger. Unoccupied properties also do not produce a yield. The attraction of an occupied NPM /property is that there are big incentives for the homeowner to pay the mortgage once restructured by EBC.

Not least: the homeowner does not become an official credit-risk (a major hassle in the US as it will obstruct simple TV purchases, credit card applications, never mind future house purchases); the loan is re-structured in a manner that can be re-financed (many of the adjustable-mortgages turned good-debt into toxic debt as they were founded on the basis that incomes and property prices would rise, and so would mortgage repayments).

The EBC formula allows for loans to be re-structured back into what the home-owner can afford. In addition, with the tumbling house prices eroding the homeowner's equity under the NPM, the EBC re-structured version restores equity to the homeowner providing further incentive to repay the lending. In short, homeowner's are given a major opportunity to recover their seemingly lost home.

"It's not only a good investment strategy but a moral one" says Mal-schinger.

Secondly, Malschinger believes that the US government's commitment to restoring homeowner confidence will ensure property prices will recover and that mortgage defaults will reduce.

Government commitment provides further security to the EBC product by way of the TARP- associated Hope for Homeowners programme (H4H). Under this programme, government will guarantee mortgage repayments as long as the government receives their 1.5 per cent insurance premium.

Condition to the guarantee will influence EBC's asset selection process. They include that the loan should be within a 90 per cent LTV ratio; mortgage repayments should be within 31 per cent of the homeowner's income, and the original loan must have begun before last January 1.

"Armed with this guarantee we go out and kick the tyres of the loans we select" says Malschinger in suggesting that their product will be superior to big institutional versions simply because the latter will be desperate to spread risk and find mortgages to fill their quota's whilst the EBC version needs to be more selective.

The two key features then, seem to revolve around the incentives supplied to homeowners to pay re-structured mortgages, and the government guarantee. So how do investors in the EBC make money?

"We are targeting a 20 per cent per annum return" says Malschinger. Returns will stem from two sources: the yield from the mortgages and the exit strategy. If "Tapes" can be secured at 80 per cent discounts, then there is plenty of scope to pass-on massively reduced mortgages to homeowners and retain a profit. Mortgage yield therefore provide one profit-source. Secondly, EBC's exit strategy is to seek a further re-financing from lenders when the property market has recovered in, say, two to three years. Loans will be re-financed again allowing new lenders to buy clean, non-toxic, mortgage books.

At all times, investment will of course be secured by actual properties.

- The writer is Chairman of Financial Partners and Mondial.

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