It could be the hedgies that ride to the rescue

Date: Tuesday, March 18, 2008
Author: Andrew Osterland, Financial Week.com

Sixty funds are said to be prepping for bargain hunting that might restore liquidity to the banks and the mortgage-backed securities market.

A London hedge fund's offer last week to inject more capital into troubled mortgage lender Washington Mutual may be an omen of how the lifeless credit market will ultimately be revived. While bankers and investors may be looking to Ben Bernanke and the Federal Reserve to save the market, its saviors in the end are likely to be—God help us—hedge fund managers.

Indeed, Mr. Bernanke may be willing to pump another $200 billion into the banking system to ease the pain. But until trading resumes in the debt markets—particularly for mortgage-backed paper and syndicated loans—lenders will likely keep their cash in their pockets. “The Fed's moves increase liquidity,” said Chip McDonald, a securities lawyer with Jones Day. “It helps, but it isn't a cure.”

Some analysts say that unless the Fed is willing to set up a Resolution Trust Corp.-like agency to buy in troubled mortgages and structured-debt obligations—rather than just offering short-term financing for the holders—the markets aren't likely to revive anytime soon.

That's where hedge funds come in. While recent liquidations at high-profile funds like Carlyle Capital and Peloton have cast doubts on the health of hedgies, industry watchers say many of the funds remain extremely well capitalized. “Those funds that have used a lot of leverage are vulnerable,” said Brian Snider, senior vice president at hedge fund research firm Hennessee Group.

But Mr. Snider said that about 60 other hedge funds are preparing to go bargain shopping for distressed (read: mortgage-backed) debt and leveraged loans for sale by besieged financial institutions.

The London fund, Toscafund Asset Management, approached the board of Washington Mutual with an offer to participate in any consortium looking to recapitalize the mortgage lender, according to a report in the Wall Street Journal. Toscafund is part of Old Oak Holdings, which has a sizable stake in WaMu.

Such moves by hedge funds will help shore up the banks and begin to establish floors for “toxic” asset prices, industry experts say. “They're going to be buyers of paper from other hedge funds and from the investment banks,” said Mr. Snider. “People are expecting about $200 billion worth of mortgages will be sold.”

Dallas-based Highland Capital Management will be one of the buyers. The firm recently raised $1 billion to buy distressed collateralized debt obligations and buyout debt from the banks, according to Bloomberg. The firm has already invested more than $38 billion in assets—most of it in loans, bonds and structured products.

Other players poised to jump into distressed debt include funds organized by Goldman Sachs, Finstocks Capital Management, CapGen and Castle Creek. When the market starts to move, they are likely to put their money to work quickly.

“When there are forced liquidations and vultures start picking at the assets, people will start buying,” said John Garvey, head of PWC's financial services advisory practice. “A lot of people are going to make a fortune on this.”

The fund managers won't just be looking for distressed debt either. Sagus Partners, an Atlanta-based money manager, recently raised an undisclosed amount of capital to invest in the beaten-down stocks of small banks in the Southeast. The fund plans to invest three-quarters of the money in community bank stocks.

Other hedge funds may look for combinations of preferred stock with warrants or convertible debt—especially in the banking sector, said Mr. McDonald.

The thinly stretched banks will be looking for investments they can count as tier one or tier two capital. Most likely that will mean convertible debt that allows fund managers to arbitrage between the debt and common stock of companies. “The hedge funds will help people survive,” said Mr. McDonald. “And they'll weed out others that won't.”

It's not exactly the Resolution Trust Corp. FW