Profit from distressed assets

In a previous article, we looked at distressed bond investing. Another version of the distressed strategy aims to profit from remnants of the securitized loan pools that took centre stage in the financial crash of 2008.

What are securitized loan pools?

A major bank takes commercial or residential mortgages, or corporate loans, and bundles them together. The bundle is then sliced into sections, like a pizza. The sections are called “tranches” and are presented to the market as income-generating securities that investors can purchase.

Each tranche gets a credit rating based on how safe or risky its underlying loans are. Pre-crisis, some were rated AAA, others B, and others everything in between. Higher-rated tranches get lower returns but are first in line for payouts; lower-rated tranches get higher returns but are last in line for payment if things turn sour.

“As we went through 2008 and 2009 in the U.S. […] a lot of the underlying assets severely deteriorated,” notes Marjorie Hogan, CIO at Altum Capital Management LLC in New York. As a result, “not every tranche is likely to be paid in full; those distressed tranches are among the investments we make.”

In many cases, Hogan’s firm is buying the right to interest payments from the tranches’ underlying distressed loans. “You’re legally entitled to everything, including the principal, but you’re not likely to get anything but four or five years of interest,” Hogan explains.

Return on investment is essentially the difference between the price the firm pays for the right to the interest, and the cash flow the interest payments actually generate. The tranche’s seller has offloaded the risk of non-payment to Altum.

To mitigate this risk, Hogan and her team have built statistical models to evaluate the contents of tranches they’re considering investing in. “We’re trying to understand the behaviour of the individual assets in the pool. If they’re corporate loans, for instance, we want to know something about their creditworthiness.”

The models allow them to project whether, and for how long, interest will be paid. Hogan emphasizes that in most cases, it’s unlikely a distressed tranche rebounds to pre-crisis performance. “Usually the impairments are permanent. The tranche had a number of defaulted loans and they’ll never be made up. So it’s a question of estimating the return from what remains.”

She adds these funds are for large institutional investors, such as endowments, and individual investors with a very high net worth.