Investment opportunities abound in a down market

Last November, when Congress authorized the U.S. Department of Treasury to purchase troubled assets from banks, it was focused mostly on creating liquidity in the mortgage-backed securities market. Only a month later, the Treasury abandoned its plan to purchase assets, largely because of the difficulty of valuing assets that normally are priced by the market.

In place of its original plan and in an effort to stimulate the economy, the Treasury chose to invest directly by purchasing equity in healthy financial institutions.

The Treasury’s decision against purchasing troubled assets does not indicate that the secondary market for commercial or residential whole loan assets is failing. Instead, it highlights opportunities for private investors to earn decent returns while restoring liquidity in the financial industry. Indeed, throughout 2008, financial institutions traded billions of dollars worth of troubled assets, particularly distressed whole loans, to investors in the secondary market.

Distressed whole loans are distinct residential and commercial loan obligations in which the borrower has either defaulted or is near default. Whole loans consist of raw land, partially developed land with infrastructure, partially completed construction, fully completed construction, or any combination thereof. Whole loans are easier to value, and thus more liquid, than mortgage-backed securities because whole loans are not comingled with other assets in complex instruments that have fractional ownership.

Typical purchasers of distressed whole loans include private equity groups, hedge funds, real estate developers, pension funds and high-net worth individuals. Real estate firms and developers with access to capital are positioned particularly well to take advantage of the opportunities presented in the current market.

But in a market where cash is king, any investor with sufficient capital should consider investing in whole loans.

However, unlike the investment boom that helped to inflate the housing bubble, investors should not expect a quick return by flipping the collateral. Most of the current investment opportunities require an investor to have adequate cash flow and the patience to hold an asset until the market recovers.

Assigning a present value to distressed loans is difficult, in part because debt holders and so-called opportunistic investors often disagree over whether, or to what extent, home and land prices will continue to fall. Nonetheless, many commercial banks – freshly infused with government funds – are expected to continue bringing assets to the market through 2009.

In fact, many predict that 2009 will bring a more active secondary market for whole loan assets than that of 2008 because of a combination of the increasing number of anticipated loan defaults and the cost of foreclosure proceedings. Developers are continuing to default on commercial loans because of a slump in housing demand, and residential loan default rates are likely to increase as unemployment escalates and short-term adjustable rate mortgages reset.

Moreover, the tightening credit standards have made it difficult for many borrowers to refinance at lower rates or at all. Commercial loan default rates also are likely to increase as manufacturers and retailers suffer the pain of weakened spending.

Observers also believe that sales of whole loan assets will accelerate now that the Treasury has stepped aside. Whole loan investment activity slowed in the second half of 2008 because of uncertainty over the direction of the market and uncertainty about Congressional action.  Investors adopted a “wait-and-see” attitude, cautiously monitoring whether the Treasury would purchase, guarantee, insure or resell assets on the secondary market. This uncertainty evaporated at the end of 2008 when the Treasury all but abandoned its original strategy and instead focused on investing directly in financial institutions.

With capital infusions flowing from the Treasury, many financial institutions will be motivated more than ever to sell distressed whole loans. Others might be less inclined to sell distressed whole loans, relying instead on a recapitalization by the government to cover losses resulting from loan defaults. Seeking to restore shareholder value and emerge from this crisis in a financially stronger position, some banks might attempt to reduce exposure by proactively selling risky and near-default loans in addition to those assets that are already in default.

But, investors should not expect fire-sale prices. With the Treasury currently opting not to purchase assets, the secondary market is once again dominated by private investors, and competition is fierce. Because most financial institutions offer distressed assets in sealed-bid auctions, investors should expect to pay the market-driven fair value for whole loans.

Part of the challenge of investing in distressed assets is identifying the right time to invest. With recently renewed efforts by the government to enter the secondary market and a projected market turnaround in 2010, that “right time” might have arrived.

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