Cashing In on the Market Chaos

Aug. 16, 2007 — -- There is opportunity in chaos. People with an appetite for risk can still make money in the rocky financial markets and rest assured many are trying.

So how do so-called smart people make money when everyone else is sweating it? Simply stated, they buy things that no one else wants and get a steep discount in the process.

Over the last two weeks, many hedge funds have announced losses on holdings of bonds backed by subprime mortgages. These mortgages, which were given to borrowers with weak credit histories, have lost value as increasing numbers of subprime homeowners have defaulted on their home loans.

Giant hedge funds and private equity firms with the ability to raise capital are circling these assets, weighing the risk. According to a number of people who've been in contact with top firms, some of these top-tier hedge funds are likely to see opportunity in mortgage-backed bonds that many others will not touch.

Many firms specialize in the purchase of distressed assets, a category that includes debt with a low probability of repayment. These firms can often purchase debt cheaply, and if borrowers pay back their loans as scheduled, the hedge funds can reap significant windfalls.

"No question about it — distressed assets are probably oversold, and people will look to buy them," said Stuart Greenbaum, professor and former dean at the Olin School of Business, Washington University in St. Louis. "Potential buyers are hedge funds, foreign buyers, even the Chinese government."

Analysts are careful to highlight the risk inherent in buying these assets in such an uncertain environment.

"If things get a whole lot worse, then [buyers] will lose a lot of money," said associate professor Richard Stanton of Berkeley Haas School of Business. "No one knows where this crisis is going to end up."

"You have to have the right frame of mind to buy [these assets.] No one knows where the bottom is exactly," Greenbaum said.

Mortgage Companies Suffer; Cheap Loans for Sale

Private equity firms may soon move in to buy out embattled originators of home mortgages. These buyouts (often known as leveraged buyouts because of the large sums of debt used in the purchases) are often part of a plan to buy a company cheaply, improve its operations, and then take it public for a big return. Currently, these firms are eyeing mortgage lenders suffering large losses or going bankrupt, which could prove to be profitable investments if operations can be improved.

"Private equity people are carefully looking at these opportunities [in mortgage originator buyouts]," says Greenbaum. "They're sitting on top of huge piles of money, and they'd be foolish if they weren't looking at them. There are all kinds of buying opportunities."

An example of this is the potential purchase of struggling mortgage lender Accredited Home Lenders Holding Corp by Lone Star Fund V LP, a private equity firm. However, Lone Star may have realized that the timing is not yet ideal, and terminated the deal last Friday. Accredited is now suing to force the deal through.

"Private equity people are carefully looking at these opportunities [in mortgage originator buyouts]," said Greenbaum. "They're sitting on top of huge piles of money, and they'd be foolish if they weren't looking at them. There are all kinds of buying opportunities."

Charge More for Money

Across the financial spectrum, everyone has had a hard time borrowing money in recent weeks, whether they are an individual seeking a mortgage or large companies looking to issue debt. In the short term, the business of lending consumers and institutions money is likely to become more profitable.

Lenders are keenly aware of the losses that have resulted from lending money too freely and have become more cautious. In industry parlance, credit spreads are widening, which means that lenders are charging more for the risk of lending out their cash.

This could be a boon to lenders in the near term, as they can generate a higher return than in past months and years just for providing loans to those in needs.

Berkeley Haas' Stanton noted that this widening of credit spreads will lead to higher profits for many lenders. "Originators are going to be able to charge higher rates as liquidity dries up, particularly to the people who find it hardest to borrow money," said Stanton.

Cheap Stocks Hurt by the Herd

There will likely be some or a lot of money made buying stocks that are temporarily underpriced. Many companies related to the mortgage business have seen their stocks go down in recent weeks. Companies with strong underlying fundamentals are potentially attractive, depending on an investor's appetite for risk.

Analysts point out that some banks and financial institutions are trading well under 10 times earnings and have large stocks of cash to pay out dividends.

"Fundamental investors, [Warren] Buffet-types — they're probably thinking in terms of buying opportunities," said Greenbaum.