New York (HedgeCo.Net) - While the U.S. Treasury has done all it can to stave off rumors of a government bailout of Fannie Mae and Freddie Mac , some say the inevitable rescue is bound to take place after attempts to raise capital for the two mortgage giants have proved futile.

Preferred shares of the two companies are trading as low as 19 cents on the dollar, fueled by assumptions that their dividends will be suspended. This belief was the reason behind Moody’s recent ratings downgrade of their preferred stock to Baa3, the lowest possible investment-grade. Meanwhile, shares of both companies have experienced month after month of sharp declines, with Freddie down 93 percent and Fannie down 89 percent since November.

Together, the two companies account for over $5 trillion of outstanding U.S. mortgages. As the number of foreclosures reached record heights thanks to defaults on mortgages by subprime borrowers, Freddie Fannie have taken a beating since last summer, writing down almost $15 billion and forcing some to believe they will not be able to weather this housing crisis without the help of Uncle Sam.

Both Freddie and Fannie make money by offering mortgage-backed security bonds to investors. By selling these bonds, they assume the risk involved in the repayment of these loans. In exchange, they get to keep a guarantee fee that investors pay upon purchasing the bonds. It is easy to see, then, how the two companies that were believed to be “too big to fail,” started to experience problems. As more and more borrowers were unable to pay their mortgages, the responsibility fell on Freddie and Fannie. As they tried to stay afloat in their sea of debt, values of their securities started to plummet.

Recent attempts to try and find investors have been unsuccessful. Hedge funds like the Carlyle Group and Blackstone both expressed interest, only to rescind until further action by Treasury Secretary Henry Paulson.

“I think it starts with the constant doom and gloom, which makes investors quick to react when there is any sign of trouble ahead, and rightfully so,” explains Michael Facchini, Portfolio Manager for Chicago-based Regent Global Funds.  “Right now, investors are only interested in the cream of the crop when it comes to the MBS markets.”

Federal Reserve Chairman Ben Bernanke has spoken several times about increased regulation of the companies, thanks to the widespread belief that Freddie and Fannie are government-backed. While both were created by Congress in an effort to increase homeownership and profits through the sale of their mortgage backed securities, they are in no way guaranteed by government funds.

In July, the Treasury and Federal Reserve outlined a plan to save Fannie and Freddie in order to prevent any chance of a Bear Stearns-like debacle. Among the suggestions, Paulson’s plan allowed for the Treasury to purchase shares of the two companies, should it prove to be necessary. That time has come, with some estimating the government may have to purchase about $60 billion worth of preferred shares.

Shares of Fannie Mae closed on Monday at $5.19, up 4 percent, while Freddie Mac rose 17 percent to close at $3.29.

By: Julie Scuderi
Senior Editor for HedgeCo.Net

Distressed Debt is starting to make a lot of noise in the alternative investment arena and with everyone jumping on the boat; it might be ready to tip.  I have seen numerous announcements of new distressed debt funds and I think we will keep seeing more down the line.  Here are questions you should be asking; who are going to be the winners and losers and does anyone really know how distressed the debt really is?

The buzz in the investment air went from buying real estate to buying distressed debt.  What I would like to concentrate on here is distressed debt in the form of real estate mortgages.  Being a fund manager of a specialized fund that operates as an asset based lender in the business of alternative financing, we are getting hit almost daily with people looking for money for foreclosure acquisitions.  Everyone is talking about buying foreclosures and the media is again helping to purport the good news/bad news story by publishing articles about investors making big money in foreclosures.   The most favored structure is for investors to negotiate short sales with banks, and the banks are more than happy to oblige.  A short sale for those of you not familiar with the term, is a sale of a mortgage note for less than its face value.  Banks do this because they want to get the bad debt off of their books.  This works well in a good market because it gives the new note holder instant equity in an appreciating asset with the hope of a large gain on an eventual foreclosure.  Granted, in this current market short sale pricing is a little more discounted than usual, but for good reason since the housing market is a bit in shambles.  Once an investor actually does negotiate a short sale and take possession of the note, the long foreclosure process begins.  First off, real estate is not a liquid asset and the foreclosure process makes it even more illiquid, if you are looking for a quick turnaround look somewhere else.  The foreclosure process is not only long and tedious, but if you are unfortunate enough to buy a note for a residential property that is owner occupied, the law is not on your side.  As a rule, commercial property is more of a non-regulated structure that is more of a business agreement then the regulated monster that is residential lending.  In residential lending, the law gives the borrower every possible leniency and time is on their side. Carrying costs like debt, taxes, maintenance, and insurance to name a few,  start to quickly eat into profit, and  a residential owner can stretch out a foreclosure for anywhere between 6 to 18 months,  and depending on the state and depending on how much they fight it, it could go even longer than that. Imagine having to service the debt that was used to buy the foreclosure, and every month the payment to carry that debt eats into the profit.    However, that is only the start of the pain because you also need to add the legal bills that will start piling up and then add the potential damage that will have to be repaired when the borrower leaves (needless to say, evicting someone from their own house brings out the worst in people).  Wrap it all up and distressed debt starts looking less like a slam dunk and more like a dunking tank.

The big question is how certain are the funds betting on this strategy and furthermore,  I am curious about whether or not there is a long term strategy for these funds?   If there is a long term strategy, what is it because  the amount of new loans being made is decreasing and once we churn through the current large volume of bad debt and foreclosures, how much business will there be to support a multi-billion dollar fund.

This is not to say that there aren’t a lot of very skilled fund managers out there with the experience and know how to make this kind of strategy pay off big, but if I had to take a guess, I would say that the Asset Based Lenders(ABL) are going to be the big winners here. Now I am possibly biased, because in full disclosure the fund I co-manage is an asset based lender collateralizing on commercial real estate but here are the facts to back up why the ABL’s are the play here.  It takes cash to negotiate a short sale, and it is next to impossible to get a bank to give you an unsecured line to go out and negotiate short sales. Even trying to get a loan on a commercial property that you already own is becoming a magic trick so these buyers only choice is to go to alternative financing sources and these sources can charge what they want for the simple reason of supply and demand. When I say they can charge what they want I am talking about rates in the neighborhood of 11%-20% on average. Not only can they charge what they want but they can also afford to be cautious. Not only do most of them only lend on commercial real estate, but during the heyday, banks were lending somewhere between 80% to 100% loan-to-value(LTV) while ABL’s were generally lending around a 65% (LTV).   In addition, most good ABL’s are originating and underwriting their own loans and with an experienced ABL that knows how to sift through the numbers and nuances, they know what the end looks like before the start.

ABL’s are doing well but the significant returns are still ahead of them.  One must consider that the ABL’s are probably going to lend around 65% LTV on a note that has already been negotiated down probably between 25%-30%.  In fact, the new norm for responsible ABL’s seem to be below a 60% LTV.  That means that a note that was discounted say 30%, is then discounted by the ABL’s another 40% and clearly the security starts looking a little more secure.  To sum it up, ABL’s are making great money short term with the potential to secure large gains long term through foreclosure. Through this, you clearly have both a short and long term strategy.

So in short, I am saying that there is a huge opportunity in distressed debt. However, the most lasting and secure opportunity is in the hands of whoever is at the end of the end game, and that long end game player is an Asset Based Lender.

Copyright: Dominic Mazzone, Regent Global Funds 2008

Lately, a lot of investors and friends have asked my opinion about the effects of the credit crisis on commercial real estate. You’d have to be living in a cave not to know about residential values falling, but there doesn’t seem to be a general consensus about where commercial is going. If I had to forecast, and technically I do because the fund I co-manage operates as an asset based lender collateralizing on commercial real estate, then I would say we are heading back to reality. To understand where reality is, I think it’s important to understand the unreal place commercial real estate has been in. During the boom, commercial real estate, and most notably income properties, seemed to lose their very definition. Income property by its name is supposed to produce income. Since real estate became everyone’s favorite alternative investment, there were a lot more buyers competing for the same income properties and many of those inexperienced buyers didn’t understand the methods of valuating them. The fervor to just own property seemed to be greater than the glaring fundamentals of the property they were buying. Commercial real estate’s most basic valuation method is the income approach, and the outcome provides a capitalization rate (CAP). Without going into a whole seminar on the topic, it is basically net income before debt divided by the price. While people should have been buying properties north of an 8% CAP (the higher the better when you are the buyer), they were buying them down in the 5’s and 6’s, and I have even seen some extremely over-valued scenarios in the 3’s. At those prices, there is a lot of out of pocket money going into servicing the debt on a monthly basis, and it was happening all in the name of price appreciation. That’s just not how this alternative investment is supposed to work. However, it was actually working for a brief time because of the upward momentum of the market, and if your time horizon was short, there were decent profits to be made off of a flip.

We are now seeing CAP rates starting to creep back up north of 7%, which translates into lower values. High valued areas are still coming in lower than that, but that is a function of perception on future valuations and not a reality based off of current cash flow. The numbers are under the microscope even more so because of more stringent lending guidelines, and also due to the fact that most of the buyers that are left are professional investors that live and die by these valuation formulas. . At the end of the day, if you are valuating commercial real estate on price comparisons then it looks like it’s starting to slide. However, if you are basing your valuations on the income approach, it’s clear that commercial real estate is going back to exactly where it should be; producing income. When I was first getting involved in real estate, I received the best piece of free advice from a very wise man. He said, “Owning commercial real estate is like a business and almost every business needs to generate income. So let the income be the cake and the appreciation be the icing, and everyday will feel like a birthday.”

Copyright: Dominic Mazzone, Regent Global Funds 2008

Often investors get caught by marketing like anyone else and become absolutely in love with a brand.  Case in point is that they’ll take lower returns from a large, name brand fund over the higher returns of a lesser known, small fund.  To be fair, the large name brand funds may have earned that brand due to solid past performance.  However, sometimes a brand name is only a name and as the saying goes, you are only as good as your last quarter.  With all the volatility in the market affected by every jitter around the world, a short-term outlook is becoming as important as a long-term one.  Small funds have the benefit of being both agile and flexible to move with the volatile market, and capitalize on traditional and alternative investment strategies before the larger competition.  Another extremely important factor to consider when looking at the size of funds is its relative inflow compared to its outflow.  This is very important when looking at hedge funds and other funds that have an alternative investment strategy that is not publically traded or correlated to the global financial markets.  In simple terms, a large fund that has a huge amount of assets that need to be invested have an issue of where to put all of the money because they are not dealing in a market with liquidity.  It is because of this that guidelines are stretched and additional risk is taken all because there are investor dollars expecting a return.  The ability to pick and choose the investments get caught by the demand side, and the managers end up with a few hopes and dreams in the portfolio, instead of all solid choices. All of the prior points are important, but I think the greatest benefit of a small fund is the accessibility to the managers.  I have touched on this before in “Fund Managers Need to be Accessible and Personally Invested“, and accessibility is an absolute must in this market.  I will be coming out with a full article on the benefits of small funds, but I would like to leave you with this. It’s a fact of life that most big things started out small.  That goes for everything from structures, governments, markets, companies, and the funds that invest in all of them. The real returns on all of these were not garnered at the end, but more so at the beginning when the ideas were fresh and the motivations clear.  Ask yourself if you are sacrificing your investment dollars for an old brand, because running with the crowd can sometimes get you trampled.

Copyright: Dominic Mazzone, Regent Global Funds 2008

This “Investment Perspective” comes straight from the rooms in banks that are filled with the proverbial bean counters known as underwriters that are making the lives of hard money lenders very easy and very profitable.  It’s clear that the banks are running out of both good decisions and good excuses for denying loans to businesses, property investors, and individuals.  It seems that we have reached the lunatic fringe in that even a person with AAA credit, great income, and a substantial net worth is not deemed as credit worthy.  It seems that the new paradigm in lending guidelines is that you must have more money sitting in a bank account than the amount you want to borrow.  It is because of this that hard money lenders are being asked to step up to the plate to fill the vacuum created by the credit crisis. Hard money, aka private money or any financing that is an alternative from conventional bank financing, is quickly becoming one of the only sources to get deals done. Many asset based lenders(ABL) in the form of ABL funds are operating as hard money lenders and are generating large profits.  Rates seem to be between 11%-20% and rising due to the demand.  The old adage goes that “cash is king”, and hard money is becoming the king’s champion. One interesting correlation to consider is this; as interest rates begin to rise, how high will hard money rates go if the banking guidelines remain tight?  Only demand will tell.

Copyright: Dominic Mazzone, Regent Global Funds 2008

Today’s Idea comes from an offshoot of an article I wrote a while back called, “Euro’s Have Two Ways of Profiting in U.S. Dollar Investments” where I discussed US dollar investments as a long term hedge for investors holding Euros.  I made a basic argument for the U.S. dollar to gain against the Euro in the next 5 years, and the additional benefits from that currency exchange while still reaping a good return in something like an alternative investment. I still stand on that opinion and I feel the same way if not stronger about the Canadian dollar. Canada’s economy for the most part is predicated on a weak US dollar and there have been several issues related to the Canadian dollar being on par with the US dollar.  Many Americans may not know this but just about every U.S. based fortune 500 company has a noticeable presence in Canada.  Due to the Canadian dollar being weak for so long, these companies were doing a lot of their manufacturing in Canada as well as headquartering their call center operations there.   Since the Canadian dollar has been rising the manufacturing has been going elsewhere and India has been eating away at the call center business for years. These issues and others have been affecting the economy and have been masked due to the large revenues coming in from Canada’s vast resources like oil, copper, and nickel to name a few.  However, in my opinion the Bank of Canada has been artificially keeping their rates low and it seems that their goal is to assure that the Canadian dollar doesn’t gain any more strength.  In fact, the Canadian dollar has been dropping like a stone for the last two weeks due to the drop in oil and the US dollar gaining strength.  Investors holding Canadian dollar’s need to consider investing into a US dollar investment in their Canadian held portfolios.  The currency appreciation alone in the last two weeks would have been reaped about a 5% return, and with something like an alternative investment fund that can pay upwards of 9-10% this could be a pretty profitable hedge against the falling Canadian dollar. Not to mention that the TSX is looking a bit pricey right now, the Canadian economy is starting to feel the affects of a global slowdown, and with a Canadian election also looming in fall, you couldn’t ask for more uncertainty.

Copyright: Dominic Mazzone, Regent Global Funds 2008

Today’s Idea is about an age old debate about debt vs. equity.  It is interesting to think back a couple of years ago when there really weren’t that many debt funds offering up an alternative investment,  in comparison to the amount of private equity funds, which was the signature source of alternative investing. As a fund manager of a debt fund I remember seeing a lot of raised eyebrows when explaining our fund to both investors and financial institutions back then, and I think that was due to a lot of people thinking that the good times would roll forever.  Debt is obviously getting a lot of attention right now and it is sometimes hard to distinguish the good debt from the bad debt. This will end up being a full blown article on www.investingsymposium.com but here is a sample of what I am talking about.  There are so many different debt vehicles that we can’t cover them all but let’s talk about the principles that most of them share. In its most simplistic form, bad debt is debt that won’t be repaid without adequate collateral. Good debt is either a loan that will be repaid or a loan that will not be repaid that is backed by adequate collateral.  In essence, with good debt if the loan pays off or not you still get paid in the end.  In this cycle, an entity whether it is corporate or otherwise is issuing equity to bring more money into the coiffeurs and that is basically bringing in additional collateral to cover their debt.  The greatest factor around collateralized debt is that the borrower needs to pay you before paying out their equity partners, be it in a private equity setting as an alternative investment or in a corporate scenario as bonds.  This is the basis of asset based lending, and the reason why this is becoming the alternative investment of choice.  Asset based lenders understand the need to over collateralize hence providing the security needed to be good debt. So you need to ask yourself one simple question. Would you rather be holding equity paper that is valued by revenue after paying debt, or would you rather be holding the debt that gets paid before the equity paper?

You can read more about the basics of asset based lending by clicking here.

Copyright: Dominic Mazzone, Regent Global Funds 2008

Wouldn’t it be nice if every time someone asked you to borrow $100, they gave you their iPOD to hold onto as collateral?  I’m sure they would be much more compelled to actually pay you back as opposed to conveniently “forgetting” to do so.  Seems like a simple concept, wouldn’t you say?  Well, as simple as it is, it’s actually a concept that has many investors retreating to the basics during this troubled economy.  Now more than ever, ABL’s (or Asset Based Lending investment funds) are gaining attention and significant momentum simply due to demand from both the lending and investment industries.  Say goodbye to the days when lenders would give you money because you had a decent credit score and a nice smile.  Now they want you to actually be accountable and have skin in the game.  How dare they expect such a thing!

Asset based lending simply refers to any financing offered to a borrower that is secured against their assets, and if the debt is not satisfied the asset is seized by the lender.  The most common example of asset based lending is a mortgage that is secured against a piece of property.  However, in the hedge fund and alternative investment world, asset based lending can refer to much more than loans on just real estate.  ABL considers assets such as business inventory, accounts receivable, company equipment and machinery, intellectual property, marketable securities, equity ownership in a company, and of course real property (IE, real estate).  Funds usually specialize in lending on a specific type of asset, and the risk for their investors varies depending on what they’re collateralizing against.  For instance, loans that are underwritten using a business’s accounts receivable as the underlying asset are typically higher risk compared to loans that are underwritten using an income-producing apartment building.  The former assumes that the business will be receiving money owed by customers and ultimately has the business to fall back on if the receivables are not received.  The latter assumes rents will be paid and ultimately has the building to fall back on if rent is not paid to the borrower.  Loans against property are typically considered lower risk because they are secured against a physical asset, that being real estate, which typically holds its value over time.

So, why such a demand in this current economic cycle?  With banks continuing to shut down their lending operations because they are so leveraged on their portfolios, the only lenders left  are those profitable ABL funds that offer loans with higher interest rates under their stricter terms.  Banks can no longer compete because of their lack of liquidity and their unprofitable margins from their extremely low rates.  Hence, the credit crisis.  Banks were too loose with their guidelines, providing highly-leveraged financing at very low rates, while ABL fund required more skin in the game, more security to back-up the loan, and rates that allowed them to remain profitable, even if a portion of their loan portfolio went into default.  Now borrowers are either forced or in many cases choose to turn to alternative financing, private lenders and ABL funds to acquire the financing they need.  As a result, alternative financing is becoming less of the alternative and more of the norm, and thus positioning itself to become the conventional financing of the future (and near future at that).  These ABL’s can pick the “cream of the crop” loan and distressed debt opportunities, and demand even more collateral from their borrowers with stricter terms than before, thus making the ABL funds much more resilient and secure as they continue to take over the capital markets.  ABL has not only become the financing option for most borrowers as of late, but their demand from the lending industry has translated into a alternative investment opportunity for many investors looking to get their money placed into a more predictable and sound investment vehicle.  If you think about it, the demand for money on one side of the fence presents an opportunity for the supplier on the other side of the fence.  It all goes back to the Golden Rule (whoever has the gold makes the rules!).

So, let’s return back to the idea of providing a $100 loan for a friend secured by their iPOD, a tangible asset I think we can all agree is marketable.  Let’s say the fair market value of the specific unit in question is $150.  If someone were to put up their $150 iPOD to borrow $100 from you and they were to skip town, you would still be sitting pretty (assuming you did your due diligence to make sure the unit was in good shape, functioning, etc).  Well, in this scenario, you would be holding an asset with a 67% LTV, or Loan-To-Value (simply loan amount divided by the value of the asset), meaning there is a 33% equity buffer available to protect you from a loss, and even present additional profit.  This puts a whole new spin on things the next time your cousin-in-law asks for a small loan at the next family barbecue, doesn’t it?  Try talking a little asset based lending with him and then see how much he needs the money.

Today’s idea comes from some of the recent announcements about how large corporations are using job cuts as an alternative to growth, and in essence keeping their bottom line in shape.  With the economy in a recession, it’s that time again for large corporations to start slashing jobs and trimming the fat, all in the name of profitability.  However, I think we may start finding out that there is not a lot of fat to cut, and through this exercise we could be cutting into the bone, or better yet, their revenue generating muscle.  If you take a look at many of the large corporations, they have been going through a protracted cutting exercise that hasn’t really factored into our employment numbers because of the gradual nature of the layoffs.  Up until the last 12 months, those unemployed workers have been getting somewhat absorbed into the system.  However, over the last year there has been about a 1% uptick in unemployment and that number will most likely continue to rise a bit.  The traditional thinking around downsizing is that the remaining workers will pick up the slack, and because of this, it will make a company more profitable.  However, what happens when a company downsizes to a point of breakage, where the remaining workforce can no longer handle the additional load and they cease to be effective.  In essence, they start running into a standstill and I guess we could call this the “Downsizing’s Negative Returns Theory.”   When compensation plans for executives and senior management are weighted heavily on short term profitability, we could run into a conflict of interest:  downsizing between the corporations long term well being and personal compensation.  I think it’s clear that, bottom-line, profitability is a party that can last only so long without top line growth.

Copyright: Dominic Mazzone Regent Global Funds 2008

Today’s Idea is just a quick thought about the current market schizophrenia.   On July 12^th I saw a headline that read “Oil Hits Record High on Supply Fears” “.  If you were living in a cave and saw this headline you would probably think that there is a shortage of oil and rightly so.   However, yesterday I saw a headline read,” Oil hits 7 week low on demand worries.  Wait a minute, how can that be possible if only 17 days ago we had a supply issue?  In fact on Monday there were additional supply concerns due to bombings in Nigeria.  The fatal fault causing market schizophrenia lies in the market,  and its traders fascination with daily news that has given them a minute by minute perspective instead of the long term one they should have.  Now don’t get me wrong, they are traders and that is what they are supposed to be doing to a degree.  However we have come to a point where it is affecting the direction of the market with such force that is may become habit even after the smoke clears.  The commodities seem to be the ones that are moving the most, and it is no wonder that investors in commodities are starting to get skittish and looking into alternative investments. Because trying to gauge how political, scientific, logistic, geographic, financial, supply, and demand  issues will affect the price of oil and the market as a whole, is like trying to predict the long term health of the global economy.  Lots of people talking about it, lots of people tinkering with it,  but without any real foresight into what to do about it.

Copyright: Dominic Mazzone Regent Global Funds 2008