But the smarties all seem to have one trade on – which is long distressed loans short financial institutions.
That is at least the broad position in the Paulson letter.
And far from me to encourage you onto a crowded trade – the position makes sense.
There are plenty of assets trading at 60-70c on the dollar that sit on bank balance sheets at much higher prices. If you force the banks to recognise the assets at 70c on the dollar they are amazingly insolvent.
(a) the assets are underpriced, or
(b) the banks are overpriced or
Long junky loans short financial institutions is just an old fashioned arbitrage – and the few unimpaired arb funds (eg Paulson) are making hay...
Are the junky assets really underpriced in the market?
There are plenty of assets trading at 60 cents on the dollar. Diversified pools of mortgages (admittedly less-than-prime pools) often seem to trade at this level. AAA strips against those pools are often 70c in the dollar and where 12 percent of the assets need to go bad before you bear any loss. Implicitly there needs to be 40 percent losses before you lose money on these investments.
I know it is bad out there – but 40 percent losses imply worse than 60 percent defaults with 60 percent loss given default. It is simply not going to happen on a widespread basis (though I can show you individual securitisations that are worse than this).
So why don’t people bid up the price of the junky assets? Well some are – see the Paulson letter – and he has made good money doing things like that.
But there is a return problem. Some of these assets are quite long dated – you might get paid over ten years. And meanwhile you get say 10/7 times the AAA yield (the stuff is trading at 70c in the dollar) and it might pay 85 cents in another 10 years – so you get nearly another 2% per annum in carry.
Well 10/7 times treasuries isn’t very much – less than 4% and nearly 2% carry – and whoa you have an asset on which you won’t lose money indeed on which you probably will make five percent.
That really excites me. Asset prices are way down – this crash might be the investment opportunity of a lifetime – and I have a smorgasboard of assets to chose from on which I will not lose money over the long term – indeed on which I might make 5% per annum.
I am just thrilled.
So how are those assets really? Underpriced but hardly exciting. To be exciting they have to be insanely underpriced. There are a few insanely underpriced assets out there, but John Paulson (Paulson funds) won’t tell you what they are. And even then they are not that exciting.
No – to be exciting you need to borrow against them. You need to be able to use leverage. Cheap leverage. Lots of leverage. And it can’t be margin loans or the like – because the asset prices are so volatile that your funding might go away.
But – with permanent cheap funding at government rates it should be profitable to buy those assets. Seven to one levered at government rates (which are a couple of percent) the returns will be spectacular.
So if the Geithner plan is to attract say one hundred and fifty billion of private risk capital and allow it permanent and secure access to say a trillion dollars of government money at a government rates then hey – I am in. (I would require the interest rate risk be matched too.)
It would be a pretty big gift from the government – as nobody – a good bank or a bad bank – can borrow at the same (extraordinarily low) rate as the US Treasury. But as a plan it might just work. And because 150 billion of real private spondulicks is at risk there are some pretty strong incentives for the private sector manager to get it right.
Well who should be the private sector manager?
I don’t know. Most of them won’t work for a $500 thousand dollar salary. And that is problematic.
But – hey its my civic duty. I will do it.
Yes – you heard me, I would do it for a $500K salary. And no base fees – and a very small performance fee. Admittedly the very small performance fee will be on a very large amount of money – and with all that cheap government leverage it might leave me as rich as Croesus – say Bob Rubin rich. Indeed as the underpriced assets are common and the only problem is the inability to lever them – I should make an absolute killing if Mr Geithner will give me enough cheap, matched and permanent funding.
Indeed I would never bother with this fund I am setting up. I would get my original clients together and raise a few hundred million of private money to start the bail out fund. I will even put in most my own net worth.
Oh, and I wouldn't hide the motive either. Its greed.
How about it Tim? You game?
How about it Tim? You game?