The Strange Case of the Secret $2 Billion Asset Sale

Andy Obermueller's picture

Monday, August 10, 2009 - 7:41pm

by Andy Obermueller

I'm going to show you how to buy $2 billion worth of assets for pennies on the dollar.

I'm not kidding. If you want in on the action, you just have to come to Houston. I'll meet you at 600 Travis St,, Suite 5800, at 10 a.m. on Thursday. That's the office of Sanders Morris Harris Group, which is conducting the auction of 223 individual securities over two days.

The face value of the assets to be sold ranges from $1.5 million to $65 million. The prices paid could range, depending on quality, from 2 or 3 cents on the dollar to as high as 80 or 85 cents on the dollar. The investor who buys the assets at the auction bears all responsibility for collecting whatever they can from the underlying debtors.

But before you book your ticket, you should understand three things: What's being sold, why it's being sold, and how to make money from it.

What's Being Sold
The assets are income-producing securities, mostly mortgages and home-equity loans. The seller is, alas, a secret. What I gathered from Sanders Morris Harris is that it had been hired to liquidate a failed CDO. A CDO, or "collateralized debt obligation," is structured financial product that derives income from its ownership of other assets.

CDO investors basically pool their money and use it to buy other debt. These loans earn interest, which is collected and passed along to the CDO's investors.

Why These Assets Are Being Sold
Structured financial products like CDOs are regularly tested to make sure they have enough capital, liquidity and collateral. If they don't, and the problem can't be corrected quickly, then the whole thing has to be wound down. It's almost like a bankruptcy. A trustee is appointed to dispose of assets; investors get the proceeds. That's what's going on here. But since we don't know which CDO is being sold off, it's impossible to know the exact reason it went under.

It's not too hard to guess. The basic reason will be the same for any failed CDO: Its assets stopped producing, the market for its assets dried up in the subprime crisis, and the CDO didn't have cash to make interest payments to investors. The collapse of mortgage-related securities nearly imploded the financial system. In 2007, CDOs held $481.6 billion in assets. By the end of 2008, that had fallen to just $61.9 billion, an -87% decline.

How To Make Money From It
A $500,000 mortgage is only worth $500,000 if the borrower makes the payments. When the loan stops performing, its worth falls to a percentage of the current value of the underlying asset. The trick with a mortgage is to buy it cheaper than the net value of the property. Home-equity loans become profitable when an investor buys a big enough volume of loans at a sufficiently low price to come out ahead in time.

Home-equity debt is cheaper than mortgage debt because there is no asset behind it anymore. The equity evaporated as the price of the home fell. In cases where the borrower suddenly has no equity, the bank has no recourse if the loan goes bad. With no asset to secure an asset-backed security, the only thing you can hope for is a borrower who feels morally obligated to pay back the money he has borrowed.

Good luck with that.

index.gif" alt="" />The Tool that Can Give You an Edge
Nothing is certain but death and taxes -- and the fact that someone is going to make money off of these assets, though at a massive loss to the holders of the original CDO. And if you want to meet me in Houston for the auction, there's only one more thing you need to know. How to come up with a good bid. It's not easy. But Markit's ABX index, the benchmark for securities backed by home loans made to borrowers with shaky credit, can offer a starting point.

The ev doesn't reflect actual prices so much as it measures demand. As you can see from the chart, demand for these securities -- and thus price -- has fallen sharply in the past two years. As far as where the actual bidding, the best tactic is to show up in Houston. If you want to buy a security, all you have to do is offer a higher price than the rest of the bidders.

An Easier Way
If you like the idea of buying cheap assets and the financial sector appeals to you, there are lots easier ways than chasing down homeowners in default.

Bank of America (NYSE: BAC), for instance, is currently selling for 72 cents on the dollar. (And, with one of the lowest short ratios in the S&P 500, is a company almost no one on Wall Street expects to go down.)

Regions Financial (NYSE: RF) is selling for just 39 cents on the dollar. And for investors willing to shoulder some risk, CIT Group (NYSE: CIT), the troubled finance company, can be bought for a mere 13 cents on the dollar.

All of those significantly undervalued investments can be bought from your desktop -- who wants to go to Houston in August, for heaven's sake? -- and they offer every bit as much upside as the CDO assets, but without the headaches that come with buying and attempting to collect on distressed debt.

Andy Obermueller does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of CIT in one or more of its “real money” portfolios.