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July 30, 2009

Let Us Prey

By Spear's

Following the recent carnage in the financial markets, scavengers are closing in. But there’s a difference between great carrion and rotten roadkill, says Rob Cox

E very market panic produces its fair share of notable casualties. The Asian financial crisis of the late 1990s took out the biggest hedge fund of its day, Long-Term Capital Management. The junk-bond route earlier in that decade led to the disappearance of the formerly venerable investment bank Drexel Burnham Lambert.

The 1987 crash erased a handful of storied Wall Street names and the excesses of the decade led to the savings and loans disaster. And let us not forget the great market crash of 1929 or the panic of 1907, which wiped out virtually all America’s trust banks.    Yet from the ashes of financial disaster, there almost always rises a hero or two — an investor or firm that cannily profits by playing the other side of the table from the losers and emerges richer and more powerful. The detritus of the crash of 2008 has included some very large financial institutions: Bear Stearns, Lehman Brothers and, in the UK, Northern Rock.

To this we can add a whole coven of megabanks that, though kept alive by intravenous taxpayer drips, are effectively the walking dead: Citigroup, Bank of America, Lloyds and Royal Bank of Scotland. But where are the heroes?  So far a handful of players have managed to walk away from the past year’s wreckage with few scratches, and in some cases larger businesses or fat profits from betting against the house. JPMorgan, for example, added the bones of Bear Stearns and retail bank Washington Mutual to its US franchise. But it is now struggling with the troubles of the American consumer, a battle it must win to be declared a firm winner.

John Paulson, the hedge-fund manager who bet against the subprime market, is a notable hero, at least for his investors, for whom he minted billions in returns at a moment when nearly every other asset class known to man went south.  But the opportunity for even bigger winners to sally forth is still an open book, as the carcasses of the recent Age of Overleverage, and the economic decline that it helped to accelerate, are still to be picked over. Yet it is still too early to identify who will rise to the top of this colony of vultures. 

Consider the feast they will have the chance to consume. In just the first quarter of the year, some $2 trillion in debt securities was either defaulted upon or rendered distressed, according to Edward Altman, a professor at New York University’s Stern School of Business. That compares to just $2.2 trillion for the whole of last year. And this is still just the beginning.

The first-quarter figures suggest a rate of default of less than 4 per cent of outstanding issuance. That is incredibly low, given the level of distress in the credit markets and the broader global economy. Indeed, in 2002 the failure rate among high-yield bond issuers peaked at 12.8 per cent. Prof Altman predicts the crisis will see a peak near 13.5 per cent, with investors recovering about a quarter of the value of their investments, through either the exchange of new securities or the bankruptcy process. 

But timing their swoop is not easy. Even some of the most practised vultures have got it hopelessly wrong. Take Cerberus, the private-equity firm that made its name by scooping up debt from troubled companies so that it could take control and restructure them. It is led by the intensely press-averse Stephen Feinberg, and has included among its roster of advisers former Vice-President Dan Quayle and former Treasury Secretary John Snow.

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That didn’t prevent the firm from getting it hopelessly wrong in Detroit, where it cobbled together a series of investments in the automotive sector, culminating in the purchase of Chrysler from Daimler, for which it was the only bidder. 

Cerberus was right in one respect — that Chrysler was a distressed company that somebody could restructure. But its timing was fundamentally flawed. To keep Chrysler alive, Cerberus has had virtually to renounce all its claims to the company’s equity as a condition for receiving government aid. And that, too, was not sufficient to keep Chrysler from the brink of bankruptcy.    

Cerberus is in good company among formerly acknowledged leaders of the vulture pack who got it sorely wrong. Texas Pacific Group, which rolled the dice on companies such as Continental Airlines that others had given up for dead in previous market routs, tried to catch a falling knife in the financial industry last year, only to see some of its digits amputated. The firm overseen by David Bonderman led an early $7 billion investment in Washington Mutual in April.

While it was risky, it looked as if TPG was receiving some protection against further deterioration at WaMu: it got the stock at a discount, received in-the-money convertible securities and warrants, harvested lots of fees and put in place an anti-dilution ‘ratchet’ that made it punitive for WaMu to raise additional capital. By September, regulators had declared WaMu insolvent and sold its remains to JPMorgan for $1.9 billion. TPG’s investment was wiped out.   

As the 2008 banking crisis winds up and the economic one of 2009 unfolds, there will be many more carcasses to pick over. But as any investor knows, past success is not necessarily indicative of future returns. Likewise, the vultures of the past may not emerge as the victors of the future. 

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