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Market Update Distressed Mortgage Demand and the Public-Private Partnership
Christopher Skardon March 17, 2009
Enter the Government
At current market prices, a $4 trillion asset class… Gorelick Brothers Capital has spent the better part of the last 18 months evaluating, and allocating capital to, distressed mortgage funds. Broadly, these funds have invested in assets including residential mortgage backed securities (RMBS) and whole loans (WLs), commercial mortgage backed securities (CMBS) and trading strategies related to these assets. As detailed below, we estimate that these asset classes total approximately $7 trillion in nominal value and $4 trillion in market value. To date we have reviewed over 140 new fund proposals, mostly from hedge funds, private equity and other money managers. These funds have targeted approximately $70 billion in new capital and have been able to raise about $35 billion to date. This tally excludes private equity firms investing chiefly in commercial real estate loans and equity, as well as distressed debt funds focused on corporate bonds and loans. In the face of overwhelming supply, $35 billion of fresh capital has hardly made a dent in the opportunity. In fact, the risk/reward profile for new investment has improved over the last year with un-levered yields increasing from the low-teens to the 20% area. For most investors, there have been several unfortunate false starts. Funds that invested in distressed mortgages in 2008 on a “long-only” basis lost money, and funds using leverage lost a lot of money. Against this capital-starved backdrop, we welcome the newest and largest potential investor: the Treasury Department’s Public-Private Investment Fund (PPIF), introduced last month as part of the Government’s Financial Stability Plan (FSP). Its basic premise is to finance private investor purchases of up to $1 trillion in distressed assets. We expect PPIF’s to offer term, non-recourse leverage in order to lure private capital from the sidelines, reduce liquidity premiums and stabilize the market. As illustrated in the simple timeline below, it seems to us PPIF is likely to play a leading role in clearing bank balance sheets starting very soon. Treasury’s Financial Stability Plan (FSP) Timeline
Stress Tests Private Capital Raise Treasury Equity Injections
Only $35b raised privately, Government funding to fill the void…
Asset Sales to Public-Private Investment Fund (PPIF)
Source: Gorelick Brothers Capital, LLC For further information please contact Michael Davis, Director of Investor Relations, MDavis@GorelickandSons.com Gorelick Brothers Capital, LLC ● 4064 Colony Road, Suite 340 ● Charlotte, NC 28211 ● (704) 442-1094
Arm’s length pricing and ample financing are hopeful signs…
Investors have several reasons to be hopeful. Capital attraction improves as investors gain confidence in arm’s length pricing and potential supply. Treasury has explicitly endorsed a pricing method that “…allows private sector buyers to determine the price for current troubled and previously illiquid assets.”1 Forced selling as a result of FSP’s stress tests can be met with ample financing for new buyers. Treasury seems to have estimated that 12% to 25% of the available market value will likely trade over the coming year, so the amount of financing is appropriate (25% x $4 trillion = $1 trillion). This significant source of new demand should foster grater confidence that today’s market price will hold in the face of tomorrow’s selling pressures.
Other Capital Sources
The Government has explicitly specified its goal of $500 to $1,000 billion in PPIF buying power, but how much private capital is available? Likely sources of additional private capital include pension funds, endowments and foundations, sovereign wealth funds, private equity funds and hedge funds. Nominally, these investors have over $15 trillion of assets under management (Table 1). While that figure is significant, we believe only a small fraction is likely to take advantage of a Government financing offer, and we believe creating $1 trillion in new demand will require leverage on the order of 5x. Note: For purposes of the discussion below, we seek to estimate the maximum amount of capital that could be available. We assume Government provides $1 trillion in financing, and our other estimates are likewise purposely optimistic.
U.S. Based Sources of "Private" Capital Public Pension Funds3 Private Pension Funds Foundations
6 7 8 4 5 2
Total (Bn) 3,000 1,030 4,112 263 2,493 3,190 1,473 15,561
Leverage of about 5x required…
University Endowments Private Equity* Hedge Funds* Total
Sovereign Wealth Funds*
*Sovereign Wealth Funds are non-U.S. source, and Private Equity and Hedge Funds receive significant foreign investment
Available Private Capital: The Tally
Cash & Short Term Investments. Our first optimistic assumption is that some portion of cash balances on allocators’ balance sheets may be held for the purpose of making tactical investments. We focused on cash amounts available at pension funds, endowments, foundations and sovereign wealth funds (SWFs). (We don’t have a reasonable gauge for hedge funds, but the lion’s share of hedge funds has neither the mandate nor the skill to invest in these assets, and we suspect many are holding cash for the purpose of funding redemptions.10) We estimate total cash balances average about 5% of assets, or about $470 billion.11 Almost half of that amount is at SWFs, but only approximately 34% of their exposure is to U.S. assets.12 We estimate
Perhaps some tactical allocation of cash balances…
www.financialstability.gov, “Fact Sheet: Financial Stability Plan,” Pg. 3, 2/10/2009 This is an educated guess, and probably optimistic. Caveats: 1. Many pensions, endowments and foundations have a 6/30 year end, and these amounts are not adjusted for significant market losses since 6/30/08; 2. Approximately 50% of private equity (and one can assume hedge fund) assets come from pensions, endowments, foundations and SWFs. So there is some double counting. 3 Public Pension Funds: Beth Almeida, Kelly Kenneally & David Madland, Ph.D., "The New Intersection on the Road to Retirement," 5/2/2008. 4 www.watsonwyatt.com. “Dramatic Drops in Interest Rates Forecast Much Lower DB Plan Funding Status on Accounting Basis for 2008.” 5 National Association of College and University Business Officers, "2007 NACUBO Endowment Study" 6 Foundation Center, "Top 100 U.S. Foundations by Asset Size," 2/5/2009 7 Preqin, LLC 8 Balin, Bryan J. "Sovereign Wealth Funds: A Critical Analysis," 3/21/2008, The Johns Hopkins University School of Advanced International Studies. 9 The EurekaHedge Report, February 2009, pg. 3 10 WSJ, 3/2/2009. Morgan Stanley Analyst, Huw Van Steenis is cited as estimating that total hedge fund assets might fall to less than $1 trillion from their year end 2008 levels. 11 We used the following institutional portfolio allocations as our benchmarks: Pensions – CalPERS; Endowments – Davidson College; Foundations – Ford Foundation; SWFs –Government of Singapore Investment Corporation. This data was based on 2007/2008 fiscal year end reporting. On average, portfolio allocations to cash or short term investments were 5.1%. 12 Government of Singapore, “Report on the Management of the Government’s Portfolio for the Year 2007/8,” page 11. GORELICK BROTHERS -2CAPITAL
pensions hold $72 billion in cash, but we think most is encumbered by increasing retiree payments and unfunded private equity capital commitments. Endowments and foundations have approximately $173 billion of cash and equivalents, about 4% of their total assets. Recent losses and pressure to maintain 4%-5% annual distributions are likely to limit reinvestment of cash. Our guess is that just over 10%, or $52 billion, of existing cash balances could be available for new investments in distressed mortgage assets. Existing Capital. A handful of hedge funds and private equity funds control the vast majority of existing capital available to invest in distressed mortgage assets. With rare exception, pension funds, endowments, foundations and SWFs do not yet have meaningful staff dedicated to distressed mortgage opportunities, and most will initially outsource investment to external managers. As noted above, we estimate that distressed mortgage funds (including those raised by PIMCO, Blackrock, TCW, Paulson, etc.) have raised $35 billion to date. Of that amount, our research indicates at least half has already been invested. We believe an additional $34 billion could migrate from distressed corporate debt, fixed income or multi-strategy hedge funds.13 Considering that very few fund managers have both the mandate to invest in distressed mortgage assets and the requisite expertise, analytics and infrastructure (including, for example, servicing capacity for whole loans14), we suspect our estimate is generous. The other source of existing capital is private equity. Private equity managers have up to $1 trillion in “dry powder,” of which approximately $200 billion is intended for real estate funds.15 Typically, real estate funds focus on commercial real estate ownership opportunities by making equity and mezzanine loan investments. Controlling assets is the key to their mandate. We expect some will move up the capital structure into CMBS AAA debt as it offers un-levered yields in the low to midTable 2. teens. The amount of dry powder is likely overstated since the vast majority of private equity limited partners (Table 2)—pensions, endowments, banks, insurance companies and foundations—are not in a Private Equity LPs position to meet capital calls. Ultimately, we think that private equity will maintain its preference for real estate loans, equity and operating companies, but might allocate up to $50 billion to CMBS Public Pension Funds 14% investments.
Fund of Funds Managers Family Offices/Foundations Banks and I Banks Endowment Plans Private Pension Plans Insurance Companies Investment Companies Government Agencies High-Net-Worth Individuals Other
Source: Preqin Ltd.
Few managers with mortgage credit mandate or expertise…
14% 10% 9% 8% 6% 5% 2% 2% 15% 15% 100%
Table 3. Incremental Private Capital16 (Bn $)
Pensions, Endowments, Foundations, SWFs Hedge Funds Private Equity Allocation Adjustment Total
Source: Gorelick Brothers Capital, LLC
52 50 50 48 200
We should also consider the possibility that portfolio allocations will shift away from other asset classes towards distressed mortgage opportunities.17 We think this process will take time as most allocators look for established performance track records prior to investing. Nevertheless, as a “plug,” we add $48 billion to our tally, bringing the total to $200 billion of incremental private capital (Table 3).
We assume that 5% to 10% of distressed debt, fixed income and multi-strategy hedge fund assets migrate to distressed mortgage opportunities. Gross amounts were sourced from EurekaHedge data, as of YE 2008. Constrained capacity in the nation’s residential mortgage servicing and special servicing industries deserves a lengthy and dedicated discussion. Even if adequate capacity existed (we believe it does not), existing providers must overturn longstanding cultural traits, financial incentives, contractual arrangements and widely accepted policies and practices that are at best ill-suited to relieving current mortgage distress. 15 “Preqin Private Equity Spotlight,” Volume 5, Issue 2. February 2009 16 The primary sources of this incremental capital are: cash and short term securities, existing un-invested capital dedicated to direct or complimentary strategies (e.g.., structured finance hedge funds) and higher allocations to RMBS and residential whole loans from private equity “real estate” funds. 17 E.g. on 3/3/09, “Pensions & Investments” newspaper reported that CalSTRS is considering a 5% allocation to “a new distressed investments portfolio that will include fixed income, real estate, and private equity…” We suspect that some but not most of this allocation will be dedicated to distressed mortgages. GORELICK BROTHERS -3CAPITAL
The Public-Private Partnership Opportunity
If the PPIF is fully deployed, using 5x leverage, then it could theoretically own $1.2 trillion market value of assets ($200 billion in private capital + $1 trillion in Government financing). The notional value of PPIF’s most likely target assets is approximately $7 trillion. Applying recent typical market prices for these assets, we think their current market value is in the range of $4 trillion (Table 4). Eligible assets are likely to include non-agency RMBS, residential mortgage WLs and CMBS, but the program might also comprise CLOs, CDOs and non-TALF eligible ABS, such as seasoned credit cards, auto and student loans.18 Table 4. PPIF Asset Opportunity Nominal
Asset Type Non-Agency RMBS Residential Whole Loans CMBS Total
2,025 4,235 724 6,984
60% 60% 55%
1,215 2,541 398 4,154
29% 61% 10%
Source: Goldman Sachs, Morgan Stanley, Gorelick Brothers Capital, LLC
Risks, Returns and the Role of Government
Risk and Return. To determine the risk and return profile of the PPIF opportunity set, we assume 5x leverage ($5 borrowed for every $1 of private capital) and pro-rata allocation of investment across asset types. Based on the yield and financing assumptions in Table 5, we project PPIF’s returns and risk in Table 6. The weighted average annual return opportunity for private capital is approximately 67%.19 Potential returns that high do not come without considerable risk. We would note that non-Agency RMBS is particularly treacherous when leverage is applied. Because most RMBS has a low current yield, interest income is usually only a small contributor to profit. Instead, the reward is highly dependent on principal return, exposing holders to the considerable risk of further home price depreciation. CMBS and WL higher current yields offer more positive carry and a better risk and return profile (See “Levered Current Yield” in Table 5).
Compelling levered yields for all asset types…
The Government’s Term Asset-Backed Securities Loan Facility (TALF), is expected to initiate in March, 2009 and will provide term funding for investments in newly issued credit card, auto loan, student loan and commercial mortgage securities. Currently, all RMBS and secondary ABS are excluded. 19 This return assumes equal average lives and amortization of the asset types. It will hold true for a couple of years but will diminish over time as RMBS and WLs amortize faster than CMBS. GORELICK BROTHERS -4CAPITAL
PPIF Levered Return Profile Yield to Maturity 18% 15% 13% Current Yield 1.25% 11.67% 9.09% Leverage 20 Cost 1.50% 3.00% 4.00% Annual Defeasance -0.25% 8.67% 5.09% Levered Yield 81.50% 63.00% 49.00% Levered Current Yield -1.25% 43.33% 25.45%
Asset Type Non Agency RMBS Whole Loans CMBS
Leverage 5 5 5
Coupon 0.75% 7.00% 5.00%
Source: Gorelick Brothers Capital, LLC
Fairness & flexibility as guiding principles…
Role of Government I: Principles. Two main principles should guide Government. The first principle is fairness. PPIF’s commendable commitment to market based pricing should be matched by guidelines encouraging broad-based investor participation. A program benefiting an oligopoly of private investors would be anti-competitive and compromise public trust. While a limited competition scheme among several Government financed partnerships might be workable, we believe a market’s efficiency varies directly with the extent of its participants’ diversity. More, rather than fewer, participants, and variations among them in risk bias, size, investment mandate and other traits are all factors that improve the likelihood of recreating a working market.21 The second principle is flexibility regarding Government’s role as either a “lender” or “investor.” Ideally, the Government would fill solely the role of lender, taking only senior risk protected by investors’ equity. But, given insufficient private capital supply, in certain instances Government may need to make equity investments. In other words, Government must be prepared to balance risk, reward and necessity. Role of Government II: Lender or Investor? We believe the Government should be a lender for Non-Agency RMBS and CMBS, but a lender and investor for residential mortgage whole loans. Taxpayers are already massively overexposed to first loss mortgage risk via the Government’s implicit and explicit guarantees of Fannie Mae, Freddie Mac and Ginnie Mae debt. It seems inappropriate for taxpayer’s to double-down on that risk by making the same bet in non-Agency RMBS. We think the high return potential for non-Agency RMBS (see “Probability of Private Capital Participation” in Table 6) should be sufficient to attract the $60+/billion of private capital required. Similarly, we think CMBS will have little trouble attracting private capital. It is the smallest asset class and will likely be met by sufficient hedge fund and private equity “dry powder” (approximately $19 billion based on 5x leverage, see Table 6). Given CMBS’s relatively less severe supply/demand imbalance and the economic and political differences between residential and commercial real estate, we suspect the Government may offer less leverage to CMBS buyers. Doing so should considerably improve the taxpayer’s risk profile.
Based on LIBOR + 1%, 5 yr Swaps + 1%, and 10 yr Swaps + 1%, which will likely be the financing cost We infer from recent news reports that Government may model aspects of PPIF on suggestions made in “How to Make TARP II Work” by Harvard Professor Lucian A. Bebchuk. See http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1341939_code17037.pdf?abstractid=1341939&mirid=1.
GORELICK BROTHERS CAPITAL
PPIF Return and Risk Profile Public Senior 100% 100% 100% Public Sub 0% 50% 0% Private Sub 100% 50% 100% Public Return 1% 7% 1% 4% Private Return 81.50% 63% 49% 67% Probability of Private Capital Participation Medium Low High
Asset Type Non Agency RMBS Whole Loans CMBS Total
Total 351 734 115 1,200
Senior 292 612 96 1,000
Sub 58 122 19 200
Private Risk High High Medium
Public Risk Medium Medium Low
Source: Gorelick Brothers Capital, LLC
Whole loans pose the greatest challenge…
Residential mortgage whole loans are by far the largest asset type and will have the most trouble attracting sufficient equity investment. Totaling approximately $4 trillion notional on bank and financial company balance sheets, WLs are likely to pose the greatest risk in the FSP’s bank “stress tests.” WLs are typically held at cost (par in most cases) absent evidence of impairment. FSP stress tests will certainly reveal extraordinary potential “mark to market” losses arising from future impairment (90+ delinquency) in WL portfolios. On the other hand, WLs also attract a 50% capital charge, and disposition provides meaningful capital relief. Moving excess WL exposure from bank balance sheets is imperative, but we do not see $122 billion of available private capital to absorb the potential supply. The largest dedicated WL fund is only $2 billion.22 In order to facilitate WL liquidity, Government must take substantial first loss risk. While taxpayer risk will increase, the reward will be a higher return, and FDIC has already engaged in public-private WL trades that serve as an appropriate model.
PPIF: The Path to Neighborhood Stability and Pension Solvency
Taxpayer’s may well resist taking first loss exposure to WLs. Not only might this be seen as accepting losses arising from loans to “unworthy” borrowers, but PPIF also explicitly absorbs bank risk—the latest “third rail” of politics. To avoid this, PPIF needs to demonstrate a clear benefit to taxpayers. We believe that the benefit lies in PPIF’s ability to help protect neighborhoods from foreclosure blight while simultaneously improving state and municipal pension solvency. PPIF will limit both future home price depreciation and the decline of neighborhoods by reducing the incidence of foreclosure. The program is intended to facilitate the sale of WLs to private investors who, in turn, will seek to maximize their investment. In the course of evaluating scores of investment managers, we have seen many whole loan investment models. Without exception, all show that the best way to maximize profit is to reduce or avoid mortgage delinquency and foreclosure. Public policy has heretofore frequently favored foreclosure moratoria and thereby exacerbated losses. By contrast, private investors have consistently pursued aggressive modifications to keep borrowers in homes and prevent detrimental neighborhood “fire sales.” The FDIC is already working in partnership with a number of such managers and is well aware of their capabilities.
Private WL investors reduce foreclosures, not delay them…
To date, we estimate that WL funds have risen between $10 to $11 bn. Servicing capacity is a critical component to successful WL investing. Most investors will want to move servicing from banks as a condition of purchase. GORELICK BROTHERS -6CAPITAL
Whole loans offer pension funds a path to solvency…
In addition to the Federal Government, state and municipal pensions should be the primary source of private capital for residential mortgage whole loans. Given the breadth of the mortgage crisis, there is probably no better way for them to benefit their constituents. Pensions are taxpayer funded, but in the face of lower tax revenues and investment losses, they are rapidly falling behind on their obligations. According to Wilshire Table 7. Consulting, the median state fund was under-funded by 16% as of 23 fiscal year end 2008. As many funds’ fiscal years end in June, Public Pension Risk and Return – Wilshire Model that funding deficit has certainly grown. Ultimately, an underfunded pension plan becomes a taxpayer liability. We suggest the Treasury Department recommend that pension funds allocate up to Asset % Risk Return Sharpe 4% of assets to distressed mortgage opportunities.24 Doing so Domestic Equity 38.10% 16.00% 8.50% 0.50 would generate as much as $100 billion of additional capital to fill International Equity 18.80% 17.00% 8.50% 0.47 25 the WL investor equity gap. Using Wilshire’s allocation, risk and return assumptions, we believe that adding distressed mortgages to pension assets could significantly improve their earning potential and repair their funding gap. In Table 7 we show the impact of a 4% allocation to PPIF assets. Expected annual returns improve from 7% to 9.4%, risk increases from 13.1% to 14.4%, and the Sharpe ratio increases from .52 to .55.26 It is hard to believe that the increased risk would be considered excessive given the market based entry point, lack of current exposure, and the poor performance of existing allocations. The reward is compelling: stabilized state and local housing markets and healthier pension funds.
Domestic Debt Securities International Debt Securities Real Estate Alternative Investments Other PPIF Total Total w/4% PPIF 26.70% 0.90% 5.90% 5.60% 4.00% 100.00% 5.00% 10.00% 15.00% 26.00% 0.05% 50.00% 13.10% 14.42% 4.00% 3.75% 7.00% 11.55% 0.50% 67.00% 7.00% 9.36% 0.70 0.33 0.43 0.43 1.33 0.52 0.55
Source: Wilshre Consulting, Goreilck Brothers Capital, LLC
Be Prepared, Be Clear, Be Creative
PPIF’s success is critical to a rapid recovery… Generous leverage affords very high nominal investor returns. In many respects, PPIF looks too good to be true. Returns in excess of 60% should not engender overconfidence, however, as success faces a number potential hurdles. Investors may not be ready to use leverage again. As participants in the structured products market know, combining leverage with securitized home loans proved fatal for many investors. Even today, there are disaster stories regarding leveraged trades in high yield loans and commercial real estate made less than a year ago by very sophisticated investors. Additionally, we suspect equity investors may find better terms investing in operating companies. In this case, an investment in a new or re-capitalized bank (such as IndyMac) could actually allow more leverage than PPIF.27 Not only could these banks have a second bite at the home mortgage apple, but their owners would also have the additional upside of a future “clean bank” IPO.
Wilshire Consulting, “2009 Wilshire Report on State Retirement Systems: Funding Levels and Asset Allocation,” 3/3/2009. Full Disclosure: GBC manages a distressed mortgage opportunities fund of funds, so we could benefit from this recommendation 25 Based on our estimate of approximately $3 trillion in public pension fund assets, modestly reduced to reflect recent investment losses and selective participation. 26 This improved return will not last forever, of course. But PPIF does offer term leverage, which should match the life the assets, so it is reasonable to expect that this benefit will last at least a 3 to 5 years. We assumed 50% for PPIF’s risk, or roughly 2x Wilshire’s risk for alternative investments. 27 Banks capital structures leverage equity 10x to 12x, which is considerably more that PPIF will likely allow. Therefore, if assets are held at their trading value on bank balance sheets, it would be more efficient for investors to recapitalize banks and hold on to the distressed mortgage assets. However, we believe that this is an unlikely outcome since it seems contrary to the public statements of Secretary Geithner, who has expressed a preference that banks sell their bad assets. GORELICK BROTHERS -7CAPITAL
The one clear advantage to PPIF is its imminent availability. With a bit of creativity and cooperation, it could blossom into a program that best serves taxpayers by blending Federal, state and local funding with private capital and management skills. A clean start is essential. If it is too vague or narrow in application, investors will lack confidence, the Financial Stability Plan will risk failure and the mortgage crisis will prolong. If launched with clear, coherent and fair incentives for private investors and well defined benefits for taxpayers, then PPIF could assist the rebirth of the U.S. mortgage market.
© Gorelick Brothers Capital, LLC The forecasts and opinions contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation. Some information herein reflects proprietary research based upon various data sources and some information has been taken from third-party sources. Such sources are believed to be reliable but have not been independently verified for accuracy or completeness. The information provided is intended for informational discussion purposes only, and does not constitute an offer to sell or a solicitation of an offer to buy any securities and does not constitute investment advice. An offer to invest may be made only through the applicable confidential offering memorandum. No information contained herein either in whole or in part may be reproduced or redistributed without our express written consent.
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