Securitization: Distressed asset buyer beware

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Despite a new round of fundraising for distressed ABS, a market floor is not necessarily in sight.

One year ago, when the depth and breadth of the crisis in the US sub-prime mortgage market was first coming to light, a move into distressed ABS investing seemed like a prescient and nimble decision. Twelve months later and those early adopters are licking their wounds, burnt by prices that stubbornly refuse to stop falling.

Recent news that Pimco is now looking to raise a further $5 billion to invest in distressed non-agency RMBS and CMBS comes amid market estimates that $275 billion had been raised in distressed funds by the first quarter of this year, and $35 billion has been raised by hedge funds specifically to invest in distressed MBS. One could be forgiven for thinking that the market has decided the end is in sight.

Is it? The way that all markets heal themselves is by allowing prices to fall to the point at which they become absurdly cheap and then buyers are lured back in. But it is far from clear that the ABS market has reached that point.

The closest the market has come to establishing some sort of clearing price for distressed ABS is the recent liquidation of Cheyne Finance’s defunct structured investment vehicle. And it is hard to draw a sense that the worst is definitely over from that exercise.

The receivers put up 31% of the assets for sale, only 21% sold and there were only 11 interested bidders. The highest bid was 44% of par. One structured finance investor recently told this magazine that being in this market was akin to sitting at the bottom of a huge cliff with nowhere to hide from the tumbling rocks. "Some of the cash prices we have seen have been extraordinarily low – just ridiculous," he muses. So how can these latest distressed funds be sure that they won’t get burnt too?

They can’t. Things are still very messy out there: $31 billion-worth of SIV paper has defaulted since October 2007 and only a fraction has so far been restructured. Delinquency rates for sub-prime mortgages written in 2006 now top 40% – and there is still an awful lot of paper out there that is backed by these loans. The SIV restructurings that have so far taken place – Cheyne and Rhinebridge – involved the weakest vehicles with the poorest-quality assets. But the ABS overhang still has a long way to run, and the market needs to reach the point where prices are moving for fundamental rather than technical reasons.

It is still no place for the fainthearted.