The following article first appeared in the December 2007/January 2008 edition of AsianInvestor magazine. Each month we offer a feature from the magazine. To subscribe, please email us at [email protected]

Picture this. You work in an investment bank as a CDO structurer in the securitisation department. You are not going to be getting a bonus in 2007. Everyone who has been linked to your deals is not getting a bonus either. So you are everybodyÆs scapegoat, from traders through to sales. In fact, except for those in the company æsandboxÆ, nobody in the bank is getting more than a token bonus. It is all your fault, everybody hates you, and youÆre not going to be allowed to do securitisation deals in 2008 either.

So go and start a hedge fund in 2008. A lot of people in this predicament are thinking about doing just that.

ôThe situation evolving now with subprime instruments is similar to that which resulted in those institutionally organised distressed businesses established after 1997 in Asia,ö says lawyer Spencer Privett at Maples and Calder in Hong Kong. ôGiven current market conditions, the opportunity cost of leaving a job at an investment bank to set up a hedge fund might now be less than it was in 2001-2004.ö

The banks have got piles of debt on their books that they cannot get rid of quickly in the usual way via CDOs and securitisations. They want to offload this debt. If subprime mortgages become cheap enough, buyers will be able to absorb defaults because they can still profit simply by selling the collateral underlying the debt.

ôThe alternatives industry is starting to talk about implementing this strategy and concluding that itÆs a great idea, because we are in a liquidity crunch more than a default risk scenario and valuations right now are low,ö says Mark Shipman at law firm Clifford Chance in Hong Kong. ôIt is a strategy of interest not just to the CDO people still sitting at their desks, but to the larger hedge-fund managers, and also the proprietary trading desks of the banks and securities houses.ö

Fortress Investment Group, Blackstone Group and BlackRock have all given indications during the last few weeks that they are in the course of setting up vehicles and planning on embarking on a bargain hunt, investing directly into the mortgages themselves rather than via the structure of CDOs. Fortress currently carries subprime exposure of 1% to 2% of its total $39.8 billion in assets, mainly through two mortgage-origination and servicing companies.

ôThere is severely diminished liquidity, and opportunities to deploy will expand for financing businesses, credit and structured hedge,ö says lawyer David Goldstein at White and Case in New York. ôPeople setting up distressed debt funds are attracting serious institutional investors. Distressed debt is not longer synonymous with vulture funds and is now regarded as a liquidity provider.ö

Is the market really is as bogged-down as the pundits would have us believe? It seems so. Accounting standard FASB 157, concerning the valuation of assets classified by banks as Level 3 (assets priced using a firmÆs own pricing models), has just been implemented and that may take matters from bad to worse.

Although Level 3 assets are thinly traded, the ABX series of indices gives a guide to the market value of some $1.2 trillion of subprime mortgage securities (that equates to just over 10% of the total mortgage market in the United States). These statistics show that the lowest grades of 2006 vintage debt are worthless; triple-B grades are down to just 18 cents on the dollar. Double-A grades are trading at around 60 cents, and triple-A grades are near to 85 cents. Moreover, much of the entire $3 trillion global market for collateralised debt obligations is under strain.

ôManagers are getting calls every day to buy pools of debt at distressed prices, and they have the ability to be opportunistic,ö says Jaime Castan, head of research at RMF, one of Man InvestmentsÆ fund-of-hedge-fund subsidiaries. ôWe are seeing vehicles being set up, and as a fund-of-hedge-funds investor, we are interested. The hedge funds can benefit from forced sellers and deploy quickly.ö

Merrill Lynch has declared a 30% write-down on its holding of CDOs, offering a glimpse into the true values. Few of the banks have admitted to losses on anything like the scale suggested by market prices. UBS is still booking its US mortgage debt at 90 cents on the dollar. While nobody knows what lies within the Level 3 categorisation, the new rule could spell trouble. Citigroup has $128 billion of assets in this category, or 205% of its tangible equity. The figures for other banks include: Morgan Stanley, $88 billion, (275%); Goldman Sachs, $72 billion (212%); and Lehman Brothers, $35 billion (194%).

Turning to the instruments themselves, the CDOs are starting to fall apart. Take for example a CDO bearing the name of æCarinaÆ. The majority of the controlling noteholders has recently directed the trustee to sell the collateral, becoming the first deal to hit an event of default where the super-senior class has chosen to liquidate.

ôThe really interesting bit will be that this action will establish a market price for this crap,ö says a managing director of an American bank in Hong Kong responsible for credit risk. ôWhen I hear things like the triple-A tranche of some CDO is trading at a 14% discount and that the triple-B tranche is virtually worthless (3 cents on the dollar), I think that terms like æmark to make believeÆ are not far off. A day of reckoning for the big boys with tons of this heap of dung riding at inflated prices on their balance sheet may not be far off either.ö

The investors, fingers burnt, are disinclined to stand in front of their investment committees in order to argue the merits of re-investing in CDOs. There are not many new CDO instruments being created in any case due to apathy from banks, bond insurers and investors.

Investors may not be enthusiastic about investing in CDOs at present, but they are interested in investing in a hedge fund that buys and trades the debts and those pools of receivables that would have lain beneath a CDO.

This represents a dramatic shift in allocation style for the original investor, moving from investing in CDOs, to investing in a distressed debt hedge fund. The quantum leap required though might be psychological, because in contemporary terms, trading debt sourced at a discount might be a lot safer than the supposedly prudent CDO instruments sitting around in limbo today.

However, a more reasonable outcome investor-wise is that such a leap is going to be a step too far for the disgruntled CDO investor and therefore one might expect a different type of investor to move in. This then, is an opportunity for the sophisticated alternatives investor.

So the new funds will look to buy those portfolios of debts, the receivables that had been sitting there still waiting to be securitised, as well as obligations deconstructed from unwound CDOs.

Reflecting the underlying instruments, the terms of such a hedge fund would likely be a hybridised hedge fund/private equity style structure, closed-end with six to nine month redemption periods.

Initially, there was a perception that there would have to be a hustle by funds to tap the bargains on offer, but as the sheer magnitude of the debt overhang becomes apparent, there looks to be a window for deployment that could extend over an extended term. Performance fees will have to be calculated in the most conservative way, in order to retain confidence from shrewd investors.

ôPeople thought there was a 12-18 month buying opportunity, but now structured credit funds look to have a longer horizon and people donÆt need to hurry,ö says David Goldstein of White and Case. ôNobody trusts the pricing nowadays, so it is valued at cost plus accrued capital gains (meaning, the interest paid), with no extras on how much the unrealized value might fetch. You get the profits at the back-end. This will eliminate conflicts of interest on valuations.ö

So that is the brand new hot hedge fund strategy coming for 2008. If you are that securitisation expert, there is light at the end of the tunnel. Perhaps a new job beckons: at your own hedge fund, or working at someone elseÆs fund, or even you sticking around in banking. After all it was the banks themselves that set up the CDOs in the first place. They, more than anyone else, should have a sense of their value, or rather worthlessness.