Some institutional investors have begun appointing distressed debt managers, on stand-by as big financial institutions look for buyers of risky debt instruments that have slid in value. But many think there is room for the valuations of these assets to fall further. SIMON MUMME reports.

Despite the multi-billion dollar write-offs, stashes of venomous subprime debt and corporate loans whose values have dived for want of liquidity weigh down the balance sheets of big American investment banks. Would-be buyers stand by, looking for gold in the muck. Some hedge funds had already shorted the subprime mortgage securities market before it tumbled, with US firms Paulsons and Harbinger among the prescient.

Those who missed out the first time are now awaiting the second opportunity to profit from the carnage: by investing in some of these now-distressed assets for the long-term, according to Simon Eagleton, principal with Mercer Investment Consulting. But the valuations of these assets continue to reduce, and investors are waiting to see how much wider credit spreads will go.

The short answer? “No one actually knows what this stuff will be worth,” Eagleton says. Last December, there was approximately $430 billion of subprime losses in the global financial system that no institutions had owned up to, according to Peter Quinton, head of research at Bell Potter. He said that while a lot of subprime paper will be worthless, vultures are known to have bid 30 cents in the dollar for some of the derelict assets.

As early as June 2007, $9 billion hedge fund firm Marathon Asset Management announced it was setting up a subprimefocused distressed debt fund. In Australia, institutional investors are waiting to see how far valuations fall, and which assets their vulture managers want to pull out of the muck.

The Australian Reward Investment Alliance (ARIA) has set aside 1 per cent of its $18 billion portfolio to put into distressed debt opportunities as they arise. Alison Tarditi, ARIA chief investment officer, calls this strategy a “recession hedge”. According to David Field, senior portfolio manager in the global fixed interest division of Queensland Investment Corporation (QIC), investors should hit the distressed debt “sweet spot” some time in the second half of 2008, with more opportunities emerging in the following two years.

Field, who is responsible for researching and selecting external credit managers, says the definition of distressed debt has been stretched to include securities that have lost up to 10 per cent of their value, trading at $0.92 instead of $0.98, for example. Such assets were overvalued, not distressed. However, “about 80 per cent of the money in distressed debt vehicles goes to this type of debt,” Field says. Truly distressed assets have lost 70 per cent or more of their value, he says. Many of the subprime-backed securities that were written in late 2005 and onwards stand in this category.

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