Global Investing

Hobson’s choice

April 16, 2009

Imagine you’re an institutional investor holding a great deal more illiquid, price-impaired assets than you’re comfortable with. Do you a) hold on to them and pray that the price rebounds, or b) sell now and take a loss, before things get even worse?

This is the dilemma facing institutional investors who went just that little bit too far out along the risk curve in search of extra yield. According to Tom Graf, who heads BNY Mellon’s global workout solutions business, clients have to-date largely preferred to wait for markets to rebound, and in some cases this could well make sense.

The workout unit seeks to establish an intrinsic fair value for those assets that have lost their lustre since the sub-prime implosion in 2007. Graf says the illiquid assets most commonly found in institutional portfolios are non-agency “Alt-A” mortgages, which sold like hot cakes during the US property boom. Non-agency means anything not secured through friendly government-backed Fannie Mae and Freddie Mac, whilst Alt-A mortgages require less documentation than traditional loans, allowing borrowers to inflate their income and assets.

If the loan originated before 2005, Graf says it may still have enjoyed significant appreciation, so he would recommend that clients sell. “But if the loans are of a later vintage they might be trading so distressed that we would advise clients to hold on, in the hope that they come back.”

Graf is hopeful that the US’s new plan to scrub toxic assets from bank balance sheets – the Public-Private Investment Program – will help inflate asset prices through the introduction of leverage. “It won’t be a cure-all for credit risk, but it should create some price appreciation,” he said. So far so good.

But what if you’re holding permanently impaired assets? ”We have situations where we are urging clients to sell, even though it will create a book value loss,” says Graf. Naturally, investors are often reluctant to write off such assets.

The deciding factor is how much worse do you think it will get? Graf says that even prime mortgages are coming under stress because house price declines have been so significant, and believes we haven’t yet seen the impact of the bottom in commercial real estate.

“I also have a lot of concern about the performance of consumer loans,” he adds. “We have seen some negative trends in auto loans, student loans, and credit cards. This may be the last shoe to drop.”

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