Investors Look to Profit from Mortgage Woes

Here is a line from a letter that a New York hedge fund sent to investors: "The meltdown in the subprime mortgage market has been absolutely stunning."

No surprise there. The meltdown has been widely reported. What may come as a surprise, though, is that the fund is inviting readers to "capitalize from the carnage" by investing in mortgages at fire-sale prices.

The invitation was reported by "Investment News." And the hedge fund is not the only one looking for a silver lining in the storm clouds over the mortgage industry.

Shopping for mortgage bonds these days is kind of like buying vinyl records at a garage sale. There might be some bargains in the bin, but you will not know until you get them on a turntable and find out just how badly scratched they are.

"There are some opportunities to take advantage of now, but the peak of the opportunity has not come yet. And it is coming soon," says James Midanek, of Black Pearl Asset Management in California.

Midanek is planning to buy mortgages later this year when the price is right.

These days, most mortgages are bundled into securities and sold to investors, who count on borrowers — even the high-risk ones — making their monthly payments.

For years, when home prices were rising, most borrowers did pay. But with home prices leveling off this year, more than a million borrowers are expected to default on their mortgages.

Managing Director Fred Cannon, of the investment bank Keefe, Bruyette & Woods says it turns out the models used for predicting defaults were not as good as people thought.

"For example, generally, credit scores are a great indicator of an individual's ability and willingness to pay back a mortgage. It turns out that, while that's an important indicator, a bigger indicator turned out to be home price appreciation, or, in the case of this last year, depreciation," Cannon says.

With defaults rising, most investors have been scared off, and the market for mortgage-backed securities has all but dried up. The few that are being sold are selling at a discount. That is where bargain hunters like Midanek see a buying opportunity.

"There are, underlying all these packages of loans, some good loans, some loans that will not default and not be foreclosed. So, what we're trying to do is estimate the amount of the loans that will survive, that will continue to pay, even in the harshest of conditions," Midanek says.

To find the most bullet-proof mortgages, Midanek looks for borrowers who live in their home, rather than real estate speculators who are more likely to walk away from a mortgage. He also tries to avoid buying too many home loans in a single area of the country.

Other contrarian investors are also on the lookout.

Wilbur Ross, who made a fortune investing in troubled steel and coal companies, has put $50 million into the bankrupt American Home Mortgage Corp. Bank of America invested $2 billion into the struggling home lender Countrywide. That gives Bank of America the option to buy a substantial stake in Countrywide at below-market prices.

Cabot Money Management's Rob Lutts says this kind of bargain hunting takes deep pockets and nerves.

"It's not a time for amateurs because this is still a dangerous sector of the market," Lutts says.

Daring investors who do put money into the mortgage market may be helping borrowers, as well as themselves, while those who follow their natural instinct to steer clear could make matters worse. That is because the tighter the credit crunch gets, the more borrowers are likely to default on their loans.

Bank of America calls its Countrywide investment both a show of confidence in the lender and an effort to put much needed liquidity back in the mortgage business.

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