FUND WATCH


Should You Buy Toxic-Asset Funds?

Jeffrey R. Kosnett

The yields on busted mortgage bonds are alluring, but be careful.



Ben Kyle, a retired professor of chemical engineering at Kansas State University, asks a question that you, too, may have pondered. He wants to know how he can profit from the Treasury Department's plan to transfer up to $1 trillion of "toxic" bank assets into the hands of investors, small and large. The assets represent mortgage-backed securities for both commercial and residential properties as well as other loans and derivatives that have lost an enormous amount of value, causing big losses at banks and playing a crucial role in triggering the financial crisis.

Optimists think these distressed assets will recover much of their lost value if two things happen: One, the nation's financial sector stabilizes and eventually climbs out of the hole. Two, the government creates a workable, liquid market in which the public can buy and sell the assets at fair prices. The government intends to be a 50-50 partner with private investors in the plan, known as the Public-Private Investment Program, or PPIP. If all goes swimmingly, the assets could leap in value from the 15 cents on the dollar that experts estimate the worst of them are worth today to perhaps 30 cents to 60 cents on the dollar.

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You can deride those who want to invest in this stuff as madcap speculators, but the annals of banking and real estate are full of people who got rich by buying distressed assets and waiting and waiting. And because the U.S. Treasury will be your partner, perhaps the risks aren't as great as they seem at first glance. Having Uncle Sam as a partner is one reason Ben Kyle is tempted. His thought is to invest $10,000 (the most he's willing to risk) in a toxic-asset-owning mutual fund in the hope that he can earn 10% a year. "I would be relying on someone's judgment or expertise here," Kyle says.

The practicalities. Kyle and the rest of us get our chance soon. The Obama administration wants "retail investors," or ordinary people, to be eligible for the PPIP. By the middle of May, the Treasury will appoint at least five, and possibly more, investment firms as qualified PPIP Fund Managers. We're talking about firms like BlackRock, which says it has applied; Pimco, which declines to say; and Eaton Vance, which didn't respond to a request for information. The managers will almost certainly be familiar names because the Treasury is requiring that they have at least $10 billion of assets under management and experience handling distressed assets.

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The products they offer won't be ordinary mutual funds with daily pricing and the ability to get your money out the next day. Instead, the funds will allow investors to withdraw money periodically, with the specifics probably up to their sponsors. They will be long-only -- that is, the funds will not be permitted to sell the assets short in a bet that their prices will fall even further -- and they will be asked to predominantly follow a buy-and-hold strategy.

You may have read about the PPIP as "government subsidized." That's not quite accurate. The Treasury intends to invest $1 for every $1 raised from private investors. It may then add some borrowed money to create a leveraged investment. The Treasury will be like every other investor in that it hopes to earn a profit when the value of the assets increases. In theory, such gains would reduce the ultimate cost to the taxpayers of the multiple bank rescue efforts. The U.S. also stands to gain if the PPIP strengthens the banks enough to boost the value of all the preferred stock the government now owns and has been unwilling to shed so far.

The government's basic motivation is clear. What about yours? Is a toxic-asset fund appropriate for your IRA or 401(k) plan? Will it serve as a counter to other high-risk investments, such as emerging-markets bonds or leveraged closed-end real estate funds?

Douglas Elliott, a banking scholar at the Brookings Institution, in Washington, D.C., says that if he were putting these assets on the pyramid of risk, "they would be significantly riskier than most junk-bond funds." The funds that own them will have to issue "a ton of disclosure" so that the government won't be on the defensive if ordinary investors lose money.

Given this assessment, the 10% annual return that Ben Kyle is aiming for seems too modest. After all, you can get more than 8% from triple-B-rated bonds, the lowest investment-grade category, and 15% or so from a typical junk-bond fund. In a good year, junk is capable of returning 30%.

The fact is, there isn't a good precedent with which to compare the PPIP. Elliott says the PPIP differs from the government's ultimately successful plan from the 1980s to resell seized assets from insolvent savings and loan associations. The s&ls mostly held secured mortgages, land and real estate, as well as a few odd assets, such as restaurants and fruit farms. Most of their holdings were tangible and fairly easy to appraise. Busted mortgage securities and derivatives are not so simple. No one trusts Wall Street's ability to evaluate this stuff, and there's no liquid market right now anyway.

Liquidity and pricing are the real risks, says Rob Arnott, president of Research Affiliates, an investment firm. He thinks fund managers will do their best to explain the assets and the risks, but he wonders about competing with and sharing earnings with the government. To attract better managers, the government has so far agreed not to limit what the investment firms can pay their people.

Another issue is sure to be how you will be able to get your money out. The closest approximation to these funds, as currently described, looks like leveraged real estate limited partnerships. Rather than being able to sell your partnership units on the open market, you may be able to redeem them only through their sponsor-and only once a month or once a quarter, at that. The Treasury, in fact, wants to see whether the investment firms can come up with "innovative proposals" to accommodate individual investors. One possibility would be to establish one set of withdrawal rules for institutions and another, more-liberal set for individuals.

There's no question that PPIP investments will be risky. Will the funds be operating on a level playing field? In April, Neil Barofsky, the government's watchdog for the bank bailouts, warned in a report that the PPIP seems to be tailor-made for waste and fraud. Barofsky's report implied that because money managers have been known to engage in front-running and to favor certain customers, they might be tempted to pull similar stunts here. But the Treasury will be the biggest investor of all in the PPIP, by tens of billions. I can't imagine the government engaging in such shenanigans, and I expect Uncle Sam to keep a close eye on his private partners.

The bigger issue is whether there is any reason to think mortgage bonds and defaulted loans worth one-fourth of their original value can rally enough to make the risks of these funds worth your while. There is also a chance that some banks will decide to keep most of their distressed portfolios, reducing your opportunity to make a windfall. So don't put a dime into any PPIP fund that you can't afford to lose or see locked up for at least three years.



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