Sub-prime crisis generates distressed debt opportunities

As confidence in the structured credit market plummets in response to the ever worsening crisis in US sub prime mortgages, the implications for the wider credit market are far reaching warns Francois Barthelemy, of F&C Partners, manager of the F&C Event Driven Limited.

F&C Event Driven, a £75 million closed end fund of hedge funds which listed last month on the London Stock Exchange, has very limited exposure to the structured credit market which Barthelemy believes is on the brink of crisis.

"As the full impact of the US sub prime mortgage debacle unfolds there is a real risk of crisis of confidence in structured credit markets. On a worst case scenario the fallout could equal the turbulence experienced by global equity markets post the WorldCom debacle," said Barthelemy.

According to Barthelemy artificially high ratings could be to blame.

"The past few years have seen the emergence of a swathe of credit hedge funds which at launch were marketed as investing in a portfolio of highly rated AAA and AA securities, mostly backed by pools of so-called "hard" assets such as mortgages or credit card receipts. These funds were able show almost no volatility and steady returns, and were hence leveraged by some of the more aggressive investors.

"However, despite their high ratings, these securities were able to generate a spread significantly higher than the funding cost of leverage, an indication that their ratings may have been out of sync with what the market was willing to pay for. In any case, the managers were not prepared for the speed with which the US mortgage market has deteriorated leading to a sharp mark down in the value of their bonds. The outcome has been public auction of some of the more liquid bonds and in more extreme cases, the take-over of some of the assets by prime brokers who had lent to the hedge funds. I believe this could result in a significant review in the roles played by ratings agencies as well as dealers and asset managers in pricing or valuing their assets," concluded Barthelemy.

Barthelemy said if the mortgage crisis continued the Fund would look to make some plays in the distressed hedge fund sector which he believes is starting to throw up some interesting and potentially very lucrative opportunities.