New Two Harbors REIT Seek To Profit From Opaque CDOs
June 15 2009 - 3:00PM
Dow Jones News
Optimists may view the creation of Two Harbors Investment Corp.,
a real estate investment trust set up to invest in discounted and
distressed mortgage securities, as a sign of a housing
turnaround.
Instead, Steve Kuhn, one of the co-chief-investment officers and
a former asset manager at Goldman Sachs Group Inc. (GS), views it
as a way to make money from the complexities of opaque investment
products that burned a large swath of investors and fueled the
downfall of storied Wall Street firms.
A part of the investment strategy for Two Harbors' - a REIT
whose creation was announced Thursday - is to earn returns from
mortgage securities including subprime debt, such as those made up
of option ARMs and Alt-A mortgages, which may reside in complex
structures such as collateralized-debt obligations.
The REIT's management team members are "experts at those
structures," Kuhn said in an interview Friday, and "that can mean a
big difference in value."
Option adjustable-rate mortgages, or option ARMs, are a risky
type of home loan that allowed borrowers to make only minimal
payments in the early years. The balance of such loans increases
when borrowers choose to pay less than the normal interest due.
Alt-A loans typically allowed borrowers to avoid fully documenting
their income or assets.
Collateralized-debt obligations, or CDOs, are complex structured
investments put together by Wall Street firms. They are typically
made up of mortgage bonds backed by pools of home loans. CDOs are
divvied up into slices based on their risks and returns and sold to
investors such as hedge funds, insurance companies and pension
funds. Many CDOs also reside on the books of Wall Street firms.
As strapped homeowners increasingly fell behind on their
mortgage payments, these investments racked up devastating losses,
including at Citigroup Inc. (C); fueled the demise of Wall Street
icons such as Bear Stearns; and played a major role in the hefty
bailout of insurance giant American International Group Inc. (AIG)
by the U.S. government.
Two Harbors is seeking to make money off mortgage securities
that may be residing within these out-of-favor structured
investments. The new management hopes to do so by spotting
opportunities within their dense structures.
The REIT is "focused on who the borrower groups are (and) also
the cash flow structure of the security," Two Harbors' Kuhn
said.
For instance, one CDO may differ from another in several ways.
Some deals gave more rights to investors of the senior,
higher-rated slices while others allowed the investors in the
lower-rated pieces a veto vote. Some allowed the acceleration of
payments to senior noteholders or gave them a say in the sale of
assets within a CDO during stressful times. Others contained
provisions that diverted payments from the underlying collateral of
mortgage loans to first pay off senior investors.
A part of Two Harbors' investment strategy is about
"understanding those rules," Kuhn said.
In some instances, the prospectus or the document used while
marketing the CDOs to investors subtly differed from the actual
contract or indenture. In others, terms and conditions may have
appeared in places or in parts of the documents where investors are
unlikely to look for them.
Two Harbors' other co-chief-investment officer, Bill Roth, will
join the company Tuesday after having worked at Citigroup since
1981. Most recently, Roth was a part of Citi's trading group that
invested the bank's funds in asset-backed securities, including
mortgages.
Two Harbors will also invest in mortgage securities falling
under the umbrella of Fannie Mae (FNM) and Freddie Mac (FRE), the
two government-controlled mortgage finance giants.
-By Aparajita Saha-Bubna, Dow Jones Newswires; 617-654-6729;
aparajita.saha-bubna@dowjones.com