Paulson’s Hedge Fund Buys Distressed Debt, Mortgage Securities

Why invest in this opportunity

By Tom Kohn – Jun 12, 2009

June 12 (Bloomberg) — Paulson & Co., the hedge fund that made more than $3 billion betting the U.S. housing market would collapse, is buying so-called distressed debt and mortgage-backed securities.

John Paulson’s $28 billion company bet against housing prices amid the 2007 subprime crisis in a strategy known as shorting. Now it’s seeking to profit from the global financial crisis by picking assets that look cheap.

“We’ve been adding pretty steadily to our long distressed positions,” Sandra Lee, a senior vice president at the New York-based fund, said at a Euromoney conference in Hong Kong yesterday. “Where we shorted the lower quality subprime securitizations, we’re now going long the better-quality jumbo, prime securitizations.”

The deepest economic slump since World War II and $1.48 trillion of losses and writedowns at financial institutions worldwide have weakened companies’ ability to pay their debt. The U.S. speculative-grade default rate will reach an all-time high of 14.3 percent by March 2010 after leveraged buyouts push European corporate defaults to a record 14.7 percent this year, Standard & Poor’s forecasts.

The extra yield investors demand to hold speculative-grade, or junk, corporate bonds rather than government securities fell 10.73 percentage points to 11.2 percentage points this year after rising to a record 21.93 points Dec. 15, according to Merrill Lynch & Co.’s Global High-Yield Corporate Bond index. Junk bonds are securities rated below BBB- by Standard & Poor’s and Baa3 by Moody’s Investors Service

Yield Spread

Bonds are termed distressed when they yield at least 10 percentage points more than similar-maturity government notes. U.S. distressed debt securities returned 49.2 percent this year compared to a loss of 1.3 percent in the same period last year, Merrill data show.

So-called jumbo mortgages are typically home loans greater than $417,000. The Federal Reserve said March 18 it will buy as much as $1.25 trillion in securities from mortgage buyers Fannie Mae and Freddie Mac to help drive borrowing costs lower.

Paulson is buying the debt of banks and finance companies, especially those that received government help, according to Lee.

“That’s often space distressed managers traditionally tend to overlook,” she said. “We’ve been amassing quite a bit of assets in this area.”