The Art of Distressed Investing

Today's comment is by Eric Roseman, Investment Director and Editor of Commodity Trend Alert.

Dear A-Letter Reader,

Credit spreads are widening. Default rates are rising. The credit crunch continues to infect global markets.

The good news: We're about to enter one of the best markets for busted credits in 2008. And distressed debt money managers are licking their chops - ready to pounce on the bargains.

The last credit-busting cycle lasted from 1997 to 2002. This era resulted in huge bargains after the Asian markets collapsed in mid-1997, the near demise of Long Term Capital Management in August 1998 and finally, the dot.com frenzy in 2000.

In each bear market, you could still find huge scraps of value hidden among the carnage after incredible periods of excessive speculation.

Financials Get Crushed!

Worst Bear Market Since 1990 for Banks

And now, we're in the midst of the worst bear market for financial services stocks since 1990.

Swarms of vulture specialists are circling the busted credits in mortgage lending, investment banking and mortgage-backed securities like collateralized debt obligations (CDOs). Many of the companies and securities in this smashed-out sector now trade at big discounts to their face value following tremendous losses since July.

For investors looking for some value-added punch, this sector offers incredible opportunities later in 2008, as we face more mortgage-related problems and soaring defaults next year.

What's a Credit Crunch?

When disaster strikes an asset class or a company, vultures specializing in distressed investing typically circle near the mortally wounded sectors. They buy bargains for just pennies on the dollar.

At those times, distressed companies desperately need a White Knight to rescue their businesses. A "White Knight" is a cash-rich entity that's able to inject immediate liquidity into a company to keep the business afloat. That's exactly what's happening today in the mortgage business where the cash-crunch is growing even as the Federal Reserve continues to cut lending rates.

A "credit crunch" is denying credit to those companies or entities that would otherwise normally secure financing under normal economic circumstances. Many businesses and prospective homeowners can't secure financing this year - despite harboring positive cash flow. When that happens, and banks aren't willing to lend, you've got a credit crunch.

Penthouse and Mona Lisa

Distressed debt and asset-backed hedge funds specialize in a unique form of investing, unlike conventional mutual funds, in high-yield or corporate bonds. Many of these hedge funds also leverage these deals. That strategy can backfire if interest rates spike or financing falters.

These credit-savvy managers usually have a big chunk of their own money in the same funds as their investors. More importantly, these fund managers come from a highly focused credit background.

Sometimes distressed debt money managers will arrange to buy a targeted company only under certain conditions. They may arrange an asset-backed swap or collateralize the takeover candidates' assets.

For example, back in the late 1980s, Bob Guccione, founder and former publisher of Penthouse magazine, sought to secure over US$100 million for his floundering adult magazine.

But money-center banks wouldn't lend Guccione enough money to save Penthouse. So Guccione moved on to the hedge fund sector. He approached asset-backed specialists - small boutiques flush with cash - to make secured and sometimes, unconventional loans. Guccione secured his loan, but with a twist.

Distressed debt and asset-backed hedge funds get around traditional lending rules by seeking to collateralize personal assets.

In Guccione's case, a prominent New York-based hedge fund collateralized Penthouse's loan. But to give Penthouse the loan, the hedge fund secured Guccione's esteemed collection of fine art. Guccione's collection included a Mona Lisa, arguably the most famous painting in the world.

E*Trade a Fresh Target for Vultures

This year, E*Trade is a prime example of a distressed company. E*Trade is one of America's largest online discount trading companies.

E*Trade sought to supplement and boost its trading revenues earlier this decade. They took a good chunk of their retained earnings and invested these assets into sub-prime mortgages. That strategy worked wonders earlier this decade when real estate boomed. But since then, this strategy has threatened to bankrupt the company during the worst mortgage-backed crisis in 17 years.

E*Trade is now looking to sell to the highest bidder. On November 29, hedge fund raider, Citadel Investment Group, announced a multi-billion dollar investment in the ailing online broker. Citadel believes its assets, even busted sub-mortgages, will bottom later next year as the U.S. economy eventually recovers from a slowdown.

Overall, most distressed debt specialists are still sitting on the sidelines and waiting for markets to bottom. And when they do, an avalanche of deals will start to flow. The time to invest in these products is now, not 12 months from now.

The next 12 months will reward distressed debt money managers and their investors enormously. The sub-prime fallout will continue and more businesses will approach bankruptcy.

The best bargains in more than 15 years are approaching. Make sure you get a slice of the pie.

ERIC ROSEMAN, Investment Director

P.S. This February 20-23, I'll join 18 other investment experts from around the world in St. Kitts for The Sovereign Society's Emergency Money Summit. In St. Kitts, I'll introduce attendees to one of the best distressed debt hedge funds in the world since 1990. This fund has earned numerous performance awards for its low volatility and incredible track record, including no losses since inception.

Also, the same family offers a multi-manager distressed debt and event-driven hedge fund with numerous performance accolades since 1994, including no annual losses. And best of all, you don't have to fork over a few hundred thousand dollars to invest, either! Click here to find out more about our Emergency Money Summit.

European Tax Havens Thrive
- No Matter What Anyone Says

Around the world, welfare states are trying to stop their citizens from using tax havens.

And yet two of Europe's leading offshore tax havens - Monaco and Andorra - have seen a major influx of foreign funds into their banks recently. Both nations have strict banking secrecy guaranteed by law. That's an increasingly rare luxury anywhere.

Financial professionals in Monaco say they are attracting cash from wealthy individuals who want privacy. These individuals want to keep their assets away from the clutches of their governments. Most of the cash is coming from the Middle East and Europe.

The banks in both jurisdictions refuse to disclose exactly how much money they've attracted lately. But industry analysts estimate it could be as much as €20 billion (US$29.5 billion) over the last 18 months. It's estimated both Monaco and Andorra have €70 billion (US$103.3 billion) in total managed assets overall.

Since 2005 some big names in banking and finance have set up offices in Monaco, including Goldman Sachs. And Monaco hopes to double the amount in her banks in the coming years.

Meanwhile, high in the Pyrenees between France and Spain, the Republic of Andorra has also seen new many accounts at their banks.

The mere fact that these tax havens are attracting high volumes of funds makes them less likely to lose their "tax haven status" anytime soon.

It makes them less likely to cooperate with the Organization for Economic and Community Development (OECD), the self-appointed advocates of high taxes and no financial privacy.

Both nations remain on OECD blacklists for their refusal to impose taxes and loosen financial privacy laws. That just means they're unwilling to bend to the OECD's demands.

If you're looking for maximum privacy and legal tax avoidance, we can explain where these places are and how you can take advantage of them. Click here for some ideas on where to look.

BOB BAUMAN, Legal Counsel

Privacy & Rights

U.K. Police: Give Us Your Encryption
Keys or Go to Jail Part II

As I described in yesterday's A-Letter, police in the United Kingdom now have the power to demand that PC users turn over their encryption keys. If you don't comply, you can face two years in prison.

The U.K. police just used this power, perhaps for the first time. But they didn't use it against a terrorist or money-launderer. They used it against an animal rights activist.

The activist claims she didn't realize there were any encrypted files on her PC. She says she has no idea how they got there, much less how to decrypt them.

This is a more plausible claim that it might appear. It's fairly simple to download encrypted files on your PC without your knowledge.

For instance, music, movies and other media you download from the Internet may be encrypted. These files can be locked after a certain number of viewings or after a certain date. Could you be imprisoned for not being able to decrypt an episode of Bambi you downloaded long ago?

Likewise, it's possible to have encrypted files on your PC you didn't place there yourself. This is particularly true if you have enable your PC to share files (I don't recommend it by the way). If you do, others can download files (encrypted or otherwise) to your PC.

This may also occur if hackers download a virus to your PC that automatically encrypts your files. Sometimes, the hackers demand a ransom in order to decrypt your files. But it's possible that someone could simply maliciously encrypt your files, then disappear.

Using a good firewall and regularly updating your anti-virus software can prevent most such attacks. But there are no guarantees.

You could hardly be expected to have the encryption keys to files someone else maliciously locked, could you? This is what the animal rights activist says happened to her. She says she has no idea how the encrypted files got on her computer, and doesn't have the key or passphrase to decrypt them. They will probably sort this issue out at her trial.

Incidentally, I'm not defending activists who uses sabotage and vandalism to demonstrate their views. That's not the point.

The point is that the state can target anyone protesting the status quo for any reason it seems fit. The government can see you as a terrorist if you advocate a less-than-popular viewpoint. That's especially true if some of the tactics others advocating your pet cause injure others or damage property.

If you injure someone or damage property, you should be held accountable. That's true regardless of your personal motives for committing the crime. And police have every right to investigate your actions through the normal process - obtaining a search warrant based on probable cause, etc.

It crosses the line though, when police demand that you provide the means of incriminating yourself, under penalty of imprisonment.

That's what RIPA is all about. That's why it's so dangerous.

I can only hope the U.K. courts decline to enforce RIPA against activists in social protest groups. Otherwise, we could all face the same dilemma as animal rights advocates, whether we agree with their tactics or not.

To learn more about how to protect your privacy, on and off the Internet, click here.

MARK NESTMANN, Privacy Expert & President
The Nestmann Group
www.nestmann.com

• You've given out your SSN to anyone in the past 6 months...
• You belong to any church or organization...
• You hold 50% or more of your assets in any U.S. bank...