GORELICK

BROTHERS
CAPITAL
Market Update
Distressed Mortgage Demand and the Public-Private Partnership

Christopher Skardon
March 17, 2009

Enter the Government

Gorelick Brothers Capital has spent the better part of the last 18 months evaluating, and allocating capital to, distressed mortgage funds. Broadly, these
At current market
funds have invested in assets including residential mortgage backed securities (RMBS) and whole loans (WLs), commercial mortgage backed securities
prices, a $4
(CMBS) and trading strategies related to these assets. As detailed below, we estimate that these asset classes total approximately $7 trillion in nominal
trillion asset
value and $4 trillion in market value.
class…
To date we have reviewed over 140 new fund proposals, mostly from hedge funds, private equity and other money managers. These funds have
targeted approximately $70 billion in new capital and have been able to raise about $35 billion to date. This tally excludes private equity firms
investing chiefly in commercial real estate loans and equity, as well as distressed debt funds focused on corporate bonds and loans. In the face of
Only $35b raised overwhelming supply, $35 billion of fresh capital has hardly made a dent in the opportunity. In fact, the risk/reward profile for new investment has
privately, improved over the last year with un-levered yields increasing from the low-teens to the 20% area. For most investors, there have been several
Government unfortunate false starts. Funds that invested in distressed mortgages in 2008 on a “long-only” basis lost money, and funds using leverage lost a lot of
funding to fill the money.
void…
Against this capital-starved backdrop, we welcome the newest and largest potential investor: the Treasury Department’s Public-Private Investment Fund
(PPIF), introduced last month as part of the Government’s Financial Stability Plan (FSP). Its basic premise is to finance private investor purchases of
up to $1 trillion in distressed assets. We expect PPIF’s to offer term, non-recourse leverage in order to lure private capital from the sidelines, reduce
liquidity premiums and stabilize the market.

As illustrated in the simple timeline below, it seems to us PPIF is likely to play a leading role in clearing bank balance sheets starting very soon.

Treasury’s Financial Stability Plan (FSP) Timeline

Stress Tests Private Capital Raise Treasury Equity Injections
Asset Sales to Public-Private Investment Fund (PPIF)

th st
April 30 Oct 31
Source: Gorelick Brothers Capital, LLC

For further information please contact Michael Davis, Director of Investor Relations, MDavis@GorelickandSons.com
Gorelick Brothers Capital, LLC ● 4064 Colony Road, Suite 340 ● Charlotte, NC 28211 ● (704) 442-1094
 Investors have several reasons to be hopeful. Capital attraction improves as investors gain confidence in arm’s length pricing and potential supply.
Arm’s length
Treasury has explicitly endorsed a pricing method that “…allows private sector buyers to determine the price for current troubled and previously
pricing and ample
illiquid assets.”1 Forced selling as a result of FSP’s stress tests can be met with ample financing for new buyers. Treasury seems to have estimated that
financing are
12% to 25% of the available market value will likely trade over the coming year, so the amount of financing is appropriate (25% x $4 trillion = $1
hopeful signs…
trillion). This significant source of new demand should foster grater confidence that today’s market price will hold in the face of tomorrow’s selling
pressures.
Table 1.
Other Capital Sources U.S. Based Sources of "Private" Capital
2

Total (Bn)
The Government has explicitly specified its goal of $500 to $1,000 billion in PPIF buying power, Public Pension Funds3 3,000
Leverage of about but how much private capital is available? Likely sources of additional private capital include 4
Private Pension Funds 1,030
5x required… pension funds, endowments and foundations, sovereign wealth funds, private equity funds and 5
University Endowments 4,112
hedge funds. Nominally, these investors have over $15 trillion of assets under management (Table
6
1). While that figure is significant, we believe only a small fraction is likely to take advantage of a Foundations 263
7
Government financing offer, and we believe creating $1 trillion in new demand will require Private Equity* 2,493
8
leverage on the order of 5x. Sovereign Wealth Funds* 3,190
9
Hedge Funds* 1,473
Note: For purposes of the discussion below, we seek to estimate the maximum amount of capital Total 15,561
that could be available. We assume Government provides $1 trillion in financing, and our other
*Sovereign Wealth Funds are non-U.S. source, and Private Equity and
estimates are likewise purposely optimistic. Hedge Funds receive significant foreign investment

Available Private Capital: The Tally

Cash & Short Term Investments. Our first optimistic assumption is that some portion of cash balances on allocators’ balance sheets may be held for
the purpose of making tactical investments. We focused on cash amounts available at pension funds, endowments, foundations and sovereign wealth
Perhaps some funds (SWFs). (We don’t have a reasonable gauge for hedge funds, but the lion’s share of hedge funds has neither the mandate nor the skill to invest in
tactical allocation these assets, and we suspect many are holding cash for the purpose of funding redemptions.10) We estimate total cash balances average about 5% of
of cash balances… assets, or about $470 billion.11 Almost half of that amount is at SWFs, but only approximately 34% of their exposure is to U.S. assets.12 We estimate

1
www.financialstability.gov, “Fact Sheet: Financial Stability Plan,” Pg. 3, 2/10/2009
2
This is an educated guess, and probably optimistic. Caveats: 1. Many pensions, endowments and foundations have a 6/30 year end, and these amounts are not adjusted for significant market losses since 6/30/08; 2.
Approximately 50% of private equity (and one can assume hedge fund) assets come from pensions, endowments, foundations and SWFs. So there is some double counting.
3
Public Pension Funds: Beth Almeida, Kelly Kenneally & David Madland, Ph.D., "The New Intersection on the Road to Retirement," 5/2/2008.
4
www.watsonwyatt.com. “Dramatic Drops in Interest Rates Forecast Much Lower DB Plan Funding Status on Accounting Basis for 2008.”
5
National Association of College and University Business Officers, "2007 NACUBO Endowment Study"
6
Foundation Center, "Top 100 U.S. Foundations by Asset Size," 2/5/2009
7
Preqin, LLC
8
Balin, Bryan J. "Sovereign Wealth Funds: A Critical Analysis," 3/21/2008, The Johns Hopkins University School of Advanced International Studies.
9
The EurekaHedge Report, February 2009, pg. 3
10
WSJ, 3/2/2009. Morgan Stanley Analyst, Huw Van Steenis is cited as estimating that total hedge fund assets might fall to less than $1 trillion from their year end 2008 levels.
11
We used the following institutional portfolio allocations as our benchmarks: Pensions – CalPERS; Endowments – Davidson College; Foundations – Ford Foundation; SWFs –Government of Singapore Investment
Corporation. This data was based on 2007/2008 fiscal year end reporting. On average, portfolio allocations to cash or short term investments were 5.1%.
12
Government of Singapore, “Report on the Management of the Government’s Portfolio for the Year 2007/8,” page 11.
GORELICK
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 pensions hold $72 billion in cash, but we think most is encumbered by increasing retiree payments and unfunded private equity capital commitments.
Endowments and foundations have approximately $173 billion of cash and equivalents, about 4% of their total assets. Recent losses and pressure to
maintain 4%-5% annual distributions are likely to limit reinvestment of cash. Our guess is that just over 10%, or $52 billion, of existing cash balances
could be available for new investments in distressed mortgage assets.

Existing Capital. A handful of hedge funds and private equity funds control the vast majority of existing capital available to invest in distressed
mortgage assets. With rare exception, pension funds, endowments, foundations and SWFs do not yet have meaningful staff dedicated to distressed
mortgage opportunities, and most will initially outsource investment to external managers. As noted above, we estimate that distressed mortgage funds
Few managers with (including those raised by PIMCO, Blackrock, TCW, Paulson, etc.) have raised $35 billion to date. Of that amount, our research indicates at least half
mortgage credit has already been invested. We believe an additional $34 billion could migrate from distressed corporate debt, fixed income or multi-strategy hedge
mandate or funds.13 Considering that very few fund managers have both the mandate to invest in distressed mortgage assets and the requisite expertise, analytics
expertise… and infrastructure (including, for example, servicing capacity for whole loans14), we suspect our estimate is generous.

The other source of existing capital is private equity. Private equity managers have up to $1 trillion in “dry powder,” of which approximately $200
billion is intended for real estate funds.15 Typically, real estate funds focus on commercial real estate ownership opportunities by making equity and
mezzanine loan investments. Controlling assets is the key to their mandate. We expect some will
move up the capital structure into CMBS AAA debt as it offers un-levered yields in the low to mid-
Table 2.
teens. The amount of dry powder is likely overstated since the vast majority of private equity limited
partners (Table 2)—pensions, endowments, banks, insurance companies and foundations—are not in a
Private Equity LPs
position to meet capital calls. Ultimately, we think that private equity will maintain its preference for
Public Pension Funds 14% real estate loans, equity and operating companies, but might allocate up to $50 billion to CMBS
investments.
Fund of Funds Managers 14%
Family Offices/Foundations 10%
We should also consider the possibility
Banks and I Banks 9% Table 3.
that portfolio allocations will shift
Endowment Plans 8% away from other asset classes towards
Private Pension Plans 6% Incremental Private Capital16 distressed mortgage opportunities.17
(Bn $) We think this process will take time as
Insurance Companies 5%
Investment Companies 2% Pensions, Endowments, Foundations, SWFs 52 most allocators look for established
Hedge Funds 50 performance track records prior to
Government Agencies 2%
Private Equity 50 investing. Nevertheless, as a “plug,”
High-Net-Worth Individuals 15%
Allocation Adjustment 48 we add $48 billion to our tally,
Other 15% bringing the total to $200 billion of
Total 200
100% incremental private capital (Table 3).
Source: Preqin Ltd. Source: Gorelick Brothers Capital, LLC

13
We assume that 5% to 10% of distressed debt, fixed income and multi-strategy hedge fund assets migrate to distressed mortgage opportunities. Gross amounts were sourced from EurekaHedge data, as of YE 2008.
14
Constrained capacity in the nation’s residential mortgage servicing and special servicing industries deserves a lengthy and dedicated discussion. Even if adequate capacity existed (we believe it does not), existing providers
must overturn longstanding cultural traits, financial incentives, contractual arrangements and widely accepted policies and practices that are at best ill-suited to relieving current mortgage distress.
15
“Preqin Private Equity Spotlight,” Volume 5, Issue 2. February 2009
16
The primary sources of this incremental capital are: cash and short term securities, existing un-invested capital dedicated to direct or complimentary strategies (e.g.., structured finance hedge funds) and higher allocations to
RMBS and residential whole loans from private equity “real estate” funds.
17
E.g. on 3/3/09, “Pensions & Investments” newspaper reported that CalSTRS is considering a 5% allocation to “a new distressed investments portfolio that will include fixed income, real estate, and private equity…” We
suspect that some but not most of this allocation will be dedicated to distressed mortgages.
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The Public-Private Partnership Opportunity

If the PPIF is fully deployed, using 5x leverage, then it could theoretically own $1.2 trillion market value of assets ($200 billion in private capital + $1
trillion in Government financing). The notional value of PPIF’s most likely target assets is approximately $7 trillion. Applying recent typical market
prices for these assets, we think their current market value is in the range of $4 trillion (Table 4). Eligible assets are likely to include non-agency
RMBS, residential mortgage WLs and CMBS, but the program might also comprise CLOs, CDOs and non-TALF eligible ABS, such as seasoned credit
cards, auto and student loans.18

Table 4.

PPIF Asset Opportunity

Nominal
Est Market
Asset Type (Bn $) Price Value %
Non-Agency RMBS 2,025 60% 1,215 29%
Residential Whole Loans 4,235 60% 2,541 61%
CMBS 724 55% 398 10%
Total 6,984 4,154 100%

Source: Goldman Sachs, Morgan Stanley, Gorelick Brothers Capital, LLC

Risks, Returns and the Role of Government

Risk and Return. To determine the risk and return profile of the PPIF opportunity set, we assume 5x leverage ($5 borrowed for every $1 of private
capital) and pro-rata allocation of investment across asset types. Based on the yield and financing assumptions in Table 5, we project PPIF’s returns and
Compelling risk in Table 6. The weighted average annual return opportunity for private capital is approximately 67%.19 Potential returns that high do not come
levered yields without considerable risk. We would note that non-Agency RMBS is particularly treacherous when leverage is applied. Because most RMBS has a
for all asset low current yield, interest income is usually only a small contributor to profit. Instead, the reward is highly dependent on principal return, exposing
types… holders to the considerable risk of further home price depreciation. CMBS and WL higher current yields offer more positive carry and a better risk and
return profile (See “Levered Current Yield” in Table 5).

18
The Government’s Term Asset-Backed Securities Loan Facility (TALF), is expected to initiate in March, 2009 and will provide term funding for investments in newly issued credit card, auto loan, student loan and
commercial mortgage securities. Currently, all RMBS and secondary ABS are excluded.
19
This return assumes equal average lives and amortization of the asset types. It will hold true for a couple of years but will diminish over time as RMBS and WLs amortize faster than CMBS.
GORELICK
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 Table 5.

PPIF Levered Return Profile

Levered
Yield to Current Leverage Annual Levered Current
20
Asset Type Leverage Maturity Coupon Yield Cost Defeasance Yield Yield
Non Agency RMBS 5 18% 0.75% 1.25% 1.50% -0.25% 81.50% -1.25%
Whole Loans 5 15% 7.00% 11.67% 3.00% 8.67% 63.00% 43.33%
CMBS 5 13% 5.00% 9.09% 4.00% 5.09% 49.00% 25.45%

Source: Gorelick Brothers Capital, LLC

Role of Government I: Principles. Two main principles should guide Government. The first principle is fairness. PPIF’s commendable commitment
to market based pricing should be matched by guidelines encouraging broad-based investor participation. A program benefiting an oligopoly of private
investors would be anti-competitive and compromise public trust. While a limited competition scheme among several Government financed
partnerships might be workable, we believe a market’s efficiency varies directly with the extent of its participants’ diversity. More, rather than fewer,
participants, and variations among them in risk bias, size, investment mandate and other traits are all factors that improve the likelihood of recreating a
Fairness & working market.21 The second principle is flexibility regarding Government’s role as either a “lender” or “investor.” Ideally, the Government would
flexibility as fill solely the role of lender, taking only senior risk protected by investors’ equity. But, given insufficient private capital supply, in certain instances
guiding Government may need to make equity investments. In other words, Government must be prepared to balance risk, reward and necessity.
principles…
Role of Government II: Lender or Investor? We believe the Government should be a lender for Non-Agency RMBS and CMBS, but a lender and
investor for residential mortgage whole loans.

Taxpayers are already massively overexposed to first loss mortgage risk via the Government’s implicit and explicit guarantees of Fannie Mae, Freddie
Mac and Ginnie Mae debt. It seems inappropriate for taxpayer’s to double-down on that risk by making the same bet in non-Agency RMBS. We think
the high return potential for non-Agency RMBS (see “Probability of Private Capital Participation” in Table 6) should be sufficient to attract the $60+/-
billion of private capital required. Similarly, we think CMBS will have little trouble attracting private capital. It is the smallest asset class and will
likely be met by sufficient hedge fund and private equity “dry powder” (approximately $19 billion based on 5x leverage, see Table 6). Given CMBS’s
relatively less severe supply/demand imbalance and the economic and political differences between residential and commercial real estate, we suspect
the Government may offer less leverage to CMBS buyers. Doing so should considerably improve the taxpayer’s risk profile.

20
Based on LIBOR + 1%, 5 yr Swaps + 1%, and 10 yr Swaps + 1%, which will likely be the financing cost
21
We infer from recent news reports that Government may model aspects of PPIF on suggestions made in “How to Make TARP II Work” by Harvard Professor Lucian A. Bebchuk. See
http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID1341939_code17037.pdf?abstractid=1341939&mirid=1.
GORELICK
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 Table 6.

PPIF Return and Risk Profile

Probability of
Public Public Private Public Private Private Capital
Asset Type Total Senior Sub Senior Sub Sub Return Return Private Risk Public Risk Participation
Non Agency RMBS 351 292 58 100% 0% 100% 1% 81.50% High Medium Medium
20
Whole Loans 734 612 122 100% 50% 50% 7% 63% High Medium Low
CMBS 115 96 19 100% 0% 100% 1% 49% Medium Low High
Total 1,200 1,000 200 4% 67%

Source: Gorelick Brothers Capital, LLC

Residential mortgage whole loans are by far the largest asset type and will have the most trouble attracting sufficient equity investment. Totaling
approximately $4 trillion notional on bank and financial company balance sheets, WLs are likely to pose the greatest risk in the FSP’s bank “stress
Whole loans tests.” WLs are typically held at cost (par in most cases) absent evidence of impairment. FSP stress tests will certainly reveal extraordinary potential
pose the “mark to market” losses arising from future impairment (90+ delinquency) in WL portfolios. On the other hand, WLs also attract a 50% capital charge,
greatest and disposition provides meaningful capital relief. Moving excess WL exposure from bank balance sheets is imperative, but we do not see $122 billion
challenge… of available private capital to absorb the potential supply. The largest dedicated WL fund is only $2 billion.22 In order to facilitate WL liquidity,
Government must take substantial first loss risk. While taxpayer risk will increase, the reward will be a higher return, and FDIC has already engaged in
public-private WL trades that serve as an appropriate model.

PPIF: The Path to Neighborhood Stability and Pension Solvency

Taxpayer’s may well resist taking first loss exposure to WLs. Not only might this be seen as accepting losses arising from loans to “unworthy”
borrowers, but PPIF also explicitly absorbs bank risk—the latest “third rail” of politics. To avoid this, PPIF needs to demonstrate a clear benefit to
Private WL taxpayers. We believe that the benefit lies in PPIF’s ability to help protect neighborhoods from foreclosure blight while simultaneously improving state
investors reduce and municipal pension solvency.
foreclosures,
not delay PPIF will limit both future home price depreciation and the decline of neighborhoods by reducing the incidence of foreclosure. The program is
them… intended to facilitate the sale of WLs to private investors who, in turn, will seek to maximize their investment. In the course of evaluating scores of
investment managers, we have seen many whole loan investment models. Without exception, all show that the best way to maximize profit is to reduce
or avoid mortgage delinquency and foreclosure. Public policy has heretofore frequently favored foreclosure moratoria and thereby exacerbated losses.
By contrast, private investors have consistently pursued aggressive modifications to keep borrowers in homes and prevent detrimental neighborhood
“fire sales.” The FDIC is already working in partnership with a number of such managers and is well aware of their capabilities.

22
To date, we estimate that WL funds have risen between $10 to $11 bn. Servicing capacity is a critical component to successful WL investing. Most investors will want to move servicing from banks as a condition of
purchase.
GORELICK
BROTHERS
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 In addition to the Federal Government, state and municipal pensions should be the primary source of private capital for residential mortgage whole
loans. Given the breadth of the mortgage crisis, there is probably no better way for them to benefit their constituents. Pensions are taxpayer funded, but
in the face of lower tax revenues and investment losses, they are
rapidly falling behind on their obligations. According to Wilshire
Consulting, the median state fund was under-funded by 16% as of Table 7.
23
fiscal year end 2008. As many funds’ fiscal years end in June,
that funding deficit has certainly grown. Ultimately, an under- Public Pension Risk and Return – Wilshire Model
funded pension plan becomes a taxpayer liability. We suggest the
Treasury Department recommend that pension funds allocate up to Asset % Risk Return Sharpe
Whole loans 4% of assets to distressed mortgage opportunities.24 Doing so Domestic Equity 38.10% 16.00% 8.50% 0.50
offer pension would generate as much as $100 billion of additional capital to fill
25 International Equity 18.80% 17.00% 8.50% 0.47
funds a path to the WL investor equity gap.
Domestic Debt Securities 26.70% 5.00% 4.00% 0.70
solvency…
International Debt Securities 0.90% 10.00% 3.75% 0.33
Using Wilshire’s allocation, risk and return assumptions, we believe
that adding distressed mortgages to pension assets could Real Estate 5.90% 15.00% 7.00% 0.43
significantly improve their earning potential and repair their Alternative Investments 5.60% 26.00% 11.55% 0.43
funding gap. In Table 7 we show the impact of a 4% allocation to Other 4.00% 0.05% 0.50% -
PPIF assets. Expected annual returns improve from 7% to 9.4%, PPIF - 50.00% 67.00% 1.33
risk increases from 13.1% to 14.4%, and the Sharpe ratio increases Total 100.00% 13.10% 7.00% 0.52
from .52 to .55.26 It is hard to believe that the increased risk would Total w/4% PPIF 14.42% 9.36% 0.55
be considered excessive given the market based entry point, lack of
current exposure, and the poor performance of existing allocations.
Source: Wilshre Consulting, Goreilck Brothers Capital, LLC
The reward is compelling: stabilized state and local housing
markets and healthier pension funds.

Be Prepared, Be Clear, Be Creative

PPIF’s success Generous leverage affords very high nominal investor returns. In many respects, PPIF looks too good to be true. Returns in excess of 60% should not
is critical to a engender overconfidence, however, as success faces a number potential hurdles. Investors may not be ready to use leverage again. As participants in
rapid the structured products market know, combining leverage with securitized home loans proved fatal for many investors. Even today, there are disaster
recovery… stories regarding leveraged trades in high yield loans and commercial real estate made less than a year ago by very sophisticated investors.
Additionally, we suspect equity investors may find better terms investing in operating companies. In this case, an investment in a new or re-capitalized
bank (such as IndyMac) could actually allow more leverage than PPIF.27 Not only could these banks have a second bite at the home mortgage apple,
but their owners would also have the additional upside of a future “clean bank” IPO.

23
Wilshire Consulting, “2009 Wilshire Report on State Retirement Systems: Funding Levels and Asset Allocation,” 3/3/2009.
24
Full Disclosure: GBC manages a distressed mortgage opportunities fund of funds, so we could benefit from this recommendation
25
Based on our estimate of approximately $3 trillion in public pension fund assets, modestly reduced to reflect recent investment losses and selective participation.
26
This improved return will not last forever, of course. But PPIF does offer term leverage, which should match the life the assets, so it is reasonable to expect that this benefit will last at least a 3 to 5 years. We assumed 50%
for PPIF’s risk, or roughly 2x Wilshire’s risk for alternative investments.
27
Banks capital structures leverage equity 10x to 12x, which is considerably more that PPIF will likely allow. Therefore, if assets are held at their trading value on bank balance sheets, it would be more efficient for investors
to recapitalize banks and hold on to the distressed mortgage assets. However, we believe that this is an unlikely outcome since it seems contrary to the public statements of Secretary Geithner, who has expressed a
preference that banks sell their bad assets.
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 The one clear advantage to PPIF is its imminent availability. With a bit of creativity and cooperation, it could blossom into a program that best serves
taxpayers by blending Federal, state and local funding with private capital and management skills. A clean start is essential. If it is too vague or narrow
in application, investors will lack confidence, the Financial Stability Plan will risk failure and the mortgage crisis will prolong. If launched with clear,
coherent and fair incentives for private investors and well defined benefits for taxpayers, then PPIF could assist the rebirth of the U.S. mortgage market.

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© Gorelick Brothers Capital, LLC

The forecasts and opinions contained herein are for illustrative purposes only and are not to be relied upon as advice or interpreted as a recommendation.
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The information provided is intended for informational discussion purposes only, and does not constitute an offer to sell or a solicitation of an offer to buy any
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