Cramer: Here's Why Third Avenue Focused Credit Fund Barred Redemptions

 | Dec 14, 2015 | 6:30 AM EST
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You would have had to have moved heaven and earth to create a worse, more loathsome portfolio than that of the stumbling Third Avenue Fund, the mutual fund that barred redemptions last week setting off turmoil, if not hysteria in the high-yield credit markets.

Now, there are two parts to this Third Avenue story. First, there's the unprecedented decision by the firm's former CEO, David Barse -- who no longer works for Third Avenue as of this weekend -- to cease redemptions of a mutual fund without even consulting the SEC. This Focused Credit Fund wasn't a hedge fund that could have special rules, like Stone Lion Capital Partners, another fund that cut off redemptions Friday evening. Focused Credit is a mutual fund, and implicit in the nature of a mutual fund is the notion that there's a posted price of what a fund's worth and if you want to you redeem your shares and get that price today.

That's just mutual fund management gone rogue. There are rules. Rules have to be followed, including running money in a responsible enough way that you have liquidity on hand to meet redemptions when your fund is doing badly. You stop buying, you start selling and you raise cash aggressively at any price because, when your fund is down 27% as this was, according to published reports, going into this catastrophic decision, you have to accept that people will want their money back.

The unilateral decision to cease redemptions on the spot to me is tantamount to a repudiation of the laws set up to protect investors in these kinds of vehicles. I do not know how the authorities can overlook this decision as Focused Credit was some sort of a hedge fund with a lock-up. The people in their fund were not high net worth individuals. They were everyday investors, albeit every day investors who reached for yield, and, in this case, got what they paid for -- a portfolio of totally unsustainable high-yielding "investments."

But it is the second term, "investments" that seems very lightly used. When I look at this fund, I see one that is reminiscent of those kinds of funds put together at the absolute high of the junk housing credit boom in 2007, with every bad vintage, every weak housing market, every second-rate examination by the ratings agencies that also gave you a chimerical outside return.

Put simply: this was a collection of the worst pieces of garbage under one roof that I have ever seen. Now, again, before I take a deep dive into the last publicly traded list of toxic investments that this firm owned, I want to emphasize that the decision to virtually turn into a Chapter 7 liquidation of assets is the real underlying issue for the rest of the market.

If there are lots of funds that mirror this one, then we are going to have weeks, if not months of firms where the prices of the mutual funds are being carried too high, and it is every man for himself to get out of them right now. You never should have been in them, and you will now have to pay a peculiarly high price vs. what is owned, because of actual structural problems in the market in which these firms trade.

That's because there is often no two-sided bid and ask to these kinds of low-rated investments. Almost every individual bond owned here is small and difficult to value. If you submitted a bid list to any firm that had to work any of these positions,  meaning if you showed a brokerage house what you owned and the prices you were willing to accept, it would be amazing, literally amazing, if any client of that firm would buy most of this stuff.

How about if the brokerage house "principaled" the merchandise, meaning how about if the broker just bought it at a very low price and then held it, so it could make some money? That's exactly what Dodd-Frank makes illegal, because the broker would basically be running a hedge fund of investments, and that's banned under the law. You can't deliberately take down investments and run them anymore. That means very little liquidity and no reason for any broker to extend itself to help Third Avenue and have his own firm benefit. Too risky legally.

Which leads me to the investments themselves. Now, we don't know for what price or when this firm bought these incredibly hideous assets. We do know that it seemed to have a strategy of buying the lowest rated pieces of paper, with the highest yield out there. Perhaps that's because it figured it could hold the paper to fruition, meaning until the investments paid off. Or maybe it figured in the interim that the vast majority of the corporates would be affiliated with companies that could continue to pay their coupons and not default. The ones that did default would be so few and far between, that the income generated from the other high yielders would more than make up for them. In other words, they would be so diversified that no one area of investment, say, oil and gas, could create a level of default that wouldn't be overcome by the income from the other investments.

And it is here that the foolhardy nature of the management really fell down. I examined every corporate imaginable, more than 50, that the fund manager had on its sheets, and based on the publicly available information I would only invest in a half dozen of them with any conviction at all, and even those seem fanciful.

Everything from the agglomerate of energy including American Eagle (AMZGQ), CHC (HELI), the fabled Energy XXI (EXXI), Hercules Offshore (HERO), Magnum Hunter (MHRC) and Linn (LINE), to retailers like Claire's Stores, to chemicals like Reichhold or technology companies like Advanced Micro Devices (AMD) to service companies like Altegrity to minerals and mining like New World Resources, AK Steel (AKS) and Noranda (NORN) to special situations like Verso Paper (VRSZ), Liberty Tire and Caesars World just stinks to high heaven.

I did think that Vertellus, a chemicals company, Affinion, an affinity concern, inVentiv, a contract research organization for the drug business, and iHeart Communications -- part of the Old Clear Channel Communications -- have some validity as going concerns. But who knows if that's the good stuff they sold to meet redemptions while carrying the bad assets, the ones stuffed into the trunk of a liquidating trust because they had virtually little or no value.

The lack of judgment, the stupidity and the bad luck of the persons who put together this portfolio is legion. If you asked me, they had no right to running a fund, because they simply couldn't have any knowledge of how badly these companies were doing. Now, again, it's distressed paper by nature, so you aren't going to get a lot of Verizon (VZ) and AT&T (T) paper.

Still, though, many of these companies have bonds that I think will end up being dramatically lower, not higher, in value, unlike what the note to investors said, and I bet the stated valuations were nowhere near what they were really worth.

Which brings me to the second damning part of the equation here. Looking at this list, I can't believe that this fund had the guts to say that it was only down 27%. I think that these pieces of paper were so ghastly that in order to sell them they would be worth half of what they might be carried out. And that's why I think it had to close. Only a fool would bid on most of these assets. I don't even know at year-end if they could get prices for them to close their books. When I, unfortunately, owned anything roughly like these pieces of paper, I would value them, maybe at best, at 20 cents on the dollar. That's why I only ever owned two distressed bonds. I couldn't value them, because I couldn't get a legit quote to sell them that didn't seem overstated. So I decided to stop buying any hard-to-value assets so I didn't overstate my year-end performance.

Could that be why the firm went rogue and decided just to gate its fund without any clearance from the government? That it was so potentially overstated in value that it would be a travesty to put a real price to the assets? The folly of so many of these investments was legion. I don't think I could call a desk and get a quote anywhere near where I see the merchandise was valued at in the public holdings list. I would think the same way about any other fund that was stupid enough to have this much horrendous paper.

Is there a mirror to this one? If so, this particular corner of "investing," again in quotes, could ruin this type of mutual fund.

And all I can say is that it should, because nothing like this should be allowed to be offered or marketed to unsophisticated investors ever again. Yes, it's that much of an offensive travesty to call this portfolio anything other than the Gowanus Canal of mutual funds -- one that no one should ever be allowed to swim in.

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