Falling share prices and increasing desperation on the part of banks and other financial institutions to unload distressed assets are attracting hedge funds more than ever. For example, UK-based hedge fund manager Toscafund Asset Management has amassed a 6 per cent stake in Seattle-based Washington Mutual, the largest US mortgage bank.

Toscafund reported that it beneficially held about 105.5 million shares of Washington Mutual as of July 16, according to a filing with the Securities and Exchange Commission, making it the second largest shareholder in the savings and loan institution after private equity group TPG, which bought a large stake in the bank during a USD7.2bn capital raising in May in which Toscafund also took part.

Washington Mutual has suffered as a result of the steep downturn in the housing market and its exposure to sub-prime mortgages. It recently posted a second-quarter loss of USD3.33bn and boosted its reserves for bad loans to USD8.46 billion. The bank lost USD1.14bn in the first quarter of the year.

Last week Merrill Lynch announced that it would sell mortgage-linked collateralised debt obligations once valued at USD30.6bn for just USD6.7 billion to Lone Star Funds, a Dallas-based private equity firm specialising in distressed debt. Many hedge funds are also diving into the beaten-down mortgage market, buying thousands of distressed loans and properties. They are hoping to profit from the urgent desire of property lenders and other investors, including Wall Street investment banks, to get toxic assets off their balance sheets.

There is speculation that investment by alternative managers in the financial sector may increase further if the US Federal Reserve reviews banking regulations that currently makes it difficult for investors to take more than a 9.9 per cent stake in a bank without registering as a bank holding company, which is subject to a wide range of restriction and must take on an unlimited liability to support the bank. Any easing of these requirements would certainly benefit investors such as hedge and private equity funds.

At the recent Gaim conference, hedge fund manager John Paulson said that a huge opportunity would eventually emerge in distressed assets. Perhaps the time has come.