How to Survive the Current Credit Crisis
Download
Report
Transcript How to Survive the Current Credit Crisis
How to Survive the Current Credit Crisis
Michael S. Caccese, Partner, K&L Gates
Richard S. Miller, Partner, K&L Gates
Anthony R.G. Nolan, Partner, K&L Gates
Laurence E. Platt, Partner, K&L Gates
December 5th, 2007
Agenda
Valuation issues
Modifying subprime mortgage loans
The Pea in the Princess' Bed: The subprime crisis
and structured credit
Knowledge & understanding of the credit crisis
Q&A
Valuation Issues
Credit crunch and subprime collapse may result in
no market for certain investments
SEC and CFTC are focusing on valuation of illiquid
investments
Valuation of certain instruments may be difficult –
follow your established valuation procedures
Valuation Issues
Valuation Methods
Market Price – market quotations
If no market quotation is available – Fair Value
Fair Value is more of an art than science
Actual determinations may be made by the Board
or through persons acting pursuant to the direction
of the Board
Valuation Issues
What is Fair Value?
Fair value depends on the circumstances of each
individual case
Generally, “fair value” is the amount the owner might
reasonably expect to receive for the security upon
current sale
This is distinct from the liquidity test which is that
securities are readily marketable (i.e., saleable at
current value within 7 days)
Valuation Issues
What is Fair Value?
Factors (SEC Accounting Release 118):
The fundamental analytical data relating to the
investment
The nature and duration of restrictions on
disposition of the securities; and
An evaluation of the forces which influence the
market in which these securities are purchased
and sold
Valuation Issues
Specific SEC Factors (SEC Accounting Release 118)
Type of security
Financial statements
Cost at date of purchase
(generally used for initial valuation)
Size of holding
Discount from market value of unrestricted securities of
the same class at the time of purchase
Valuation Issues
Specific SEC Factors (SEC Accounting Release 118)
Special reports prepared by analysts
Information as to any transactions or offers affecting
the securities
Price and extent of public trading in similar issuer or
comparable companies
Other relevant matters
Valuation Issues
How Should Fair Values be Made?
Earnings multiples
Yield to maturity
Analytical data
Discounted cash flows
Valuation Issues
FAS 157 Approaches
Market – prices of comparable securities and
transactions
Income – Present value formulas, e.g., Black-SholesMerton formula
Cost – Replacement cost; more suited for tangible
assets
Valuation Issues
What to do now?
Review and follow your valuation procedures
Monitor your investments – keep a dialogue open
with the adviser
Establish a contingency plan:
Buying out the securities (money market funds)
Liquidating accounts (non registered investment
companies)
Obtain credit support:
Support from the issuer
Lines of credit
Modifying Subprime Mortgage Loans
Statement of the Problem
Since the summer, nobody wants to make, buy or
finance subprime loans, securities backed by such
loans, or securities backed by such securities
How do we stop the free fall in valuations?
Need to reduce the actual and perceived
frequency and severity of loss on the underlying
mortgage loans
Modifying Subprime Mortgage Loans
Causes of the Problem
It all starts with real estate prices
Increasing housing valuations created phantom wealth
that borrowers could tap through home equity loans for
debt consolidation, home improvements, education,
and other personal expenses
Fewer and fewer borrowers could qualify for purchase
of money loans due to insufficient income, risk based
pricing resulting from poor credit histories and statutory
limits on the size of the loans that government
sponsored enterprises, like Fannie Mae or Freddie
Mac, could buy, or governmental agencies, like FHA or
VA, could insure or guarantee
Modifying Subprime Mortgage Loans
Causes of the Problem
After real estate prices, the major cause was revised
lending standards
Private MBS conduits established their own eligibility
criteria for the purchase and securitization of home
loans
Sweet spot was borrowers who could not qualify for
traditional financing even though they were sitting on
tremendous equity in their homes
Goal was to combine loan product type with
underwriting guidelines to qualify the borrower at the
lowest possible monthly payment that could get the
deal done
Modifying Subprime Mortgage Loans
Causes of the Problem
Accomplished goal by following three factors:
Use of nontraditional loan products: interest only;
negative amortization features such as option payment
arms; hybrid ARMS such as 2/28s, 3/27s
Underwrite at “teaser” or discounted rate, not the likely
increased amount at a reset or when amortization
began
Reliance No Doc/Reduced Doc loans
Lenders did not verify income and ability to repay
Last cause was errant modeling of the potential
frequency and severity of risk of loss
Modifying Subprime Mortgage Loans
And then the Music Stopped
Interest rates went up
Property values went down
Borrowers could not afford the reset and defaults,
foreclosures and losses have skyrocketed
There are billions and billions of dollars of mortgages
are coming up for reset in the next 12 months
Modifying Subprime Mortgage Loans
And then the Music Stopped
Federal and state regulators have stepped in,
essentially eliminating the ability of the industry to
make loans on the terms that fed the frenzy
In making this determination, the feds accepted the
fact that borrowers with impaired credit histories will
find it virtually impossible to get credit, including loans
to refinance out of their existing loans that are due to
reset
Modifying Subprime Mortgage Loans
Responses to the Problem
Federal and State Governments:
are enacting laws and regulations that would
prohibit the type of lending practices that have
contributed to the present situation
BUT.....
that doesn’t do anything for existing borrowers
who are upside down in the their loans
Modifying Subprime Mortgage Loans
Responses to the Problem
Federal and state governments are somewhat
constrained in what they can do on existing
mortgages:
US Constitution limits the ability to amend by
legislation the terms of contracts between
borrowers and lenders and between investors and
issuers of mortgage backed securities
Modifying Subprime Mortgage Loans
Responses to the Problem
There also are important public policy concerns that
influence the actions of Congress:
Fundamental fairness: who deserves protection?
Moral hazard: Should private enterprise be
rescued from bad investments?
Economic limitations: Even if it wanted to act,
aside from forcing private parties to bear the cost,
does it have the available economic resources to
rescue borrowers
Modifying Subprime Mortgage Loans
Responses to the Problem
Industry participants are constrained in what they can do on
existing mortgages:
Perception of legal/accounting constraints under FASB 140
and REMIC
Limitations on terms of mortgage servicing contracts
lack of contractual authority to modify
requirement to act in the best interests of investors or at
least not adverse to the interests of investors. Best
interests of borrower are not part of calculation under the
contract
difficulty in obtaining consents from owners given their
numbers and dispersal
Modifying Subprime Mortgage Loans
Responses to the Problem
Service providers may lack experience in handling
delinquencies at these levels and may lack
appropriate staff
Inability to contact borrowers who refuse to take
phone calls
Modifying Subprime Mortgage Loans
Responses to the Problem
So what is the government doing?
jawboning/moral persuasion
Facilitating voluntary consensus
government enforcement actions
challenging the validity of the underlying loans
e.g., Massachusetts
claiming unfair/deceptive acts and practices in
servicing of loans e.g., Ohio
proposed bankruptcy amendment
Modifying Subprime Mortgage Loans
Responses to the Problem
So what are loan servicers doing?
Entering into strategic alliance agreements with
consumer advocate non profits to try to find
borrowers
Participating in Home Alliance with the federal
government to try to find borrowers
Entering into compacts with the government to try
to come up with uniform approach to avoid the
laborious task of loan level analyses
California compact
Paulson initiative
Modifying Subprime Mortgage Loans
Consequences of Loan Modifications
Tax treatment of reduction of indebtedness
Characterization of modified loans for delinquency
and cumulative loss triggers under servicing
agreements
Modifying Subprime Mortgage Loans
Sufficiency of Response
Excluded loans:
Investor loans and second home loans
Loans in default
Loans where the borrowers refuse to engage
Many borrowers can’t afford their homes without
regard to a pending reset because they had
insufficient income in the first place
Material declines in property values may cause
borrowers to walk rather than to stretch
Modifying Subprime Mortgage Loans
Sufficiency of Response
Questions remain whether servicers will be sued by
insurers and investors if they modify (note the
proposed Castle amendment)
Enactment of proposed Bankruptcy Code
amendment could wreck havoc on the markets
If the doom and gloom and an anticipated surge in
defaults, foreclosures and the related losses do not
occur, it may boost confidence and stabilize markets
The Pea in the Princess' Bed:
The Subprime Crisis and Structured Credit
How subprime mortgage dislocation turned into the
broader credit amid liquidity crisis
Effect of market events on particular types of
structured products
ABCP Conduits, SIVs and SIV-Lites
Market Value CDOs
Cash-Flow CDOs
Synthetic CDOs
Next steps in the capital markets
It All Comes Down to
Knowledge and Understanding
Knowledge of the collateral values underlying the
investment
Determining where you have risk; and where you can
gain an advantage
Knowledge of the terms and provisions of your
investment
Not just the term and the yield, etc., but what the
documents permit in the event of market disruptions
and/or defaults by counterparties
Understanding whether the words on the paper that you
own (or want to own) have any meaning in the real
world
Questions & Answers
Contact Information
Michael S. Caccese
617.261.3133
[email protected]
Anthony R.G. Nolan
212.536.4843
[email protected]
Laurence E. Platt
202.778.9034
[email protected]
Richard S. Miller
212.536.3922
[email protected]