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How to Survive the Current Credit Crisis
Michael S. Caccese, Partner, K&L GatesRichard S. Miller, Partner, K&L Gates Anthony R.G. Nolan, Partner, K&L GatesLaurence 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
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-Sholes-Merton 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
Valuation Issues
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
Laurence E. [email protected]
Michael S. Caccese 617.261.3133 [email protected]
Anthony R.G. Nolan 212.536.4843 [email protected]
Richard S. Miller [email protected]
