How to Survive the Current Credit Crisis
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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 michael.caccese@klgates.com Anthony R.G. Nolan 212.536.4843 anthony.nolan@klgates.com Laurence E. Platt 202.778.9034 larry.platt@klgates.com Richard S. Miller 212.536.3922 richard.miller@klgates.com
