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ANALYSIS AND COMMENTARY ON CRITICAL BUSINESS AND
LEGAL ISSUES
 VALUING
SECURITIES
When Guesses
Aren’t Enough
Investors
caught up in the credit crisis are on a money rescue
mission. One key to success is determining the fair
value of investments while meeting stricter
accounting standards.
By
Douglas E.
Miles
GlobalPrivatequity.com Inc.
There’s
plenty of blame to go around for the credit crisis.
Some may see lax oversight at the root of the
problem, others profit-driven greed. But it’s
clear that many investors were all too willing to
accept highly subjective assessments of risk and
value associated with the rarely traded alternative
assets at the heart of the crisis.
Now, legal and regulatory
pressure is mounting on banks and other financial
institutions to account for these illiquid assets
buried deep within their structured products.
In this new compliance and
auditing climate, subjectivity is no longer
tolerated. The onus is on managers to unbuckle,
unravel and interpret the fair value of their
holdings not only to facilitate transactions but
also to comply with new regulations. Fortunately,
new players and new technologies are proving up to
the task.
Good principles, bad
results
Some of the principles
behind the issuance of collateralized debt
obligations and other structured vehicles by Wall
Street firms and major banks were quite sound. By
grouping securities into tranches of varying risk,
maturity and rating levels, the issuers were
facilitating the time-honored art of
diversification. It also seemed sound to back these
structures with mortgages, as real estate values had
not faced a serious decline since the end of World
War II.
Between 2002 and the end of
2006, the market was flooded with a trillion-dollar
pool of asset-backed structured paper, 30 percent of
which was backed by subprime residential mortgages.
These structures proliferated during the friendly
credit period following 9/11, when then- Federal
Reserve Chairman Alan Greenspan lowered interest
rates to a historic low of 1 percent to keep the
economy moving.
Underwritten by investment
banks and rated by leading credit agencies,
individual structures worth as much as $3 billion
started entering the market. But the investors who
were exuberantly trading assets within these
structures paid scant attention to valuating or even
understanding what was being bought and sold.
Eventually, paper holders lost track of an asset’s
actual value, risk profile, even how its associated
structure was composed.
When defaults in subprime
mortgages battered the lower-grade tranches, the
losses were sometimes covered by principal and
interest flows from the higher-grade tranches. This
causes the deterioration of the structure’s overall
creditworthiness. And when structures fail to meet
required cash flow and liquidity thresholds,
trustees are obligated to liquidate the supporting
collateral. In what becomes a rescue mission for
cash recovery, many paper holders face grim
forecasts—40 cents on the dollar at best, zero at
worst.
Determining the fair value
of these rarely traded, illiquid instruments is one
challenge. Another is meeting the Financial
Accounting Standards Board’s Fair Value Measurement
requirement (FASB Rule 157), one of several new
regulations seeking to address the lack of accuracy
and transparency that contributed to the disruption
of the global credit markets.
Fast, accurate, honest
pricing
In the world of alternative
assets, there are three so-called synthetic levels
of pricing. Level 1, the simplest, is based on
reasonably current price history. Level 2, which is
determined by an independent source, is based on the
price agreed upon between a willing buyer and seller
to exit an asset or transfer a liability. Level 3 is
based on internal accounting, rather than an
independent source. And that might be a
finger-in-the-wind guess. It may be based on an
elegant model, but is reported by the fox watching
the henhouse.
GAAP and FASB regulators
want as many asset holders as possible to report
Level 1 and Level 2 values. Level 3 values may be
trusted when reported by a major investment bank,
but if they are coming from troubled companies,
buyers and shareholders should beware.
Our company is an objective
surrogate for accounting firms and paper holders
that may be seen as having a conflicted reporting
relationship with their beaten-up assets. Focused on
Level 2 pricing, our web-based platform takes
observable market data on a given asset, such as
comparable price, category or index information, and
runs that data through a computer model simple
enough for accounting professionals and asset
managers to understand. Subscribers can observe how
the data is generated; auditors can observe how
institutions report the value of their positions.
Demand is rising for fast,
accurate and independent evaluations; we see this as
a billion-dollar industry that’s still in its
infancy. Unfortunately, it appears that the credit
and debt mess will take several years to fix.
CT
________
DOUGLAS E. MILES is founder
and CEO of Globalprivatequity.com, Inc., a
Princeton, New Jersey-based provider of information
and data services to the alternative asset market.
The firm can be found on the Web at
www.gpe-inc.com
 FIXING
THE CRISIS
Securitization
Insecurity
Securitization is
accused of playing a role in the current financial
crisis, but it also has benefits. The challenge is
preserving those benefits while fixing any problems.
By
Talcott
Franklin and
Thomas
Nealon III
Patton Boggs LLP and LNR Partners
Securitized
assets and mortgages have grown to become an
enormous segment of the economy, though they have
been little noticed by the public until recently.
Most
people’s contact with securitization came when they
received a notice to send their mortgage payment to
a new servicer. While the borrower did not realize
it, that notice often signaled that their loan,
along with others, was being deposited into a
securitization trust under one or more complex sale
and administration agreements. The new servicer sent
the borrowers’ payments to a trustee that
distributed them to investors according to
agreed-upon priorities.
Trillions of
dollars in loans have been securitized in a
relatively short period. By the first quarter of
2007, $6.6 trillion in residential mortgages and
$2.2 trillion in consumer debt backed outstanding
securities. Commercial mortgage-backed securities
totaled $758 billion, and securities backed by
corporate receivables totaled nearly $1 trillion.
The U.S.
government has encouraged securitization for more
than three decades, in recognition of its benefits.
Securitization spreads the rewards of extending
credit and reduces the barriers to entering certain
investment markets. For example, an investor did not
need to buy an actual building to participate in the
rising real estate market; instead, he or she could
buy a certificate of interest in a loan pool backed
by a diverse mix of mortgages. Securitization has
also provided credit opportunities for people
historically unable to access credit. For example,
most investors in securities cannot determine the
race or gender of individual borrowers, making
discrimination unlikely.
 On
the other hand, critics of securitization contend
that it has resulted in a discriminatory steering of
minority borrowers toward loans with unfavorable
terms, as well as an over-extension of unfavorable
credit in general. Regardless of the cause, the rise
of securitization has been accompanied by growth in
subprime loans. In fact, new subprime originations
grew from $35 billion in 1994 to almost $665 billion
in 2005. Upwards of 70 percent of these loans were
securitized.
One might
argue that the collapse of an industry based on
loans to borrowers with bad credit should come as no
surprise. On March 17, The Wall Street Journal
reported that banks and insurers had written
down more than $150 billion in securities tied to
subprime loans. Standard & Poor’s estimates that
these losses could grow to $285 billion.
But the
Journal reported that the problems seem to have
spread beyond subprime loans, suggesting that total
losses to the financial sector could exceed $1
trillion as defaults increase on commercial loans,
credit card receivables, auto loans and non-subprime
residential loans.
Because
securitization spreads risks in the same way it
spreads rewards, the crisis may grow. For example,
some observers noted a significant widening in swap
spreads after a small subprime mortgage lender
called Ownit Mortgage Solutions went bankrupt in
2006. This demonstrated how an event that would have
gone largely unnoticed prior to widespread
securitization now has a broader effect.
The fact is
that leverage drives much of the financial system.
Some have suggested that the collapse of Bear
Stearns was analogous to a run on a bank reminiscent
of the late 1920s, and the inability to leverage
resulted in its immediate demise. But Bear Stearns
is not alone in relying on leverage. Between 2004
and 2006, Americans withdrew $324 billion in home
equity for consumer spending. Revolving credit card
balances have risen 41 percent since 2003. And the
country has a negative savings rate for the first
time since the Depression. Some point to these
factors and suggest that a larger crisis may loom.
But
securitization will survive whether or not the
crisis expands, albeit in an altered form. Almost
certainly, new judicial decisions, regulations and
laws will alter the landscape of securitization. The
question is whether those changes will correct any
problems or simply set the stage for another crisis.
Many have
suggested that securitization needs greater
transparency and more clarity with respect to the
rights and obligations of its parties. However, new
layers of uncoordinated judicial decisions,
regulations, and laws romulgated by 50 states and a
federal government could easily undermine the goals
of transparency and clarity.
Of course,
some lawyers may relish the idea of several trillion
dollars in debt and securities supported by murky
documents and subjected to a patchwork of hastily
drafted and potentially contradictory laws. But what
is good for the litigator is not necessarily good
for economic progress. Hopefully, our policy makers
will resist the temptation to take action without
fully understanding the intricacies of the
securitization process and the benefits it can bring
to society.
CT
_________
Talcott J.
Franklin is a partner at Patton Boggs.
Thomas F.
Nealon III is group general counsel, Real
Estate Finance and Servicing Group, at LNR Partners
Inc. They are co-authors of Mortgage and Asset
Backed Securities Litigation Handbook, published by
Thomson-West in April.
 COPING
WITH RECESSION
When Your Business
Partner Goes Bust
The bankruptcy of a
customer, supplier or vendor can be harrowing.
Here’s how to make the best of it.
By
Max Tucker and
Eric White
Patton Boggs LLP
With a
recession seemingly upon us, corporate bankruptcies
are on the rise. Bankruptcy filings increased by
nearly 25 percent last year, and a further increase
is expected in 2008. In this challenging economic
climate, many executives will find that an important
customer, supplier or vendor has filed for
bankruptcy. It can be a troubling experience. The
fact is, less than 20 percent of bankrupt companies
successfully emerge from Chapter 11 bankruptcies.
Asset recovery is not assured, and can be slow. But
a good understanding of the process and your options
can minimize your losses and maintain business
relationships should your “partner” (whether a
customer, supplier or vendor) survive bankruptcy.
The first
you may hear of your partner’s bankruptcy is through
a rumor, or your partner may notify you that he
cannot pay you due to bankruptcy. If the partner has
already filed for bankruptcy, bankruptcy laws forbid
you from collecting debts from your partner. If you
have heard rumors, depending on how far in advance
it is before the bankruptcy filing, you may be able
to take steps to improve your position, such as
double-checking your lien filings if you are
secured, obtaining liens if unsecured and getting
guaranties from the partner’s affiliates.
However,
after the bankruptcy case has been filed, the
bankruptcy laws may permit your partner to refuse to
honor contracts going forward. You might even be
forced to give back certain payments your partner
made to you—generally only those made in the 90 days
prior to the bankruptcy filing. Fortunately, you
will have some recourse. You have the right to
assert your damages during the bankruptcy
proceeding. And, under certain circumstances, you
have the right to refuse to provide further goods
and services absent resolution of a prior bill, or
to obtain adequate assurance of future payment. (If
the company does survive bankruptcy, it likely will
emerge with fewer debts. A clear-eyed assessment of
the partner’s post-bankruptcy finances may show that
it makes business sense to enter into new
transactions with the post-bankruptcy partner.)
Shortly
after the bankruptcy is filed, you will receive a
notice informing you of your rights to file a claim
for your damages. The notice will also inform you of
a “meeting of creditors.” This meeting is highly
formalized, and most creditors do not attend.
Bankruptcy
filings are described by the chapter of the federal
Bankruptcy Code that created them. So Chapter 7
bankruptcy filings (where all assets are sold and
then the company’s debts are paid to the extent
proceeds are available) and Chapter 11 filings
(where debt repayment schedules may be extended) are
found in Chapters 7 and 11 of the Bankruptcy Code,
respectively.
In a Chapter
7 bankruptcy, the court appoints a trustee to wind
down the company, sell the assets and pay claims.
The trustee will likely become your primary source
for details about your partner’s assets and payment
schedule. By contrast, in a Chapter 11 case, a
“creditors’ committee” investigates the debtor and
helps to formulate a reorganization plan, while the
partner’s management team continues to run the
company under court supervision. You may be asked to
join this committee, typically selected from the 20
largest unsecured creditors. Serving gives you the
chance to learn about your partner’s finances and
future business prospects and to negotiate repayment
terms. But it does require participation in frequent
meetings, often held by teleconference. And you will
have the duty to represent the interests of all
unsecured creditors, not just your company.
As the
bankruptcy proceeds, expect to be inundated with
court notices. Many involve matters in which you
have no interest or control. It’s worthwhile to note
that all filings are also available through the
federal court’s computerized filing system, PACER.
But before you start tossing away notices, know that
notices that have titles that begin with “summonses”
or “complaints” in which you are named as a
defendant require your prompt attention. Even
notices with titles like “motions” and
“applications” may propose actions that are harmful
to your company; your legal counsel can help you
separate the wheat from the chaff.
You will
eventually have the chance to review the
reorganization plan—often a thick and intimidating
document. It will be accompanied by a disclosure
statement informing you of your options. Typically,
the creditors’ committee will have concluded that
the plan provides a better likelihood of asset
recovery than liquidation under Chapter 7. And the
bankruptcy court will have determined that the
information in the disclosure statement is adequate.
But this does not oblige you to accept the plan,
which could contain pitfalls for the unwary. For
example, it may include releases of rights you hold
against third parties that are not in your financial
interest to grant.
The
bankruptcy laws, while complex, are designed to
protect both the creditor and the debtor. A key
decision you will need to make is whether it makes
business or legal sense to pursue amounts owed to
you. A variety of factors come into play, such as
the viability of the business and the valuation or
availability of the assets. If, for example, your
claim is secured by a lien, or you are a landlord,
you will be entitled to special protections
unavailable to unsecured creditors. In many cases,
these protections are only obtained through prompt
and effective advocacy before the bankruptcy court.
CT
_________
Max Tucker
is of counsel to the Bankruptcy and Restructuring
practice at Patton Boggs.
Eric L.
White is a partner in the Corporate
Finance practice at Patton Boggs |
