Mortgage Securities: The Buying Begins

When it comes to restarting the market for mortgage securities, the famous quote by Winston Churchill is appropriate. As World War II began to turn in the favor of the Allies, Churchill said, “This is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” In the case of financial markets, the end of the beginning comes as banks are finding buyers for their underwater mortgages. Most notably, Black Rock. Inc., which has developed a reputation as an expert manager of depressed mortgage loans, has agreed to buy a large portfolio of distressed subprime mortgages, estimated to amount to $15 billion, from UBS AGof Switzerland for 75 cents on the dollar. This gives some hope that the mortgage market might be beginning to recover. An article in the Financial Times (May 12, 2008) notes that in previous financial crises, such asset purchases have signaled a possible turning point. This was so in the 1990s S&L loan crisis when bidders began to acquire the assets of the failed institutions.

On the other hand, while some banks appear desperate to eliminate bad loans from their balance sheets and are offering sizable discounts to possible purchasers, there are buyer fears of buying distressed assets too soon and catching a “falling knife.” Nevertheless, according to the article, more than 80 funds in the past ten months have been raising money to buy bad mortgages at a discount. Some finance houses have invested in mortgage servicing groups, which collect mortgage payments in order to gain expertise in evaluating home loans.

Valuing Distressed Loans
Because of the obvious uncertainty in predicting the full extent of price declines in U.S. home prices, valuing distressed mortgage assets is a very difficult process. In particular, buyers of mortgage debt often cannot make a reasonable determination of future losses because of the lack of historical data for declines as serious as the one that we are in the midst of. In some cases, loan-to-value ratios for subprime mortgages are as high as 100% (i.e., no equity investment by the homebuyers) or even worse, the debt is more than the current value of the property because of the existence of unreported “piggyback” loans at the time the home was bought or declines in the value of the property. The valuation problem becomes worse with more complex instruments for which no buyers may be available, particularly if these fall under “fair value” accounting rules that require securities to be “marked to market,” which in some extreme cases places very low values on an asset or portfolio of assets. As a result, while many buyers are interested in acquiring the distressed assets, there can be a huge gap between bids and offers.

Caution Advised
Little-noticed and artfully drafted terms that govern the rights and remedies of holders of different tranches of collateralized debt obligations (CDOs) have resulted in disputes and litigation between holders. Defined default triggers such as downgrades in the ratings of assets backing bonds may set off contractual provisions creating conflicts between the different tranches, enabling some holders to seize control of assets, income streams and/or control rights and remedies. Accordingly, in evaluating distressed debt, it is essential to carefully analyze the nature and structure of the loans; the impact of agreements governing rights and remedies between and among borrowers, lenders, lending syndicates and members of the syndicates; as well as applicable regulatory schemes.