2007 international conference washington, d.c. ~ november 7-9, 2007 transparent money: financial...

Washington, D.C. ~ November 7-9, 2007

2007 International 2007 International ConferenceConference

Transparent Money:Transparent Money:

Financial Institutions in an Age of Disclosure

Transparent MoneyTransparent MoneyPanel MembersPanel Members

• MODERATOR: Perry Even, Area Senior Vice President

Arthur J. Gallagher & Co.

• Scott A. Schechter, PartnerKaufman Borgeest & Ryan LLP

• Frederick M. Zauderer, Technical DirectorTravelers Bond & Financial Products

• Jack Zwingli, Chief Executive OfficerAudit Integrity

OverviewOverview

I. The Sub-Prime Mortgage Crisis

II. Anticipated Liability Exposures that Have or May Arise

III. Financial Institutions and Disclosure

Transparent Money: Transparent Money: Financial Institutions in an Financial Institutions in an

Age of DisclosureAge of Disclosure

I. THE SUB-PRIME MORTGAGE CRISIS

A. What is it?• Declining home sales • Declining home prices • Increased interest rates• Increased defaults and foreclosures• Loss of liquidity in mortgage originators



I. THE SUB-PRIME MORTGAGE CRISIS

(cont’d)

B. Where did it come from?• Significant annual home price increases since 1999• Securitization of mortgage debts• Increasing need for new loans to support demand for

CDO’s• Drop in mortgage underwriting standards• Alternative mortgage products



• According to the Wall Street Journal, 10/11/07, high rate mortgages accounted for 29% of all home loans originated in 2006.

• Sub-Prime mortgages grew from $120 B worth of origination in 2001, to a peak of $625 B in 2005, declining to $600 B in 2006.

Types of Sub-Prime mortgages:

• Adjustable-rate or hybrid mortgages 45%• Fixed-rate mortgages 25% • Negative amortization mortgages 10%• Interest-only mortgages 20%

• Capital One had a product or combination of products that allowed

a home owner to borrow 125% of the value of the home.



• Securitization: $2.5 Trillion total mortgage originations in 2006, of which $1.9 Trillion were securitized. Approximately 25% of all mortgage-backed securities were backed by Sub-Prime loans. 63% of all Sub-Prime and Alt – A loans were securitized.

• Approximately 2/3 of Sub-Prime mortgage loans are

originated by mortgage brokers.

• GAO found that from 2003 to 2005 Alternative mortgage products grew from a 10% market share to a 30% market share.



Relaxed (or lax) mortgage standards:

Borrowers with FICO AMP’s with Piggyback scores less than 700 2nd Mortgages

(financing the down payment)

2001 32.4% 1.8%

2002 33.4% 0.3% 2003 42.4% 6.3% 2004 43.1% 11.4% 2005 48.2% 25.3%



• Bankruptcy filings: consumer bankruptcy filings increased in September from a year earlier by almost 23%, representing 69,000 additional filings for that month.

• For 1st 9 months of this year consumer bankruptcy filings are up 44.76%.

• S&P cut its credit rating on $23.35 Billion of securities backed by pools of residential mortgage loans, including securities that had previously been rated AAA. In August S&P lowered some AAA rated securities to CC.



• New unemployment claims increased by 28,000 for the week of 10/28/07 from the week before. This is the largest one week increase since 2/10/07 and is attributed to the downturn in housing and the credit crisis.

• New home construction fell 10.2% in September to the lowest level in 14 years. August sales of single family homes declined by 8.3%.

• There were 1.2 Million mortgage defaults in 2006. There could be as many as 2.2 Million mortgage defaults in 2007.

• Building permit activity declined 7.3% indicating a continuation of lower construction starts into the future.



• National Association of Home Builders housing market index declined to 18, its lowest number since the index began in 1985.

• Residential foreclosures in NYC are up 64% in the 3rd

quarter when compared to a year earlier.

• 3rd Quarter increases in Los Angeles are 247%, Miami 158%.

• In September 2007, the S&P/Case-Shiller Home Price

Indices which track home prices in metropolitan areas showed an annual 4.5% decline for its 10-City Composite index, the largest decline in 16 years.



I. THE SUB-PRIME MORTGAGE CRISIS(cont’d)

C. How big is it?• Investment bank losses

• Sub-Prime lender losses

• Home builder losses

• Investor losses



• Lennar Corp., the nation’s 2nd largest homebuilder, reported a net loss of $514 Million for the quarter ended 8/31/07, the largest quarterly loss in its history. Forced to write down the value of land or write off deposits on land purchases totaling $847.5 Million. Share price has fallen 50% this year.

• Beazer Homes reported 68% of prospective buyers canceled their orders in the quarter ended 9/30/07. 36% cancellation in the immediate prior quarter. Shares were down 78% in early October from the start of the year.



Lender Losses:

• Fremont - for the six months ending June 30, 2007, Fremont lost $855.8 Million.

• American Home Mortgage has filed for Chapter 11 bankruptcy protection.

• Countrywide lost $1.2 Billion in the 3rd quarter of 2007. For the first nine months of the year, the company posted a loss of $281.6 Million versus a profit of $2.05 Billion a year earlier.

• New Century filed for bankruptcy and has liquidated most of its assets.



Lender Losses:

• Wachovia has written down $1.3 Billion.

• Washington Mutual increased loan loss reserves by $595 Million and took a charge of $147 Million for mortgage loans it decided to hold off its balance sheet.

• General Electric expects hit of $300 - $400 Million for withdrawal from the Sub-Prime market, 3rd quarterly hit in a row for its sub-prime portfolio.



Losses by Financial Institutions:• Merrill Lynch - $7.9B• UBS - $3.4B• Citigroup - $3.3B• Deutsche Bank - $3.1B• Morgan Stanley - $2.4B• JP Morgan - $2.1B• Goldman Sachs - $1.5B• Bank of America $1B• Lehman Brothers - $700M• Bear Stearns - $700M

New York Times, Sunday, October 28, 2007, “Guesstimates Won’t Cut It Anymore” – the $30 Billion in write-downs taken by big brokerage firms in the 3rd quarter are not likely to be the last. The recent write-down by Merrill Lynch will likely be followed by others as auditors perform year-end reviews and force the brokerage firms to adopt a more realistic value of their mortgage portfolios. Others have suggested that Merrill’s write down may reach $10 Billion.



Other Losses From Housing/Credit Slump:

• FedEx cut earning estimate – “freight business impacted by slowing economy, especially the housing market.”

• Lowe’s lowered its earnings forecast due to the housing slump.

• Home Depot recently fell to its 52 week low. • Whirlpool announced weaker sales due to the housing slump &

its shares fell 5%.

• Furniture companies Ethan Allen & Herman Miller are trading near their 52 week lows.



II. ANTICIPATED LIABILITY EXPOSURES THAT HAVE OR MAY ARISE

A. Against Sub-Prime lenders1. Regulatory investigations/litigation2. Litigation brought by institutional investors3. Litigation brought by shareholders of the Sub- Prime lenders

- Securities class actions - Derivative suits

4. Litigation brought by borrowers5. ERISA lawsuits by employees



B. Against Institutional Investors1. Investigations / litigation brought by regulators2. Litigation brought by their own shareholders

- Securities class actions - Derivative suits

3. Litigation brought by investors who purchased the CDO’s

- Securities class actions- Derivative suits- ERISA claims



C. Against Investment Advisors brought by clients

D. Against Other Professional Advisors including law firms, accounting firms, and other professional advisors who rendered services to anyone involved in the process

E. Against Closing Attorneys brought by lenders or borrowers – legal malpractice (RESPA, TILA)



F. Against Mortgage Brokers, Real Estate Agents, Title Companies, Appraisers, and Home Buyers brought by mortgage holders and/or originatorsG. Against Rating Agencies

1. Regulatory and congressional investigations into the role played by rating agencies and possible conflicts of interest

2. Civil litigation brought by everyone elseH. Against Home Builders

1. Shareholders - Class action securities law claims

2. Employees – ERISA claims



1. New Century Financial Corporation

2. Novastar Financial, Inc.3. IndyMac Bancorp Inc.4. Accredited Home Lenders

Holding Company5. Coast Financial Holdings,

Inc.6. Beazer Homes USA, Inc.7. Fremont General

Corporation8. American Home Mortgage

Investment Corporation9. RAIT Financial Trust

10.Luminent Mortgage Capital, Inc.

11.Countrywide Financial Corporation

12.Radian Group Inc.13. Impac Mortgage Holdings14.Thornburg Mortgage, Inc15.Care Investment Trust Inc.16.NetBank, Inc.17.Opteum, Inc.18.E*Trade Financial

Corporation

Civil Litigation: Securities and ERISA Class Actions



Civil Litigation: E&O Claims

1. Prudential v. State Street & Trust Corp. and State Street Global Advisors (lawsuit seeking to recover losses suffered by Prudential’s clients in two bond funds managed by State Street)

2. Metro PCS v. Merrill Lynch (lawsuit seeking to recover losses suffered as a result of investments in CDO’s that Merrill Lynch underwrote)

3. Luminent Mortgage Capital v. HSBC Holdings PLC (lawsuit alleging that HSBC took advantage of turmoil in the mortgage securities marketplace to repossess bonds from Luminent)

4. Unisystems v. State Street (ERISA lawsuit alleging that State Street misrepresented its bond funds as conservatively managed)

5. Marlin v. Citigroup Global Markets Inc. and Deloitte & Touche (lawsuit alleging gatekeeper claims related to American Home’s April 2007 secondary offering)

6. American Home v. Bank of America (breach of contract –depriving American Home of its bargained-for protection against price degradation of the underlying mortgage loans)

7. Bankers Life v. Credit Suisse Group (MBS investors v. underwriters) 8. Zamanksy & Associates v. Bear Stearns Cos. and Bear Stearns Asset

Management (investor suing over collapse of hedge funds)



Civil Litigation: E&O Claims (Cont’d)

8. Morgan Stanley v. Fremont Capital (breach of contract in failing to repurchase defaulted mortgages)

9. DLJ Mortgage Capital v. Sunset Direct Lending (underwriter v. lender alleging failure to buy back loans)

10. DLJ Mortgage Capital v. Infinity Home Mortgages (underwriter v. lender alleging failure to buy back loans)

11. DLJ Mortgage Capital v. NetBank (underwriter v. lender alleging failure to buy back loans)

12. DLJ Mortgage Capital v. Baltimore American Mortgage Corp. (underwriter v. lender alleging failure to buy back loans)

13. HSBC v. Various Subprime Lenders (underwriter v. lender alleging failure to buy back loans)

14. UBS Real Estate Securities v. New Century Financial (issuer/underwriter v. lender alleging failure to buy back loans)

15. McCoy v. Fremont General Corp. (ERISA claims alleging imprudent investment for pension plan)



Regulatory Investigations and Lawsuits:

• The Massachusetts AG has sued Fremont Investment & Loan accusing it of predatory lending practices in violation of the states anti-predatory lending law. Example cited is a single mother earning $1,800 per month with a $7,000 monthly mortgage payment.

• The Massachusetts Secretary of the Commonwealth, and both the New York & Ohio AG’s are investigating certain trades in two failed Bear Stearns hedge funds that went bankrupt after suffering substantial losses from investments in the subprime mortgage market. The SEC is also conducting an informal investigation into the management of the two funds.



Regulatory Investigations and Lawsuits (Cont’d):

• The New York AG is investigating the practices of Sub-Prime lenders.

• The Ohio AG has sued 10 mortgage lenders accusing them of pressuring real estate appraisers to inflate home values.

• The SEC and the States of New York and Ohio are probing whether S&P, Fitch and Moody’s gave excessively high rankings to debt that soon tumbled in value.

• The SEC has instituted approximately a dozen informal inquiries into “collateralized debt obligations” in which certain hedge funds were heavily invested.



Regulatory Investigations and Lawsuits (Cont’d):

• Alaska and Idaho AG’s are looking into claims against State Street in connection with losses that their states’ retirement plans suffered from investment bonds managed by State Street.

• The SEC is looking into how Merrill Lynch has been valuing or

“marking” its mortgage securities and how it has disclosed its positions to investors.

• The New York AG has sued a home-appraisal unit of First American Corp., alleging it defrauded consumers by allowing its biggest customer, WAMU, to exert pressure for higher property valuations to help ensure that loans went through.

• In December 2006, Countrywide agreed to pay $3.2 Million to settle charges by former New York State Attorney General Eliot Spitzer that it charged minority customers higher interest rates than whites.



III. FINANCIAL INSTITUTIONS AND DISCLOSURE Fair Value Accounting

• Why is it in the news?• What does it mean?

Reliability and Reality of Disclosure• Marking to Myth

Evaluating Risks in Financial Institution Disclosure

• The problem• A checklist



FINANCIAL INSTITUTIONS AND DISCLOSURE Fair Value Accounting

• The headlines: Fair Value’s Role in the Sub-Prime Meltdown,

Compliance Week Sep-5-07 The Unfairness of Fair Value Accounting,

eFinancialNews, Oct-9-07 Banks’ Candor Makes Street Suspicious, WSJ Oct-4-07 Will Fair Value Fly?, CFO.com Sep-1-07 Pricing Tactics of Hedge Funds Under Spotlight, WSJ

Oct-9-07 U.S. Investors Face an Age of Murky Pricing, WSJ Oct-

12-07 Marking Down Wall Street, WSJ Sep-14-07

• The implications: uncertainty and unpredictability




• The regulatory push – for fiscal year-ends > Nov-15 FAS 157 – Fair Value Measurements FAS 159 – Fair Value Opinion for Financial Assets and Liabilities

• The intent: to provide greater transparency, limit earnings volatility, reduce complexity of certain instruments (e.g., hedges)

Prevent “earnings management” practices• The basics – 3 levels of classifying assets

Level 1 – Marking to Market, the most precise Level 2 – Marking to Model, based on comparable assets Level 3 – Estimates, “using significant unobservable inputs”

(FASB)

“based on unobservable, hypothetical market behavior” (FEI letter)




• Estimates, Assumptions and Judgments Fair value accounting will introduce much greater subjectivity

“Conservatism” out the door; no “ceiling” based on historical cost

• The Auditor’s Dilemma (and the Underwriter’s, too) The 20 year problem

• Fair Value Stumps Auditors, PCAOB Told, CFO.com Jun-21-07

• “…auditors lack enough technical know-how…”

• Fair Value Measurements Vexing PCAOB, Compliance Week Jun-21-07

• “…audit a company’s judgment…nothing factual…”

FASB: principles vs. guidance




• Management motivation Financial gamesmanship – smoothing earnings,

opportunistic behavior, outright fraud Investor reaction – “People don’t even trust money

market funds,” Michael Greenberg, law professor, University of MD

Compensation – bonuses tied to value of holdings Job retention – Merrill Lynch ousts CEO O'Neal, Oct-30-

07 Litigation – Merrill hit with shareholder lawsuit over

subprime, Oct-30-07 Survival



FINANCIAL INSTITUTIONS AND DISCLOSURE Reliability and Reality of Disclosure

• “Marking to Myth” – Warren Buffett

Availability of pricing – “way less than half” of all exchange securities have available prices, Daniel Harris, Goldman, WSJ Oct-12-07

• This summer, >80% of mortgage bond investors had trouble getting prices from their dealers, WSJ Oct-12-07

• Bear Stearns: 63% of (bankrupt) fund’s net assets were fair valued by management, BusinessWeek Oct-22-07

• Big Baths, Cookie Jars and other creative accounting FAS 159 Mulligan – sell the losers with no hit to profits; buy back

• “In the wrong hands, it’s a great concern” – Neri Bukspan, S&P, CFO.com May-8-07

Dealing with subprime assets – sell to hedge funds, move off books

• Recent write-downs and the market reaction



FINANCIAL INSTITUTIONS AND DISCLOSURE Evaluating Risks in Financial Institution Disclosure

• The problem – if Merrill can’t figure out the value of their holdings, neither can you (and UBS, and Citi, etc.)

• Those doing the valuations have a huge conflict of interest Management has much greater latitude “Valuation specialists” are being paid by the company

• Asset will be overstated

• The scope of the valuation work is immense Many types of assets and liabilities are covered – several dozen

opinions/statements/pronouncements/etc. from FASB, others Fair Value can be elected on a contract by contract basis

• Virtual identical entities can take divergent measures



FINANCIAL INSTITUTIONS AND DISCLOSURE An Evaluation Checklist

Level 3 Assets – look for increase in % of total, amount Early results indicate < 10% of total for financial institutions Basis for Level 3 valuations – any attempt to sell in open market?

Write-offs (Other/Unusual/Extraordinary/Non-recurring)

Explain valuation method(s) for top illiquid holdings over past 2 years

Consistency of Fair Value measurements Number of different methods used for similar asset classes Key assumptions used Have there been an independent valuation of assets? If so, get access to

the report from the valuation specialist

Sub-Prime exposure – estimates; plans for write-offs

Financial engineering – are they moving bad assets off the books?



FINANCIAL INSTITUTIONS AND DISCLOSURE An Evaluation Checklist (cont.)

Specific financial metrics – review significant variances/volatility Loan Interest & Fees/Gross Loans – can indicate revenue recognition

issues or lower quality loans Investment Security Interest & Dividends/Investment Securities – can

indicate riskier investments Loan Loss Allowance/Gross Loans – potential over-valuation issues

Proxies for corporate integrity Trust in management, board – weak/compliant boards increase risks

• Management motivation – short-term comp, options, insider trading

• Board effectiveness – Board review of financials; meeting frequency

General risk indicators (litigation risk, fraud risk, etc.)



FINANCIAL INSTITUTIONS AND DISCLOSURE

“Valuation is an art, not a science” – Valuation Specialist and advocate for fair value accounting

“People are picking numbers out of thin air” – Professor and fair value skeptic

2007 international conference washington, d.c. ~ november 7-9, 2007 transparent money: financial...

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