The State of the Credit Market and Its Impact on Financial Reporting

Transcription

1 Financial Reporting Presents: The State of the Credit Market and Its Impact on Financial Reporting Name Date

2 Agenda The Subprime Mortgage Crisis and the Credit Crunch Financial reporting implications Other key considerations as year-end approaches Questions & Answers

3 Keep in Mind This webcast does not provide official Deloitte & Touche LLP interpretive accounting guidance Check with a qualified advisor before taking any action

4 Learning Objectives To enhance participants understanding of the credit market and related issues pertaining to: The state of the current credit environment Financial reporting ramifications Other areas that warrant management s attention

5 The Subprime Mortgage Crisis and the Credit Crunch Karen Weaver, CFA Managing Director, Global Head of Securitization Research and Regional Research Head the Americas

6 U.S. Mortgage Credit Highlights Three broad categories of credit Prime or A quality the highest quality segment Alt-A (Alternative-A) not quite prime credit quality Subprime the riskiest Three things determine quality The borrower debts relative to income, past behavior (FICO score) The collateral value of the property relative to the loan, LTV The loan s terms fixed-rate vs. adjustable-rate documentation ; e.g. paperwork used to verify income, assets, etc. 1.1

7 Subprime is Small in Terms of Outstanding Amounts US$10tr total residential mortgage market Alternative-A 10% Second Lien Loans/Lines 11% Subprime 12% Prime Agency, FNMA, FHLMC 54% Prime Jumbo Mortgages 13% Source: Census Bureau, embs, Loan Performance, Deutsche Bank 1.2

8 How do Subprime Mortgages Enter the Capital Markets? Most of them are pooled and securitized into Residential Mortgage Backed Securities ( RMBS or MBS or ABS *), which are then tranched into a series of bonds (MBS), mostly AAA-rated but also down to BB, which are purchased directly by investors or, pooled into CDOs** or, referenced in synthetic markets (Credit Default Swaps, the ABX index, etc.) * ABS refers generally to an asset-backed security, a.k.a. MBS ( mortgage-backed security ) or home equity loan (albeit a misnomer) ** A CDO is a Collateralized Debt Obligation 1.3

9 The Seeds of a Crisis Originators of subprime mortgages originate to sell; no skin in the game originators are unregulated banks, FNMA, FHLMC generally not involved Buyers of subprime MBS (and related CDOs) over-rely on ratings 82 cents of every dollar of subprime mortgages was rated AAA Rating agencies get it wrong because of optimistic assumptions on new, untested types of mortgages an actuarial approach to evaluating risk (backward-looking) a bad call on home prices (albeit a widely-held view) 1.4

10 During the Boom Subprime profits attracted capital; overcapacity led to irrational competition, on price Rates Issuance US$ (bn) Subprime Issuance Subprime mortgage profitability (Gross WAC minus funding cost) Source: Deutsche Bank 1.5

11 During the Boom and irrational competition on credit, e.g. U.S. Subprime Mortgage Innovation Run Amok Mortgage Product Interest only No money down No proof of income Low, teaser interest rate, exploding after 2 years Layered risk ; combines all of the above** % of U.S. Subprime Originations, at Peak 37% 38% 43% ~80% 26% * ARM = Adjustable Rate Mortgage ** Plus a high debt-to-income ratio and low credit score ( ), with the exception of LTV, which would have been 90-95% rather than 100% Source: Deutsche Bank 1.6

12 Subprime Mortgage Borrowers had Just Kept Refinancing, But Now the Music has Stopped Typical loan structure is a 2/28 below market fixed-rate for 2 years (the teaser period) after 2 years, loan becomes an adjustable-rate mortgage (for 28 years) Even at the teased rate, this loan is a heavy burden for the borrower total debt service as a percent of gross income ~45% standard mortgages are <33% Two years later, at reset, the teaser expires and the mortgage payment jumps ~25% In the past, ~90% of subprime borrowers refinanced the loan at reset, but due to tighter credit, these borrowers are now un-refinance-able due to falling home prices, sale of the home will not satisfy the debt 1.7

13 Example: Subprime Payment Shock* Months 1-24 During Initial Teaser Period At Reset, Subject to Cap If Uncapped, or as Caps Expire Mortgage Interest Rate 7.03% 9.45% 10.85% Monthly Payment (assumes $200K loan) $1347 $1661 $1882 Payment Shock +23% +40% Based on: Average margin of 575 bp of 6-month LIBOR; 6-month LIBOR at 5.10%; Initial Cap on first reset averages 242 bp * Universe of subprime hybrid ARMs resetting in September 2007 Source: LoanPerformance, Deutsche Bank 1.8

14 The Real Crisis is Ahead As borrowers on ~$400 bn of subprime face payment shock in the next 2 years Estimated outstanding subprime mortgages with future payment shocks ($bn) /07 1/08 7/08 1/09 7/09 1/10 7/10 Source: Loan Performance, Deutsche Bank Actual Forecasted 1.9

15 Home Prices Now Falling Case-Shiller Home Price Index Top 20 U.S. Markets (July 2007, annualized) 20% 15% 10% 5% 0% -5% -10% -15% -20% * Seasonally adjusted Source: S&P, Deutsche Bank 17% 10% 3% 3% 5% 6% 4% 1% -1% -6% -10% -19% 5% -5% -11% -9% -8% 2% -11% -10% Tampa Washington The worst is yet to come 1.10 Annualized Monthly Price Change* Atlanta Boston Charlotte Chicago Cleveland Dallas Denver Detroit Las Vegas Los Angeles Miami Minneapolis New York Phoenix Portland San Diego San Francisco Seattle

16 This Will be Drawn Out Over Several Years Volume of home sales Inventory Home prices Serious delinquencies on subprime mortgages Los Angeles, August 07 50% YOY Orange County, July 07 Inventory at 19.9 months Tale of 3 Indices NAR, OFHEO, CS Many cases, deterioration at an accelerating rate Mortgage defaults Mortgage losses Downgrades of MBS/CDOs This can take a long time 6 to 18 months in good times Loss severity clearly on upswing from 40% levels D/G methodology somewhat mysterious 1.11

17 Why has a Contained Problem Become Contagious? 1. Macroeconomic impact Subprime crisis falling home prices wealth effect causes consumers to pullback U.S. recession global recession 2. Subprime as a bellwether Investors ask, where else have we lost lending discipline? 3. You sell what you can Price pressures are transmitted 4. Lack of confidence in financial statements With inadequate disclosure, investors assume the worst. Their collective assumption becomes a multiple of the likely loss 5. Lack of confidence in rating agencies 6. DB estimates total subprime mortgage losses between $150-$300 billion 1.12

18 Broader Credit Market Outlook Base case We look for the financial credit crunch to gradually unwind and for the economy to muddle through the next few quarters without falling into a protracted slowdown We are cautiously constructive on credit given this outlook Investment grade Leveraged to the financials and unwinding of the credit crunch High Yield Leveraged to the economic outlook Risks U.S. economy weakens Further pockets of subprime exposures surface 1.13

19 Spreads Remain Tight in the General Scheme of Things Inv Grade BBB High Yield 1000 Inv Grade High Yield Jan-90 Oct-91 Jul-93 Mar-95 Dec-96 Sep-98 Jun-00 Feb-02 Nov-03 Aug-05 Apr-07 Tight spreads could persist for a long time again Source: DB Global Markets Research, Moody s 1.14

20 Polling Question #1 In what industry is your organization? Banking and finance Other financial services Manufacturing Utility/Energy Not-for-profit (e.g., universities) Other

21 Financial Reporting Implications of the Current Credit Market

22 Financial Reporting in the Current Credit Environment Impacts of the downturn in the credit market: Decline in the value of mortgages and mortgage-backed products Margin calls relating to warehouses or other funding facilities Decrease in liquidity of investment portfolios Declines in the value of MSRs and increased costs of servicing assets Difficulty in raising capital or liquidity constraints Inability to obtain insurance or guarantees on sub-prime loans Potential bankruptcies Regulatory actions 2.1

23 Financial Reporting in the Current Credit Environment Financial reporting implications: Fair value measurements in illiquid markets Adequacy of loan loss reserves LOCOM adjustments on assets held-for-sale Valuation adjustments related to foreclosed assets Impairments of MSR, AFS securities and HFI investments Recognition of early payment and default reserves Recognition of losses on commitments Expanded disclosures 2.2

24 Financial Reporting in the Current Credit Environment Impacted accounting standards: Other-than-temporary impairment Loss Reserves SFAS 5 FIN 45 SFAS 115 FSP SFAS 115/124-1 EITF Issue No SFAS 114 APB 18 Fair Value of Financial Assets SFAS 65 SFAS 115 SFAS 133 SFAS

25 Polling Question #2 How would you characterize your company s exposure to the downturn in the credit market? Significant Moderate Minimal Don t know / not applicable

26 CAQ White Papers Center for Audit Quality (CAQ) issued three white papers White Papers shared with the SEC, FASB, PCAOB and various Banking Regulators Purpose: help prepares and auditors understand application of existing GAAP in the context of illiquid market conditions 2.4

27 Fair Value Measurements Conceptual Definition Definition of fair value: The amount at which an asset could be bought or sold in a current transaction between willing parities, that is, other than a forced or liquidation sale Quoted prices in active markets are best evidence of FV Valuation techniques incorporate market participant assumptions 2.5

28 Fair Value Measurements Conceptual Definition Definition of fair value: The amount at which an asset could be bought or sold in a current transaction between willing parities, that is, other than a forced or liquidation sale Quoted prices in active markets are best evidence of FV Valuation techniques incorporate market participant SFAS 157 clarifies the definition of fair value but: Definition is not conceptually different from previous GAAP Definition remains an exchange price that focuses on market participant assumptions 2.6

29 Fair Value Measurements Key Considerations Key issues in determining fair value in the current credit environment Transactions in illiquid markets Observable transactions Using valuation models The Fair Value Continuum Subjective/Unverifiable Reliable/Verifiable Model Valuations Quoted Prices in Active Markets 2.7

30 Fair Value Measurements Illiquid Markets An illiquid market does not translate to a forced or distressed sale There is a distinction between a supply/demand imbalance and forced or distressed sales Definition of FV presumes transaction is not forced Significant decrease in demand does not mean transactions that are occurring are forced 2.8

31 Fair Value Measurements Illiquid Markets Definition of forced or distressed sale: Transaction that occurs under duress Seller forced to accept a price that willing market participants wouldn t accept Based on transaction specific factors and not general market conditions 2.9

32 Fair Value Measurements Illiquid Markets Example 1 Is this considered a forced sale? Company ABC determines that holding a particular asset is not consistent with its risk management strategy. Company ABC concludes that it will sell the asset into the market. However, the current market for that particular asset is experiencing significant illiquidity because of concerns regarding the credit quality of that asset. 2.10

33 Fair Value Measurements Illiquid Markets Example 1 Is this considered a forced sale? Company ABC determines that holding a particular asset is not consistent with its asset/liabilities management strategy. The Company concludes that it will sell the asset. However, the current market for the particular asset is experiencing significant illiquidity because of concerns regarding the credit quality of the assets underlying the security. No. Transaction is NOT a forced sale. 2.11

34 Fair Value Measurements Illiquid Markets Example 2 Is this considered a forced sale? Company ABC is under severe cash liquidity pressures because it cannot meet its normal capital requirements. To obtain cash and to avoid bankruptcy, Company ABC liquidates its investment portfolio. However, the current market for a particular asset being sold is experiencing significant illiquidity because of concerns regarding the credit quality of the asset. 2.12

35 Fair Value Measurements Illiquid Markets Example 2 Is this considered a forced sale? Company ABC is under severe cash liquidity pressures because it cannot meet its normal capital requirements. To obtain cash and to avoid bankruptcy, Company ABC liquidates its investment portfolio. However, the current market for a particular asset being sold is experiencing significant illiquidity because of concerns regarding the credit quality of the asset. Yes. Transaction IS a forced sale. 2.13

36 Fair Value Measurements Illiquid Markets Factors that indicate a sale is forced: Seller is experiencing severe cash liquidity pressures It probable that seller will enter bankruptcy Seller is experiencing repossession of collateral Seller s creditors are granting concessions 2.14

37 Fair Value Measurements Illiquid Markets 2004 SEC Enforcement Action Cannot ignore imbalance in supply and demand Must consider current market conditions when measuring fair value Cannot take a longer view of market when determining fair value Things to consider Entire market cannot be under duress Pervasive evidence needed to conclude transaction is forced 2.15

38 Fair Value Measurements Conceptual Definition Definition of fair value: The amount at which an asset could be bought or sold in a current transaction between willing parities, that is, other than a forced or liquidation sale Quoted prices in active markets are best evidence of FV Valuation techniques incorporate market participant The Fair Value Continuum Subjective/Unverifiable Reliable/Verifiable Model Valuations Quoted Prices in Active Markets 2.16

39 Fair Value Measurements Observable Transactions Active Market Quoted price is most reliable pricing source Should be used whenever available Inactive Market Not appropriate to disregard observable transactions Must incorporate into valuation model with appropriate adjustments 2.17

40 Fair Value Measurements Observable Transactions Active Market Quoted price is most reliable pricing source Should be used whenever available Transactions occurring Inactive Market frequently enough to obtain reliable pricing Not appropriate informationto disregard observable transactions Must incorporate into valuation model with appropriate adjustments 2.18

41 Fair Value Measurements Observable Transactions Active Market Quoted price is most reliable pricing source Should be used whenever available Inactive Market Not appropriate to disregard observable transactions Must incorporate into valuation model with appropriate adjustments 2.19

42 Fair Value Measurements Observable Transactions Example: Observable transactions Company ABC observes a price in the market for an asset in its portfolio. The Company believes that the price does not represent the value of the asset because the market in which the asset is trading is illiquid. Based on this price, Company ABC is unwilling to transact. 2.20

43 Polling Question #3 Can Company ABC disregard a price observed in a market simply because the entity is not "willing" to transact at that price? Yes No Don t know / not applicable

44 Fair Value Measurements Observable Transactions Example: Observable transactions Company ABC observes a price in the market for an asset in its portfolio. The Company believes that the price does not represent the value of the asset because the market in which the asset is trading is illiquid. Based on this price, Company ABC is unwilling to transact. Answer: No. Company ABC cannot disregard an observable price for an asset simply because it is unwilling to transact at the quoted price. 2.21

45 Fair Value Measurement Using Valuation Models Valuation Models: Generally used only if quoted market prices in active markets do not exist Must consider observable prices and inputs in model, even if market is inactive Cannot ignore information about market participant assumptions if information is reasonably available The Fair Value Continuum Subjective/Unverifiable Reliable/Verifiable Model Valuations Quoted Prices in Active Markets 2.22

46 Fair Value Measurement Using Valuation Models Example: Internal vs. External Market Data Company ABC is using a valuation model to determine the fair value of its holdings of privately placed corporate debt securities. In its valuation model, the Company uses its own assumptions regarding default rates. 2.23

47 Polling Question #4 If market default rate assumptions exists, can Company ABC continue to use its own assumptions if it believes market assumptions are wrong? Yes No Don t know / not applicable

48 Fair Value Measurement Using Valuation Models Example: Internal vs. External Market Data Company ABC is using a valuation model to determine the fair value of its holdings of privately placed corporate debt securities. In its valuation model, the Company uses its own assumptions regarding default rates. Answer: If market participant assumptions regarding default rates exist without undue cost and effort, Company ABC must incorporate these assumptions into its valuation model? 2.24

49 Disclosures Requirements Footnote Disclosures Transparency Concentrations of credit risk Exposure to losses Significant estimates Fair value assumptions 2.25

50 Disclosures Requirements Required Disclosures FAS 107 Disclosures about Fair Value of Financial Instruments Concentrations of credit risk FSP SOP Loan Products that Give Rise to Concentrations of Credit Risk SOP 01-6 Accounting for Certain Entities that Lend or Finance the Activities of Others Off balance sheet credit risk FIN 45 Guarantor s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantee or Indebtedness of Others Maximum amount of potential exposure under guarantees 2.26

51 Disclosures Requirements Required Disclosures (continued) SOP Disclosure of Certain Significant Risks and Uncertainties Significant estimates used in valuations FAS 5 Accounting for Contingencies Loss contingencies FAS 115 Investments in Certain Debt and Equity Securities Unrealized holding gains and losses on investments EITF The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments Unrealized losses less than and greater than 12 months Qualitative information that impairment is not other than temporary 2.27

52 Disclosures Requirements Other disclosures to consider: Disclosures similar to SFAS 157 (if not adopted) If significant unobservable inputs used in FVM Value of assets measured using unobservable inputs Management s credit risk policies Quantitative information about the market risks The effects on income of several possible changes in market prices 2.28

53 Other Key Considerations as Year-End Approaches

54 Other Key Considerations as Year-End Approaches Does your organization have Requisite internal expertise to determine fair value in the current market? 3.1

55 Other Key Considerations as Year-End Approaches Does your organization use or plan to use A third-party pricing source to value financial assets? Cannot outsource responsibility for determining fair value Must independently evaluate and challenge valuation Review valuation methodologies and pricing procedures Monitor for consistency Ensure policy is updated Source: AICPA TPA and AU

56 Polling Question #5 Are a significant portion of your organization s financial assets valued based on unobservable inputs? Yes No Don t know / not applicable

57 Other Key Considerations as Year-End Approaches Does your organization have Sufficient internal controls around its valuation processes? Independent pricing Documented policies Consistency in valuation principles Sufficient oversight monitoring controls 3.3

58 Other Key Considerations as Year-End Approaches Has your organization considered Whether other assets are impaired as a result of the current market conditions? Equity securities Loans receivable held for sale Mortgage servicing rights (MSRs) Goodwill and other intangibles Whether reserves are adequate? Guarantees Loan losses 3.4

59 Other Key Considerations as Year-End Approaches Has your organization considered The SEC Staff Accounting Bulletin No. 74 disclosure requirements related to the adoptions of SFAS 157 and SFAS 159? Notify readers that a standard has been issued Assist readers in assessing the impact of the standard on financial statements 3.5

60 Polling Question #6 Does your organization plan on electing the fair value option in SFAS 159 for certain financial assets or financial liabilities? Yes No Don t know / not applicable

61 Questions and Answers

62 Other Resources Heads Up/Roadmap Series Heads Up Accounting Consequences of Subprime Loan Modifications Financial Reporting Alert Key Accounting Issues and the Current Credit Environment Financial Reporting Alert Center for Audit Quality Issues Final White Papers Accounting Alert Center for Audit Quality Issues Letter Concerning Adoption of Statement 159 Accounting Alert SEC Expresses Concerns about Financial Reporting of Certain Strategies Related to the Adoption of Statement ug ert ert07-5

63 Other Resources Heads Up/Roadmap Series Accounting Alert Accounting Consequence of Certain Investment Strategies in Connection with Adoption of Statement ert07-4

64 Contact Information Jim Johnson Karen Weaver Christopher Rogers Georganne Walters

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67 Appendix Disclosures Additional Information Available upon Request For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see the most recently published company report or visit our global disclosure look-up page on our website at The firm may trade as principal in the fixed income securities (or in related derivatives) that are the subject of this research report. Certifications The views expressed in this report accurately reflect the personal views of the undersigned lead analyst about the subject issuers and the securities of those issuers. In addition, the undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. Karen Weaver

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