The 21st Century Credit Crisis

• Author: Eric C. Blue, Esq.
• Position: Associate in the Dallas office of Akin, Gump, Strauss, Hauer & Feld, LLP
• Pages: 04

Eric C. Blue, Esq. is an associate in the Dallas office of Akin, Gump, Strauss, Hauer & Feld, LLP. His practice focuses on corporate and securities law, with a concentration in the formation of domestic and offshore private investment funds. Mr. Blue is also a 2006 graduate of The University of Texas School of Law and a member of the Maryland State Bar Association.

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The widespread dispersion of the credit and default risk associated with subprime mortgages and securitized mortgage products, such as collateralized debt obligations (CDOs) and mortgage-backed securities (MBS), that has spread throughout the United States and international financial markets, appears to have been, in part, the result of a severe market correction in the real estate asset class, which has resulted in a reduction in home values and, in some cases, the negative amortization of the balances on outstanding mortgages.¹ This correction almost immediately impacted the banking sector and has had a precipitous effect on the ability of financial institutions to shore up their balance sheets through debt or equity issuances and has further resulted in the government bailout of a number of firms² and the bankruptcy of others.³ Throughout the evolution of this financial crisis, by late August of 2008, the impact on the liquidity of market participants began to extend to characters outside the retail and investment banking sectors, resulting in only the financially strongest of firms being able to raise capital through the bond markets. However, more recently, the impact of the crisis has spread to the commercial paper market and other forms of financing used by an increasingly large range of firms, including investment-grade institutions.⁴ This impact has resulted in a higher cost of capital for those firms that are still able to access the commercial paper market.⁵

If the magnitude of this current economic crisis could be argued to have been overshadowed by anything, it would be the United States Treasury Department’s proposal for “the mother of all bailouts.”

If the magnitude of this current economic crisis could be argued to have been overshadowed by anything, it would be the United States Treasury Department’s proposal for “the mother of all bailouts.” Treasury Secretary Paulson’s initial proposal for a $700,000,000,000 bailout package was sent by the White House to lawmakers on September 19, 2008. Section 2(a) of the original version of the “Legislative Proposal for Treasury Authority to Purchase Mortgage-Related Assets” provided that “[t]he Secretary is authorized to purchase, and to make and fund commitments to purchase, on such terms and conditions as determined by the Secretary, mortgage-related assets from any financial institution having its headquarters in the United States.”⁶ Section 6 of the proposed legislation provided that “[t]he Secretary’s authority to purchase mortgage-related assets under this Act shall be limited to $700,000,000,000 outstanding at any one time.”⁷ Since the initial proposal was put forth by the Treasury Department, there have been at least three (3) additional legislative drafts that have sought to enhance taxpayer protections and provide greater incentives for the federal government to share in the upside of any gains associated with the bailout. However, each draft resolution has been built upon the same basic framework, which involves the fundamental premise of governmental intervention in this economic crisis.⁸

This article will first provide a brief overview of the process of securitization in the real estate asset class, providing some high level assessments of the “ordinary” risk/return profile in an efficient market of an asset backed security, such as a CDO or MBS. Next, the article will attempt to build a causal connection between the now well-documented, broad-based market correction in the real estate asset class and the devaluation of the real estate backed asset securities market, resulting in the credit and liquidity crisis currently engulfing the U.S. and the global economy. Lastly, this article will survey the proposed emergency legislation from two important perspectives—a determination of fair value for troubled assets and the contribution of private participants in the acquisition process.

The Nuts and Bolts of Asset Securitization

Securitization is a process that involves the pooling and repackaging of cash-flow producing assets into securities that are then sold to investors. Any asset with a predictable stream of positive cash flow can be securitized. The process of securitizationPage 6 begins with a cash flow generating pool of assets, such as mortgages on real estate assets, that are originally held by a company or family of companies. In order to fully understand the motives behind an originator’s decision to securitize assets a quick lesson on present value analysis may prove beneficial.

For illustration purposes, let’s call our originator Quick Mortgage, Inc., and let’s say that Quick Mortgage, Inc. is a publicly-traded mortgage company that has underwritten $100,000,000 of adjustable rate mortgages over the last twelve (12) months.⁹ Quick Mortgage, Inc. determines that it would like to expand its base of operations by making loans into the high-flying south Florida condominium market and needs approximately $50,000,000 in new capital to do so. Unfortunately, because of the current dislocation of the credit and equity markets, which has resulted in shares of Quick Mortgage, Inc. being down fifty percent (50%), Quick Mortgage’s ability to raise the necessary capital through a debt or equity issuance is very slim and would be extremely expensive.

However, Quick Mortgage, Inc. has $100,000,000 of mortgages that are currently generating $520,833.00 in gross proceeds every month or $6,249,996.00 per year. Quick Mortgage, Inc. decides that securitizing these mortgage loans provides a viable alternative to accessing the capital markets.¹⁰ Additionally, increasing revenues without balance sheet financing benefits a firm such as Quick Mortgage for an additional, unintended reason; it allows the firm to increase earnings per share with the same debt-to-equity ratio.¹¹ Having made the determination that securitization is the path of least resistance for the capital raise, Quick Mortgage will pool the 100 loans together and will sell them to a special-purpose entity (SPE). The SPE will then “issue several securities backed by a beneficial interest in the receivables on these mortgages.”¹² Quick Mortgage will remove these 100 loans from its balance sheet and will then use the proceeds from selling the loans to issue new loans.

Investors will purchase the securities¹³ either through a private offering (targeting institutional investors) or on the open market. The pricing of these securities can be a highly complicated process, but, for the sake of our discussion, the price of a CDO or MBS can be quoted as a spread to a corresponding swap rate. For example, the price of our AAA-rated security might be quoted at five basis points (or less) above the swap-rate for a security issued by a benchmark issuer with a similar yield-to-maturity date (e.g. Treasuries to one month LIBOR). The SPE will then slice the securities into four tranches, each reflecting the risk/reward profile associated with a particular segment of the underlying mortgages. Tranches with a first lien on assets are typically referred to as “senior tranches” and are generally safer investments. Historically, investors who have purchased these securities tend to be insurance companies, pension funds and other risk...