Subprime Lending Issues of Valuation

1. March 18, 2008 R. Larry Johnson Veris Consulting, LLC Subprime LendingIssues of Valuation

2. Summary Questions • What and how GAAP should be applied? • Were the valuation methods appropriate? • Were the assumptions about the future reasonable? • Was the need for loss recognition a result of new information or changed circumstances? 2

3. Valuation Measurements Valuation/Impairment measurements vary under US GAAP based on type of asset 3

4. Mortgage loans MBS, CDO and other structured securities Sale transactions Servicing Rights Residual Interests Repurchase Obligations Municipal Bonds Lenders Originators Servicers Investors Banks Insurance Companies Mutual Funds Insurers The Assets and Holders 4

5. Traditional Lending Without Securitization Lends money secured by real estate BANK HOMEOWNER Pays principal and interest 5

6. Valuation of Mortgage Loans • Investment • Ability and Intent • Impairment • FAS 65, Accounting for Certain Mortgage Banking Activities • Loan loss reserves • FAS 5, Accounting for Contingencies 6

7. Valuation of Mortgage Loans • FAS 5, Accounting for Contingencies: • An estimated loss from a loss contingency shall be accrued by a charge to income if both of the following conditions are met: • It is probable that an asset has been impaired or a liability has been incurred at the date of the financial statements • The amount of loss can be reasonably estimated 7

8. Valuation of Mortgage Loans • AICPA Audit and Accounting Guide, Depository and Lending Institutions: Banks and Savings Institutions, Credit Unions, Finance Companies and Mortgage Companies: • FAS 5 prohibits loss recognition when events causing losses have not yet occurred • Future losses should not be provided for at the time loans are made • Events causing losses or impairment have not yet occurred • Generally, a loan would be impaired at origination only if a faulty credit granting decision has been made or loan credit review procedures are inadequate or overly aggressive, in which case, the loss should be recognized at the date of origination 8

9. Valuation of Mortgage Loans • Held for Sale • FAS 65, Accounting for Certain Mortgage Banking Activities: • Shall be reported at the lower of cost or fair value, determined as of the balance sheet date • The amount of the reduction shall be reported as a loss • The carrying amount of the loan shall be reduced to its expected collectible amount, which becomes the new cost basis 9

10. Valuation becomes more complex when securitization is involved… 10

11. The Impact of Securitization Homeowner P&I Mortgage $$ Servicer Lender/Conduit Mortgage Broker Mortgages $$ P&I Trustee Trust (SPE) ABS/MBS $$ Insurer Underwriter/ Placement Agent Rating Agency $$ ABS/MBS/PMI Individuals, Pension Funds, Insurance Companies, Mutual Funds, Hedge Funds Financial Interests $$ Individuals 11

12. Example of Calculation Model to Value Structured Securities • Since the default event of each asset is uncorrelated, the probability of J defaults in the portfolio simply follows binomial distribution (DS: diversity score. PD: probability of default for each asset) • With this distribution, the expected loss (EL) for each CDO tranche can now be calculated: (Lj: loss for a given tranche with J defaults) 12

13. MBS/CDO/Other Structured Securities • FAS 115, Accounting for Certain Investments in Debt and Equity Securities: • Held to maturity • Investment carried at amortized cost: subject to permanent impairment • Trading • Investment carried at fair value • Change in value recorded in income statement • Available for sale • Investment carried at fair value • Change in value recorded in equity 13

14. Sale of Mortgages • “True” Sale • Gain on Sale if: • Transferred assets isolated from transferor (SPE) • Transferee has right to pledge or exchange the assets • Transferor does not retain effective control 14

15. Sale of Mortgages • “True” Sale • Derecognize assets sold • Measure assets and liabilities at fair value • Recognize gain or loss 15

16. New Assets/Liabilities • Servicing • Residual Interests • Repurchase Obligations • All at Fair Value 16

17. FASB’s Road to Fair Value Accounting • SFAS 107 – Disclosures about Fair Value of Financial Instruments (12/91) • SFAS 115 – Accounting for Certain Investments in Debt and Equity Securities (5/93) • SFAS 119 – Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments (10/94) • SFAS 133 – Accounting for Derivative Instruments and Hedging Activities (6/98) • SFAS 137 – Accounting for Derivative Instruments and Hedging Activities-Deferral of the Effective Date of FASB Statement No. 133 (6/99) • SFAS 138 – Accounting for Certain Derivative Instruments and Certain Hedging Activities (6/00) • SFAS 149 – Amendment of Statement 133 on Derivative Instruments and Hedging Activities (4/03) • SFAS 157 – Fair Value Measurements (9/06) • SFAS 159 – The Fair Value Option for Financial Assets and Financial Liabilities (2/07) 17

18. FAS 157, Fair Value Measurements • Issued September 2006 • Effective years beginning after November 15, 2007 • Early adoption permitted • Defines fair value • Establishes a framework for measuring fair value • Expands disclosures about fair value measurements • FASB recognized: • Different definitions of fair value in existing guidance • Limited guidance for applying those definitions • Guidance dispersed among many accounting pronouncements • Differences in guidance created inconsistencies that added to the complexity in applying GAAP 18

19. FAS 157, Fair Value Measurements • Price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants • Illiquid Assets • Present value techniques • Pricing models 19

20. FAS 159, The Fair Value Option for Financial Assets and Financial Liabilities • Permits entities to choose to measure many financial instruments and certain other items at fair value • Expected to expand the use of fair value measurement • Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings 20

21. Valuation Requires Specialized Knowledge • Due to the complexity of many of the securities, it is likely that companies and auditors will utilize valuation experts to determine the value of the securities • SAS 73 provides guidance to the auditor who uses the work of a specialist in performing an audit in accordance with GAAS • Provides, as an example, the valuation of complex financial instruments 21

22. The Limitations of Financial Statements • Significant estimates • Historical in nature • Limited ability to assess the future 22

23. The Limitations of Financial Statements “Those who use financial information for business and economic decisions need to combine information provided by financial reporting with pertinent information from other sources, for example, information about general economic conditions or expectations, political events and political climate, or industry outlook.” “Financial information is a tool and, like most tools, cannot be of much direct help to those who are unable or unwilling to use it or who misuse it.” FASB Statement of Financial Accounting Concepts No. 1, Objectives of Financial Reporting by Business Enterprises 23

24. The Limitations of Financial Statements “Changes in estimates used in accounting are necessary consequences of periodic presentations of financial statements. Preparing financial statements requires estimating the effects of future events. Examples of items for which estimates are necessary are uncollectible receivables…Future events and their effects cannot be perceived with certainty; estimating, therefore, requires the exercise of judgment. Thus accounting estimates change as new events occur, as more experience is acquired, or as additional information is obtained…” “A change in an estimate should not be accounted for by restating amounts reported in financial statements of prior periods or by reporting pro forma results for prior periods.” APB Opinion 20, Accounting Changes 24

25. Summary Questions • What and how GAAP should be applied? • Were the valuation methods appropriate? • Were the assumptions about the future reasonable? • Was the need for loss recognition a result of new information or changed circumstances? 25