Sunday, September 23, 2007

Where to Look for Subprime Risk: Everywhere?

As the subprime lending mess has unfolded, one of the more interesting challenges has been trying to figure out where the subprime risk is. This query is not simply a matter of figuring out which financial institutions engaged in subprime lending (although this surely is part of the equation). The more complicated part of the inquiry is figuring out where all that subprime debt wound up, either as mortgages or after being sliced, diced, and repackaged into mortgage-backed financial instruments sold to investors.

This question is no small inquiry. As noted in a prior post (here), according to the Office of the Comptroller of the Currency, there is over $1.08 trillion in subprime mortgage debt being held outside the lending industry. What that much debt dispersed into the economy, it seems probably that the debt instruments have wound up in some pretty unexpected places. As Gretchen Morgenstern notes in her September 23, 2007 New York Times column entitled "Guess Who's Feeling the Mortgage Pain" (here), "nine months after the meltdown in the home loan market, investors are still waiting for banks, brokerage firms and other companies to come clean on losses incurred" on mortgage-backed securities.

One obvious place to look for this debt is at other financial institutions, as shown, for example, in the case of Scottish Re Group, whose recent disclosure (here) of its exposure to mortgage investment risk rocked its stock price. Morgenstern's September 23rd Times column also discusses potential issues at E*Trade Financial Corporation and the valuation of mortgage-backed assets on its balance sheet. But financial institutions are not the only companies carrying mortgage backed securities on their balance sheets. Nonfinancial companies apparently are also carrying a significant amount of these investments, too.

A September 19, 2007 Wall Street Journal article entitled "Why Firms Like Smucker May Feel Pinch of Debt Crunch" (here) took a look at several nonfincial companies that are carrying mortgage-backed securities on their balance sheets. The companies mentioned in the article include J.M. Smucker (the jelly maker), Garmin (the navigation device manufacturer), Microsoft, Netflix, and Sun Microsystems. These companies invested in the mortgage-backed instruments because they "had been viewed as relatively safe investments that produced slightly better returns than cash and governmental bonds – and could be sold quickly if needed."

The problem for these companies in the current financial environment is how these assets should be carried on their balance sheets, and specifically whether, in light of the complicated valuation questions surrounding these assets, "the cash stated on the balance sheet is a true representation of the cash available to the company." The Journal article states:

The issue for investors is how these companies determine the "fair" value of their mortgage-backed securities in the current environment, and whether they are telling the whole story about how easily these assets can be liquidated -- and for how much.
In light of the current marketplace conditions, "a company’s portfolio of securities might not be fairly valued, and the cash it could raise in a sale could be less than reported."

To be sure, the companies discussed in the Journal article may not face any immediate concerns, because by and large they are cash-rich and face no immediate pressure to sell. In addition, for most of these companies, the mortgage backed assets represent only a small part of their securities holdings. For example, mortgage-backed debt represents just 1.2% of Smucker’s assets (although it does represent 22% of the company’s total marketable securities and 100% of its noncurrent marketable assets.)

But the the list of companies in the Journal article clearly does not encompass the entire universe of nonfinancial companies that hold mortgage-backed assets on their balance sheets. And as the Scottish Re and E*Trade examples cited above shows, for some companies these investments potentially could represent a more significant percentage of assets, and raise much more serious questions regarding balance sheet valuations.

For analysts, investors, D & O underwriters, and others who want to try to understand the extent and location of mortgage investment risk, the dispersion of mortgage-backed securities on balance sheets across the economy poses a double challenge. The first challenge is that the balance sheets of the companies holding these assets may not accurately represent the true value of those companies. The companies could be vulnerable to asset value write-downs or to cash shortfall if forced to liquidate these assets, particularly if forced to accept distressed prices. The other challenge is that the very lack of transparency around asset valuations may itself be an issue, because it raises the potential for later accusations that aggrieved parties were misled about a company’s true financial condition.

The possibilities that these types of exposures could lead to shareholder claims and other disputes may not be purely theoretical. As I have noted in my running tally of subprime lending-related securities class action lawsuits (here), the subprime litigation wave is encompassing an ever-wider variety of companies and involving an increasingly diverse assortment of claims, based on a growing number of kinds of financial problems attributable to the contagion effect of the subprime lending mess. The possibility of a shareholder lawsuit arising out of a company’s exposure to mortgage investment risk may be very real.

As noted in a prior post (here), D & O underwriters have already begin inquiring about companies’ balance sheet exposure to mortgage investment risk. While at least one leading D & O insurer reportedly has sought to introduce a written questionnaire, other carriers for now have been satisfied with obtaining information more informally. It is important for applicants called upon to give supplemental information in meetings or in conference calls to keep in mind that if they make oral representations, the carrier will later look carefully at its ability to deny coverage or even to rescind the policy based on those representations. Well-advised applicants will take the same degree of care in providing answers in a meeting or in a call that they would in providing written answers in a questionnaire.

Special thanks to Dave Hensler for providing me with a copy of the Journal article.

Readers may be interested to know that Dave is one of the numerous prominent experts scheduled to speak at the Mealey's conference on "Subprime Mortgage Litigation," which I will be co-Chairing and which will take place on October 29 and 30, 2007 in Chicago. The agenda and complete list of speakers can be found here.

Jabil Circuit Settles Option Backdating Case: On September 20, 2007, Jabil Circuit announced (here) that it had settled the shareholders’ derivative lawsuits that had been filed against the company as nominal defendant and several of its directors and officers based on options backdating allegations. A Special Review Committee of the company’s Board had been appointed to review the allegations; as the company previously announced (here), the Committee concluded "that there was no merit to the allegations that the Company’s officers or anyone else issued themselves backdated stock options or attempted to cause others to issue them."

Under the settlement, which is subject to court approval, the company agreed to adopt "several new policies and procedures to improve the process through which equity awards are determined, approved and accounted for." The company also agreed that it would not object to an award to plaintiffs’ counsel of $800,000, $600,000 of which will be borne by the company’s D & O insurers.

Climate Change Disclosure: In a recent post (here), I noted the efforts of several environmental groups, state officials, and public pension funds to petition the SEC to try to require publicly traded companies to provide greater disclosure regarding their climate change exposures. In a column in the September 22, 2007 New York Times (here), Joe Nocera gave this initiative "no chance" of being adopted. He went on to describe these efforts as "feats primarily of environmental grandstanding" and noted further that:

The real problem is that these measures, appealing thought they may seem at first glance, are misleading and disingenuous. To put it more bluntly, they are an attempt to use regulation and litigation to force companies to toe the environmentist party line on global warming, and to change corporate business models in ways that are more pleasing to the environmental community. It’s environmental tyranny disguised as public policy.
Nocera concludes his column by noting that "if you want to attack global warming, then for goodness sake, attack global warming. But trying to force change through the bogus mechanism of ‘investor disclosure’? It would be funny if it weren’t so sad."

Nocera is a skilled writer who has written a compelling column. Reasonable minds may differ on his views, and whether or not the reformers’ present efforts immediately succeed, I think their larger goals of compelling publicly traded companies to provide greater disclosure of climate change related issues will, directly or indirectly, succeed over time. I think Nocera is absolutely correct that there is a political agenda at work here, but where I disagree with him is his view that the agenda has "no chance." It may be a question of when, but I think the agenda will succeed sooner or later, and I happen to think it will be sooner rather than later. That is not a statement of my political views, it is simply an observation of the current political and cultural dynamic.

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