Thursday, January 31, 2008

Subprime Litigation Risk: Outside the Financial Sector?

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As I have previously noted (here), securities backed by subprime and other residential mortgages are not just held by financial companies. A wide variety of companies invested in these securities in order to try to improve their return on cash and short-term investments. As the credit markets have deteriorated, many of these investments have declined in value, and the companies holding these investments have been forced to take write-downs or charges. The most dramatic write-downs have come from companies in the financial sector. But now companies outside the financial sector are announcing downward accounting adjustments, and some of these accounting adjustments are occurring in some unexpected places.

The most significant of these downward accounting adjustments outside the financial sector so far was announced in connection with the January 31, 2007 fourth quarter and year end earnings release (here) of Bristol-Myers Squibb. The company reported an overall net fourth quarter loss of $89 million. The loss included "an impairment charge of $275 million on the company’s investments in auction rate securities." The company reported that it has a total of $811 million invested in auction rate securities (ARS), the underlying collateral for some of which "consists of sub-prime mortgages."

The company reported that as a result of "multiple failed auctions" and downgrades, the year-end estimated market value of the ARS investments was $419 million. Although the ARS continue to pay interest, as a result of valuation models and "an analysis of other-than-temporary impairment charges," the company recorded an impairment charge of $275 million, and an unrealized pre-tax loss of $142 million. The company noted that if the credit market deteriorates further, "the company may incur additional impairments."

Bristol-Myers Squibb is not the only company outside of the financial sector to report a write-down or to take a charge based on deterioration of mortgage-backed assets. In its December 13, 2007 fiscal fourth quarter earnings release (here), Ciena reported a $13 million loss related to commercial paper issued by two structured investment vehicles (SIV) "that entered receivership and failed to make payment at maturity." And in its January 7, 2008 fiscal second quarter earnings release (here), Lawson Software reported that its revenue gains were offset by a non-operating permanent impairment charge of $4.2 million…to reduce the fair value of the auction-rate securities held by the company.

While these downward accounting adjustments are noteworthy, they do have to be put in perspective. Bristol-Myers Squibb’s $275 impairment charge should be looked at in conjunction with the company’s $2.2 billion in cash, cash equivalents and short-term securities, that it carries on its balance sheet in addition to the principal the company invested in ABS. Ciena’s $13 million loss needs to be put in the context of the company’s $1.7 billion total cash position. These companies’ adverse financial developments, while negative, certainly do not threaten these companies’ financial health.

The significance of these financial adjustments is that they happened at all; their occurrence strongly suggests that other companies outside the financial sector may also find themselves taking charges or write-downs. Some of these accounting adjustments may not be as relatively insignificant as they were for the companies mentioned above, and it is possible that some of the downward adjustments could involve a more significant impact on these other companies.

Along those lines, the Tech Trader Daily blog had an interesting recent post entitled "Tech More Exposed to Debt Troubles Than You Think" (here), in which it reported on a Merrill Lynch analysis of 190 technology companies. The analysis sought to determine which of these companies had invested their cash in "mortgage-backed securities, asset-backed securities, auction rate issues and paper issued by government-sponsored enterprises like Fannie Mae." The study found that 22 of the companies studied had "25% or more of their cash in these potentially risky categories."

Among companies specifically mentioned were Foundry Networks (with 68.3% of its $946 million cash "at risk"); Texas Instruments (66.2% of its $3.9 billion cash); Entergis (62.4% of its $126 million cash); Photon Dynamics (53.9% of its $90 million cash); Novellus (52.5% of its $1 billion cash) and Intersil (47.1% of its $578 million).

Whether these or other companies will be making downward accounting adjustments as a result of their holdings in these "risky categories" of investment remains to be seen. But the list clearly suggests at least the possibility that one or more companies could wind up taking charges or write-downs that would have a greater impact than those of Bristol-Myers Squibb or Ciena.

These kinetic possibilities pose an enormous risk for investors and for D & O underwriters. The uncertainty around where these "risky categories" of assets may reside and about whether or not these assets create balance sheet or income statement vulnerabilities makes investment and underwriting assessments enormously complicated. Indeed, the very lack of transparency around these issues could itself become an issue, because it raises the potential for later accusations that aggrieved parties were misled about a company’s true financial condition.

To be sure, there have as yet been no shareholder claims against companies outside the financial (and residential home construction) industries on these types of issues as part of the current subprime litigation wave. But as I demonstrated in my year-end analysis of the 2007 subprime-related securities lawsuits (here), the subprime wave has already expanded to encompass a broad variety of different kinds of defendant companies. At this point, the prudent assumption is that lawsuits arising out of nonfinancial companies’ exposure to mortgage-related investment risk will arise. This potential creates a very significant challenge for D & O underwriters as they attempt to underwrite, segment, and price the subprime risk, which is now clearly not limited just to the financial sector.
UPDATE: The February 1, 2008 Financial Times has an editorial entitled "Writedown Infection Spreads" (here) which is very much in the same vein as this blog post, and specifically discusses the Bristol Myers' subprime related accounting action.

Special thanks to Thomas Smith for alerting me to the Bristol-Myers impairment charge and to a loyal reader who also flagged the Brisol-Myers action and sent along the Tech Trader Daily blog link.

One More Thing to Worry About: Credit Default Swaps: As the recent turbulence involving the bond insurers has demonstrated, another type of complex instrument with which we are all going to have to get familiar is the credit default swap. According to the Seeking Alpha blog (here), the notional value of the CDS market is in excess of $45 trillion, of which the major financial institutions hold about 40% -- the implication being that the other 60% is held by somebody other than the major financial institutions.

The kind of threat this might represent is demonstrated in the January 2007 Second Circuit decision in the Aon Financial Products v. Société Générale case (here). To simplify, AON had provided a credit default swap to another party, and to protect itself, in turn bought a credit default swap from SG. The ultimate debtor defaulted, AON paid its guarantee, but SG refused. The Second Circuit held, in effect, that because of the differences in the way different guarantees were worded, SG did not have to pay even though AON did, so AON lost $10 million rather than making $100,000.

The Seeking Alpha blog post linked above has a very good short summary of the case. The blog post notes that the case provides "a fascinating insight into the risks posed by credit default swaps and demonstrates how even financial institutions and hedge funds that have used such instruments prudently may find themselves facing unexpected damages in the coming months as default rates begin their inexorable upward climb."

Special thanks to a loyal reader for the link to the Seeking Alpha post.

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