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The management of Rosetree Mortgage Opportunity Fund was planning on the purchase of U.S. residential mortgages. It needs to come up with the right valuation on how much to bid.
Victoria Ivashina; Andre F. Perold
Harvard Business Review (209088-PDF-ENG)
December 05, 2008
Case questions answered:
- Why is the $65 million loan portfolio a potentially interesting investment? Focus on the specific positives and negatives of the pool as well as the broader environment in which the purchase is taking place.
- Why is Rosetree Mortgage Opportunity Fund in a good position to buy the loan portfolio in question? Consider Rosetree’s history, Isabel Villegas’ expertise, and the setup of the fund itself.
- Use the data from Exhibits 7 and 8 to construct a set of CAPM-based discount rates to value the pool of loans. Instructions: Calculate an “asset-level” beta from the “equity” betas and Equity/EV (EV = enterprise value) ratios, and assuming that the beta on debt is zero. [You may be wondering, “Why do we do this?” The answer to why we use an un-levered or asset-level beta is because, with high average LTVs on the loans in the pool, the loans are equivalent to the physical housing assets. We assume the beta on debt to be zero as a common convention for simplicity of calculations, and because in practice, actual debt betas tend to be quite low]. So the formula is: β_Asset=β_Debt*Debt/EV+β_Equity*Equity/EV or… β_Asset=β_Equity*Equity/EV Then use that beta to construct a set of discount rates: r=r_f+β_Asset*equity risk premium For the risk-free rate, r_f, use the average of the 10, 15, 20, and 30-year treasury yields from exhibit 8. For the equity premium using 3%, 5%, and 7%. Use the three discount rates to discount the future cash flows of the pool (the column labeled “Total” NOT “Total” minus “Losses”) back to the present, under each of the four cash flow scenarios (slow growth, moderate recession, severe recession, and severe recession with renegotiation), thereby valuing the pool. Construct a 3 x 4 table summarizing your answers and clearly label the rows/columns. Presumably, not all of the REITs in Exhibit 7 are appropriate as proxies for the beta of the Rosetree pool. Which REITs did you choose to include in your calculation and why?
- In what range of values should Rosetree bid, based on the returns it thinks it should be able to earn on the portfolio, per page 4 of the case? Construct a 2 x 4 table summarizing your answer, clearly labeling the rows/columns. Explain why this set of valuations differs from the valuations you obtained in question 3. In other words, under what circumstance(s) is the CAPM a good way of constructing a discount rate, and do those conditions apply here?
- Is Rosetree a “vulture” (AKA an animal that feasts on the dead carcasses of other animals), or do you believe they serve a beneficial purpose as a financial intermediary in difficult times? Explain your answer using what you know about delinquency resolution and deadweight loss.
- Why is the $65million loan portfolio a potentially interesting investment? Looking at the loan characteristics, what are some of the potential positives and negatives of these portfolio loans (look and evaluate those very carefully)?
- What is the loan portfolio’s fair market value? Perform a discounted cash flow analysis. State and justify any assumptions you make clearly (but, again, do not focus too much of the write-up on the specific assumptions). Ignore potential taxes throughout.
- How much should Rosetree bid? (Note: you can assume that Rosetree would not use leverage.) How does this bid compare with the value you determined in part (2)? Based on those prices, also try to provide some statistics on expected returns (IRR) and risk. Discuss potential issues that may arise.
- In your analysis, you may have found that significant value can be unlocked by restructuring the troubled mortgages in the portfolio. Assume that the seller bank was not pressured to liquefy their balance sheet. What may prevent the bank from restructuring these mortgages itself (and unlocking value)? In other words, why may Rosetree be in a better position to restructure?
- The portfolio has an outstanding principal of $65m with an average LTV of 100% (LTV, or Loan-to-Value, measures the outstanding debt in relation to the value of the home that serves as collateral). Why is the offer price you determined in the first part (significantly?) lower than $65m?
- When performing a DCF valuation of the project, why did you need to adjust the betas of the comparable companies for leverage effects?
- Exhibits 1 and 2 show that only 13/175 loans are delinquent (Ex.2) and that for the 50% ARMs, the weighted-average months to first reset is 54 months (Ex.1). Does this information matter for you, and if so, is this a good thing or a bad thing (or perhaps both) and why?
- Which party of the transaction is putting together the mortgage portfolio? With relation to information asymmetries, how could this create an issue for Rosetree Mortgage Opportunity Fund, and how is Rosetree addressing potential concerns here?
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Case answers for Rosetree Mortgage Opportunity Fund
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1. Why is the $65 million loan portfolio a potentially interesting investment? Focus on the specific positives and negatives of the pool as well as the broader environment in which the purchase is taking place.
- Because it is December 2008, the people holding subprime mortgages are too highly leveraged and have a lot of pressure to liquidate their assets, meaning they may accept a lower price. Residential mortgages totaled 55 million in number, with an outstanding principal of around $11 trillion. Of these, 10 million mortgages with an initial principal of over $2.2 trillion were considered “subprime” and “Alt-A.” This gives Rosetree a lot of options for what to buy.
- In 2006, approximately 20% of all mortgages generated were subprime, up from 5% in 1994 and 8% between 2001 and 2003. This could be a pro considering Rosetree specializes in high-yield and distressed debt portfolios.
- Whole loans, which we would be buying, are particularly attractive since it would be possible to identify and work with individual borrowers to restructure their debt.
- The loans were all first-lien mortgages, and over 70% of them were the only mortgages outstanding on the property. No one else to fight with over the mortgages
- The average FICO score on the loans was 679, which is good, considering the nationwide subprime pool had a median FICO score of 620.
- Overall, 13 out of 174 loans in the portfolio were in delinquency. Still, the delinquency on these loans was below 30 days. Only a small fraction of recently delinquent loans would usually default (Moody’s projected that only 3.75% of loans delinquent for less than 30 days would default in the next 18 months).
- The average LTV ratio of the mortgages was 76% based on home values at origination (pro), but since the fall in housing prices, Rosetree estimated that the LTV now averaged 96% (con).
- Villegas believed that Rosetree was the only bidder currently reviewing the opportunity, but she could not be sure. This could pressure them to give a better price (pro) and mean there are negatives about the portfolio we have not looked at (con).
- 89% owner-occupied, so they are more likely to want to pay it
- 6% Adjustable Rate Mortgages vs. 80% in the average subprime pool
- 4 ½ years to the first-rate reset on the hybrids (pretty long time to resolve before you see a rate spike)
- 60% purchase loans vs. 40% refinance. Refi loan is based on an appraisal, while the purchase loans are based on an actual transaction.
- Over time, the standards for what constituted adequate cushion declined, and by 2005 and 2006, debt rated AAA was being issued against subprime mortgage pools with cushions below 20%.
- The portfolio included loans from 20 different states, with 41% of the properties located in California and nearly 12% in Florida, the places hit hardest by the crisis.
- 90% of the loans originated in early 2007, and a huge portion of the loans originated in that year ended up in default.
- Only a third of the portfolio loans had full documentation, and nearly 20% of the loans had no documentation when Rosetree was reviewing the transaction.
- The projections made no assumptions about mortgage resale (mortgages not foreclosed on were assumed to be held until fully paid).
2. Why is Rosetree in a good position to buy the loan portfolio in question? Consider Rosetree’s history, Isabel Villegas’ expertise, and the setup of the fund itself.
Rosetree Capital Management has a long history of investing in distressed credit instruments, and they were interested in the opportunity in troubled residential mortgages.
It was an attractive opportunity for large and small banks, as they were under pressure to liquefy their balance sheets, and residential mortgage loans and securities represented a substantial portion of their balance-sheet assets.
Rosetree wanted to purchase this pool at a discount to work with individual borrowers to restructure their debt. Loan renegotiation is not easy; however, Rosetree had developed creative techniques for making borrower contact, including using technology and incentives (such as rewards for returning phone calls).
Unlike many loan services, Rosetree Mortgage Opportunity Fund would also…
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