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Current Trends in the Capital Markets Including the Subprime Meltdown. January 17, 2008. Amy Hayman Managing Director Cain Brothers One North Franklin, Suite 300 Chicago, IL 60610 (312) 604-0578 email@example.com. Table of Contents. Performance and Current State of the Markets
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Current Trends in the Capital Markets Including the Subprime Meltdown January 17, 2008 Amy Hayman Managing Director Cain Brothers One North Franklin, Suite 300 Chicago, IL 60610 (312) 604-0578 firstname.lastname@example.org
Table of Contents • Performance and Current State of the Markets • Subprime Meltdown • Who Are The Players and What Do They Want? • Market Opportunities and Strategies
Where are Long Term Fixed Interest Rates Today Relative to the Past? While it is impossible to predict future interest rates, history suggests that it is more likely that rates will increase than decrease.
Where are Short-term Interest Rates Relative to Long-term Interest Rates? Long-term interest rates are close to the average variable interest rate since 1985. Long-term vs. Short-term Interest Rate 2000 to Today * SIFMA is the Securities Industry and Financial Markets Association Index, previously known as BMA
Variable Rate vs. Fixed Rate Tax-exempt Interest Rates • The Bond Buyer Revenue Bond Index represents the arithmetic mean of the yield on 25 various municipal revenue bonds each with a maturity of 25 years and a rating of A1 by Moody’s. • The SIFMA Municipal Swap Index is a 7-day high-grade market index comprised of tax-exempt variable rate demand obligations.
What is the Shape of the Yield Curve? While long-term swap rates have remained near historic lows, short-term rates have risen resulting in a negative slope at the beginning of the yield curve.
How Does the Current Yield Curve Impact a Forward Starting Transaction? The shape of the yield curve, although steeper than previously, has reduced the forward premium on forward starting agreements.
What is the Likely Impact on the Economy? Historically, the yield curve has been a pretty good predictor of recessions. Yield Curve Inversion and Recessions Since 1977
Where is the Impact Likely to be Felt? Housing Market Indicator S&P/Case-Shiller Home Price Index – 10 City Composite 1990 - 2007
What is the Likely Impact on Market Relationships? Short Term Interest Rates Spread Between 1 Mo. LIBOR and BMA 1990 - 2007 On average, since 1990, BMA has equaled 68.1% of LIBOR (Since 1992, BMA has equaled 67%). Average
Will Stock Market Performance Prove Any More Predictable? Morgan Stanley World Equity Index Two Year Annualized Returns 1990 - 2007 Average
What are the Takeaways? • Subprime Meltdown has tightened the credit markets. • Subprime Meltdown has resulted in increased capital costs for existing variable rate insured issues. • Quality spread curve has widened significantly. • Not all ‘BBBs’ are created equally. • Short term interest rates are much higher than in recent years. • Predicted to decrease with Fed Fund cuts. • Long term interest rates remain at or near historic lows. • Interest rate curves have steepened resulting in increase cost of forward premiums. • Based on historic relationships, a recession in the US likely. • Housing prices throughout the US have begun to decrease. • Taxable vs. tax-exempt interest rate spreads have returned to historic norms. • Equity market returns will remain volatile.
Economic Slowdown Implications for Hospitals • Rise in uninsured and underinsured; increased charity care and bad debt expense • Volume softness • Federal and state reduction in Medicare/Medicaid programs • Proposed universal healthcare coverage on hold or abandoned • More expense reductions • Capital spending deferred; growth strategies put on hold * Moody’s Investors Services, Outlook for Not for Profit Healthcare, 2008
Trends in Health Care - Market Players • Rating Agencies remain active • More Banks interested in providing direct pay Letters of Credit [LOC] • More competitive compared to Variable Rate Insured Paper • Insurers providing bond insurance policies • ‘AA’ and ‘AAA’ insurers • Recent reduction for insured variable rate auction and demand bonds • Subprime mortgage investments have impacted bond insurers • Due diligence and financial reporting • Bond market is demanding increased disclosure • Covenants have been tightening
Trends in Health Care- Monetizing Assets • Demand for capital, low capitalization rates along with operating margin pressures are leading Organizations to monetize assets • Cap Rates have increased • Focus turning towards core assets • Smart money is still pouring into health care, although on a more select basis • Investors are bidding up values of health care targets • Proceeds from sale of ancillary businesses and non-core assets are being redeployed into core activities
Not-For-Profit Health Care Ratings Historically, Non Profit Healthcare Facilities have had financial trouble. Source: S&P, Moody’s and Fitch
The Subprime Meltdown • What is a subprime mortgage? • A mortgage made to higher-risk borrowers with lower income or less credit history than “prime” borrowers • Share of subprime mortgages to total originations increased from 9% in 1996 to 20% in 2006 • Many subprime mortgages included lending incentives • Interest Only (IO) loans • Adjustable Rate Mortgage (ARM) • Borrower runs the risk of higher reset • Reset of IO loan to begin paying Principal • Reset of Interest Rate on ARM which could be a substantially higher rate
The Subprime Meltdown • Why is this becoming a problem now? • When housing market strong, many took advantage of refinancing opportunities • As housing prices started to drop, refinancing became more difficult • By October 2007, 16% of the subprime loans with adjustable rate mortgages were 90 days into default or in foreclosure proceedings (1) • Who was impacted? • Mortgage Lenders were first to be impacted • Investment and Commercial Banks with Mortgage Portfolios • Holders of Mortgage Backed Securities (MBS) • A financial instrument sold to investors derived from bank’s securitization of a pool of mortgages • What’s Next? • Record number of resets coming due in 2008 • US Legislators and Treasury Department taking action to curtail the disastrous effects • Initiating plan to limit or defer interest rate adjustments for certain borrowers • Lending practices under scrutiny and being reevaluated (1) http://www.federalreserve.gov/newsevents/speech/bernanke20071015a.htm
The Subprime Meltdown – How does this affect the municipal market? • Municipal Bond Insurers also backed debt instruments holding MBS • Insured Bonds trading at premium since August due to concerns surrounding potential downgrades • Rising debt have caused credit concerns in muni markets • News surrounding meltdown has created general panic with investors holding muni-bonds • New insured issues selling on a fixed rate basis • Rating Agencies now pressuring insurers to raise capital to cover potential losses on those securities or face downgrade • ACA has been downgraded to CCC • What’s Next? • Bond Insurers may need capital injection to maintain their ratings • CIFG received $1.5 billion to support its ‘AAA’ rating at the end of November • MBIA received $1 billion capital infusion from Warburg Pincus LLC, a private equity firm in December • MBIA was in jeopardy of losing their ‘AAA’ rating before infusion
How Has Radian Asset Assurance been affected? • Market Dislocation Due To Sub-Prime Mortgage Concerns • Variable rate interest costs began rising in August as credit conditions in the capital markets deteriorated due to problems in the sub-prime market sector. • Market Perception Of Radian Deteriorated • Market appetite soured for Radian-insured paper, not because of Radian Asset Assurance, but because Radian’s parent corporation was seen as having exposure to the sub-prime mortgage market through an affiliate. • Money Market Funds and Retail investors lost appetite for Radian paper • Money Market Funds are primary buyers of tax-exempt VRDBS and are limited by SEC Regulations to what they can hold, including ‘AA’ insured bonds. • Because of potential downgrade, many funds did not reinvest • Radians’ Ratings Stabilized Following An Intense Review By The Agencies • Fitch downgraded Radian Asset Assurance’s ratings to A+ and Radian asked Fitch to discontinue its rating. Both Moody’s and S&P reaffirmed Radian Asset Assurance’s ratings at Aa3/AA.
What Does the Future Hold? “What we are seeing now is risk being repriced, and a different perspective on risk, which I think is healthy.” - Treasury Secretary Henry Paulson, July 27, 2007 What is likely to happen following the recent turmoil in the credit markets? • It will increase companies borrowing costs for some time, but have just a minor impact on the economy • It will increase borrowing costs for a substantial period and be a significant contributor to economic slowdown • It will prove to be a short term event with no impact on the economy = 65% = 31% = 4% 27 ____________________ Source: Wall Street Journal Poll of leading economists.
Market Players • Rating Agencies • Credit Enhancers • Bond Investors • Equity Providers
Market Players Look For Steady Improvement Over Time… • Consistency • Average Performance Is More Important than Boom and Bust Performance • Market Players look for a Solid Financial Profile Profit From Operations (not just from investment reserves) • Information • Cash is king
Market Players Look for a Solid Financial Profile • Aligned with mission and goals of organization • Predictable performance based on well-defined targets • Financial model can support future needs, not just status quo
Market Players Look for Strong Leadership • Governance • Management • Accountability • Planning • Financial Stewardship
Market Players Review Many Areas of Your Business • Facility • Market • Competition • Rates Comparison • Demographic Trends • Real Estate and Economic Data • Revenue Sources – • Reliance on Government Reimbursement Programs • Investment Income/Investment Policy • Charitable Contributions • Constituency Support and Future Viability • Occupancy
Market Players Look for Clear Communication “Disclosure is good as long as everything is going well.” (Anonymous) • Timeliness • Completeness in Content • Accuracy • Format • Management Responsiveness
What Opportunities Do Today’s Markets Present? • Monetizing Assets • Hedging Interest Rate Exposure • Restructuring Fixed Rate Debt • Distressed Situations • Optimizing Investment returns with downside protection
Case Study #1 • Opportunity: Selling non core asset to maximize return of investment • Situation: Client had a CCRC that was performing below Core operations level. Client did not have an expertise in senior living and had a need for cash for their core operations • Solution: • Completed repositioning analysis to show potential buyers how bottom line could be significantly improved • Repositioning analysis helped lead to 11 bids all over asking price with the winning bid equaling a 6% cap rate • Benefits: • Client received approximately $8 million over appraised value • Client redeployed sale proceeds into Core operations
Case Study #2 • Opportunity: Restructuring Fixed Rate Debt, Hedging Interest Rate Exposure • Situation: Client had $26.0MM of high coupon fixed rate bonds under which it was in violation of financial covenants and approaching default on next interest payment date. • Solution: • Repurchased existing bonds for $21.5MM (17.0% discount) • Issued $22.0MM of variable rate, letter of backed refunding bonds • Purchased $22.0MM 4.0% 3 year interest rate cap • Benefits: • Client was able to reduce its annual debt service 20.0%, producing a debt service coverage ratio of 1.5X • Interest rate cap ensured debt service coverage would not go below 1.35X with premium paid over time
What are My Options for Managing Interest Rate Exposure? Deciding to do nothing is a decision. Do Nothing Cap Collar Swap
Case Study #3 • Opportunity: Refunding Fixed Rate Debt, Hedging Interest Rate Exposure • Situation: Client had $35.0MM of high coupon fixed rate bonds that were callable in 2008, would produce significant savings on an advance refunding but could not be advance refunded. • Solution: Executed a forward starting interest rate swap that locked in the future benefits of the refunding. • Benefits: • Client was able to lock-in expected present value savings of 13.0% • Interest rate swap starts on future call date
Regardless of the financing structure employed, you can lock-in the cost of capital on the future financing based on the current interest rate market. Execute Forward Swap Swap Payments Begin Swap Terminates 1/17/08 3/15/09 3/15/39 Funding Bonds Mature The swap protects the borrower from rising interest rates on a synthetic or traditional fixed rate financing: • Issue Variable Rate Bonds, leaving the swap in place to create a synthetic fixed rate, • Terminate swap, make or receive termination payment and issue new fixed rate bonds in the new interest rate environment. What are the Steps in Hedging the Future Interest Rate?
Case Study #4 • Opportunity: Restructuring Fixed Rate Debt, Hedging Interest Rate Exposure • Situation: Client had $18.0MM of high coupon fixed rate bonds. • Solution: • Acquired the Bonds through a tender offer and simultaneously sold the Bonds to a Trust Sponsor • Entered into a Total Return Swap with the Trust Sponsor • Entered into a variable-to-fixed rate swap • Benefits: • Client was able to reduce its interest costs 35% percent. • Bonds remained outstanding and can be called in the future. • Management time minimized.
Case Study #5 • Opportunity: Distressed Credit, Maximizing Value of Non Core Assets • Situation: Client had $1 million in operating losses at their snfs with over 50% dependence on Medicaid and a need to upgrade their core operations • Solution: • Sold snfs for $30,000 per bed • Benefits: • Client was able to realize $7 million in net proceeds • Improved financial ratios • Eliminated reliance on Medicaid • Redeployed needed capital to Client’s core operations
Case Study #6 • Opportunity: Non profit merger between friends • Situation: Organization was struggling and no longer capable of needed capital reinvestment • Solution: • Arranged non cash acquisition by a non profit System Client • Acquirer invested needed capital into Organization • Benefits: • Organization was able to maintain its’ mission • New Owner achieved significant operational savings by consolidating backroom staff, joint marketing and higher purchase volumes • Facility went from a technical default with 78% occupancy to an investment grade credit in five years
Case Study #7 • Opportunity: Optimizing investment returns with limited downsized • Situation: Client had $210.0MM global equity portfolio and wanted to minimize the potential for downside returns. • Solution: • Acquired $190.0MM in fixed income discount securities • Acquired $20.0MM in global equity option securities • Benefits: • Client will receive 140% of the return on the world equity markets. • Clients downside is limited to a maximum annual 5% loss.