10/26/2017

To: Professor Schulz

From: Taylor Kuwahara, Michael Sibbett, Harrison Stenberg, Rebecca Werbowski
Subject: Rosetree Case

The Offer

We believe that Rosetree should bid $45 million for the loan portfolio. Based on our analysis, the
bank will likely accept this offer. In order to understand this rationale, it is important to review
our assumptions and discounted cash flow analysis.

Assumptions

We used a market-risk premium of 7.5%. This was assumed because of the timing of the
opportunity. We project a future of severe recession, which would cause the market-risk
premium to rise due to higher investor uncertainty. When calculating the present value of all cash
flows, we assumed a risk-free rate equal to the 30-year Treasury rate because it is approximately
the weighted average term remaining on the portfolio of 346 months, or almost 29 years. We also
assumed cash flows that had been affected by loan renegotiation because a bank would logically
renegotiate loans during a housing crisis.

For calculating the equity beta of Rosetree, we assumed that 40% debt financing would
constitute moderate leverage. When calculating Rosetree CAPM, we used a risk free rate equal
to the 5-year Treasury yield because this project was given a length of five years. Lastly,
mortgage portfolio’s are currently unattractive and the most active buyer would be the Federal
Reserve. However, the Fed would focus on bailing out institutions they deemed crucial to the
economy or “too big to fail.” As these larger institutions populate the East Coast, it is likely that
this West Coast bank would not receive an offer from anyone but Rosetree.

Current NPV and Value to Rosetree

Now that our key assumptions have been identified, we can move on to the present value of the
portfolio. We discounted the cash flows of the portfolio using a rate of 8.03% (calculated with
the assumed risk-free rate, assumed market-premium rate, and an average unlevered beta of
similar firms). Our calculations bring the present value of the portfolio to $44.8 million (Exhibit
2). At first glance this may be low, but when you consider how the market rate is larger than the
weighted average loan rate (7% APR compounded monthly), it is clear that the portfolio is less
valuable than other current market investments.

In the case that our offer is accepted, Rosetree can expect to gain between $2.4 and $5.1 million
from this portfolio (this range comes from the range in projected IRR). These numbers were
calculated based on Rosetree’s cut of 20% of profits (Exhibit 1).

Potential Problems
There are also a couple potential problems that may arise for Rosetree. The first issue is that
some of the portfolio loan holders may hold accounts at the selling bank. With this information
available to only that bank, it is possible that the bank estimate of delinquency rates is different
than the 3.75% we projected for the portfolio (for loans delinquent 1-30 days). This is a clear
case of potential asymmetric information and could affect how the bank views Villegas’ offer;
the offer could be either too high or too low based on what the bank believes delinquency rates
will be.

Finally, the bank may have a different forecast for the economy. We chose to err on the side of
an extreme recession when forecasting future cash flows, and subsequently our offer price.
However, if the bank forecasts a less severe recession, this would affect many factors that went
into our calculations. For example, the market-risk premium would decrease in a less severe
economic recession which, leading to our offer seeming far too low for the bank to accept.

Why is it Interesting?

One reason why this portfolio is interesting is the disparity between the outstanding loan balance
and our present value. We calculated the net present value of the total loans to be lower than the
current face value which complicated forming our offer amount. The portfolio also consists of a
wide spread of FICO scores ranging from a score of 484 to 797. Ideal FICO scores are rated
above 700, but this portfolio has many loans above and below this benchmark.

Another attribute that makes this portfolio interesting is a large percentage of the loans come
from two states, California and Florida, rather than being evenly dispersed throughout the
country. Villegas may also only make one offer to the bank and is not certain Rosetree is the
only bidder. She must weigh the options of her projected future value, or offering based on
Rosetree’s potential to turn a profit and risk tipping off her competitors of her newfound strategy.

Pros

This portfolio presents many positive attributes. In terms of breaking down the portfolio
composition, 60% of the mortgages directly finance their original properties. This means the
other loans were refinanced, implying that those borrowers were under financial distress and had
to alter the terms of their debt. Mortgages for original property acquisitions are preferred over
ones that have been restructured because refinancing is often a sign that a borrower is close to
defaulting. Furthermore, many of the loans support single-family residences. A loan holder has
much more incentive to pay his loan if he or she has a family to support.

In addition to this, the FICO scores on the loans within the portfolio were scored relatively high.
While an ideal score is to be rated above a 700, given the circumstances of the market, the
current nationwide subprime pool had a median score of only 620. This made the portfolio’s
average score of 679 appear favorable in respect to the other portfolios during the same period.
Only a quarter of the portfolio had scores that dropped below 650 which were still comparably
better to the pool of loans with scores of 620.
Lastly, the portfolio consists of 175 loans, of which only 13 are in 30 day delinquency. While
this means they are late on paying back their loans, majority of loans that are under 30 days
delinquent will not default. It is projected that only 3.75% of these delinquent loans would
default within the next 18 months.

Cons

We also found a handful of negative characteristics within the portfolio. While the portfolio was
made up of loans from 20 different states, 41% of the loan properties were from California and
12% from Florida. The amount of loans in these area exposes the portfolio to greater default
chance because these two geographical areas are heavily affected by housing spikes. In this
scenario, the housing market has been hurt and the loans in these locations may soon reflect this.
A more geographically diverse mortgage pool would be less risky.

Another negative attribute was that the change in loan-to-value ratio from an initial 76% to 96%
today. When the loan-to-value ratio increased so did the risk for lenders as there is a higher
chance that the buyers will default. A fall in the value of a home, also reflects a decrease in the
amount of collateral a loan holder has.

Additionally, 25% of the loans within the portfolio had a FICO score of less than 650 which is
considered poor. Most loan makers had no incentive to check how likely these people would be
able to meet the demands of their payments. Instead, these lower FICO score loan seekers were
pushed through because the loans could be securitized.

Conclusion

We strongly feel that the bank should accept our offer of $45,000,000 for several reasons. The
loans within the portfolio are fairly illiquid and the Federal Reserve is highly unlikely to buy out
the portfolio from the bank. This is because if the Fed were to bail out any institution, it would
prioritize the larger, East Coast banks that have larger effects on the U.S. economy, therefore
making our offer the best option. The sale of the portfolio will remove risk from their financial
statements and they will be profiting off the surplus included within our offer. This helps
liquidate their balance sheets and provides a cushion in the instance that a bank run occurs.
Finally, Rosetree can expect to profit an estimated $2.4 - $5.1 million from the purchase of the
portfolio, making this a beneficial investment on their part.

Exhibit 1

(Exhibit 1) Rostree Profits in 5 years

Initial PV (thousands): $44,804.00
Purchase Offer (thousands): $45,000.00
Equity Beta 40% debt: 1.056
Cost of Capital: 9.66%
Market-Rate Premium: 7.50%
Risk-Free Rate: 1.75%
FV PV
(thousands) (thousands) Keep (20% of gain)
IRR of 15% $90,116.85 $56,828.00 $2,365.60
IRR of 20% $111,486.69 $70,304.00 $5,060.80
Exhibit 2

Discounted Cash Flows Assuming Severe Recession and Loan Renegotiation

Total CF
Year (thousands) PV (thousands) CAPM: 8.0305%
1 $8,344.00 $7,723.00 PV: $44,804.00
2 $9,514.60 $8,152.00 ^ Sum of PV of Cash Flows
3 $8,314.90 $6,595.00 Beta: 0.6334
4 $7,577.90 $5,563.00 Risk-Free Rate: 3.75%
5 $6,182.40 $4,201.00 Market-Rate Premium: 7.50%
6 $5,342.30 $3,360.00
7 $3,749.80 $2,183.00
8 $3,100.00 $1,671.00
9 $2,554.40 $1,274.00
10 $2,351.80 $1,086.00
11 $1,770.20 $756.00
12 $1,428.50 $565.00
13 $1,132.30 $414.00
14 $914.60 $310.00
15 $785.30 $246.00
16 $616.20 $179.00
17 $565.00 $151.00
18 $429.50 $106.00
19 $341.90 $78.00
20 $334.40 $71.00
21 $248.20 $49.00
22 $150.10 $27.00
23 $95.80 $16.00
24 $69.00 $10.00
25 $46.10 $6.00
26 $37.40 $5.00
27 $23.50 $2.00
28 $26.60 $3.00
29 $12.10 $1.00
30 $10.20 $1.00