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Attachment B

Asset Exchange Example

The following is an example of a transaction used by institutions to reduce the level of 

nonperforming assets through an asset exchange. This transaction structure involves a trade with 

a third party that purchases the institution’s problem assets at or very near par value. The 

transaction is marketed as a process for institutions to dispose of problem assets and replace 

them with performing assets while diversifying their loan portfolios. These transactions 

generally require the selling institution to purchase other assets from the same party, usually at a 

multiple of the assets sold, which increases risks to the regulated institution. 

Example of an asset exchange

An asset exchange marketer may approach an institution that has a high level of problem 

assets. The transaction proposal might offer a 4-to-1 or even 5-to-1 ratio asset exchange. 

Usually the selling institution has to advance cash roughly to equalize the values of the assets 

ceded and the assets received. 

In a specific case, the selling institution gave up $7 million of problem assets plus $20 

million in cash in exchange for $27 million in purported fair value of performing home equity 

lines of credit (HELOCs). The deal contained a put-back provision, in which the marketing 

company would buy back at par HELOCs that were 60 days past due, up to a specified limit and

subject to a 36-month limitation to exercise this option. The marketing company established a 

put-back reserve equal to the specified limit, with a level ranging between 5-7% of the HELOCs’

purported fair value. The put-back funds were placed in a depository account with the selling 

institution, which reduced the counterparty credit exposure. 

Risk management concerns

The selling institution deemed the new assets to be a good investment since they were

seasoned and current at the time of acquisition and/or the borrowers had high credit scores. 

However, it turned out that the pools acquired were “survivor pools” that had been carved out 

from a larger population of loans and whose seemingly good performance might not be 

indicative of future performance. Reportedly, the institution also overemphasized the high credit

scores and performance history of the acquired loans, to the detriment of other measures of risk.

As part of its due diligence, the selling institution’s management relied on a third-party 

valuation report to support the economic merits of the transaction and the value of the assets 

acquired. However, management did not closely review key valuation assumptions, which were 

provided by the marketing agent and were unduly optimistic. As a result, the acquired assets’

values were significantly overstated. The key weaknesses that resulted in an inaccurate valuation 

included:
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Not determining fair value based on key assumptions that market participants would use 

in valuing the assets. Most notably, management did not consider a risk adjustment to 

reflect the risk premium that market participants would demand as compensation for 

bearing any uncertainty inherent in the cash flows of the assets.

Unsupportable default probabilities based upon current market data and loss history.

Mapping the default probability to a single-issuer corporate bond matrix, which had little 

correlation with a pool of multiple-obligor consumer debt.

Reliance on origination loan-to-value (LTV) ratios with no consideration of the current 

LTV ratios. Some estimates placed LTV ratios at the time of the asset exchange 

transaction at well above 120%. 

Assuming a loss severity of 67% for a HELOC portfolio, where a 100% loss rate would 

be more appropriate. 

Lack of understanding of the first mortgages associated with these HELOCs and their 

risk characteristics.

Unreliable and stale information on prepayment speed. In some cases, the prepayment 

speeds were miscalculated by the third-party fair value provider.

Truncated cash flow modeling timeframe due to use of unrealistic assumptions, such as 

prepayment speed, that went into determining the performing assets’ weighted average 

life. 

The result was that the fair value was overstated and the institution incurred significant 

losses.