In 2011, the U.S. Court of Appeals for the Third Circuit (in In re American Home Mortgage Holdings, 637 F.3d 246 (3d Cir. 2011)) (AMH II) affirmed the Delaware Bankruptcy Court's holding in In re American Home Mortgage Holdings, 411 B.R. 181 (Bankr. D. Del. 2009) (AMH I) that, in distressed or dysfunctional markets, the discounted cash flow (DCF) method is an appropriate method to value mortgage loans posted as repo collateral, and therefore, to fix the claim for damages of the non-debtor repo counterparty under §562 of the Bankruptcy Code.

These opinions took investors by complete surprise as the AMH courts accepted a valuation methodology different from the ones customarily provided for in the underlying governing agreements—open market sales or by obtaining quotes from dealers and other market participants. Moreover, the AMH courts did not define or provided guidance as to the parameters of a “distressed or dysfunctional” market, thereby leaving it uncertain as to when the DCF method will be used by the courts.

Six years after AMH II, a Delaware Bankruptcy Court addressed this issue again in In re HomeBanc Mortgage, 573 B.R. 495 (Bankr. D. Del. 2017) with respect to a repo involving residential mortgage backed securities. Notwithstanding that HomeBanc involved the same time period involved in AMH, and similar though not identical underlying assets, it refused to accept the DCF method to value the repo collateral. While the HomeBanc opinion is in line with investors' expectations, it did little to provide certainty to the valuation of repo collateral in bankruptcy.

Issue-Collateral Valuation Under §562

Section 562(a) of the Bankruptcy Code provides that if a repo (and other so called safe harbored contracts) are terminated or accelerated, damages shall be measured as of the earlier of the date of liquidation, termination or acceleration. Section 562(b) provides in turn that if there are no “reasonable determinants of value” as of these dates, damages shall be measured at the earliest subsequent date on which such value exits. Hence the question: What qualifies as a reasonable determinant of value?

American Home Mortgage

In this case, AMH and Calyon were parties to a repo on approximately 5,700 mortgage loans with an unpaid principal balance of about $1.2 billion. On Aug. 1, 2007, Calyon served AMH with a notice of default and accelerated the repo. On Aug. 6, 2007, AMH filed for Chapter 11 in Delaware. In due course, Calyon filed a proof of claim on account of the damages suffered and AMH objected.

Calyon did not liquidate the repo collateral until approximately a year after the acceleration date. It argued (as supported by expert testimony) that it was unreasonable to liquidate the collateral on the acceleration date because (1) defects in the mortgage files would have caused the sale price to be around 10 percent of the remaining principal balance of the loans and (2) the market was distressed such that, even absent the defects in the mortgage loan documents, the price would have been only 50 percent of the remaining principle balance. Calyon argued that the earliest date it could have obtained a reasonable market price for the collateral was Aug. 15, 2008.

AMH argued, however, that the DCF method is a proper method to value assets, like mortgage loans, whose values are determined by their anticipated future cash flows, and that the DCF method could have been (and should be) used to value the mortgage loans as of the acceleration date.

The bankruptcy court held that Calyon established that the repo collateral could not have been sold for a reasonable price on the acceleration date. Turning into valuation of the collateral and the resulting damage claim, the court held that when a sale is unreasonable or cannot take place, one turns to market prices (presumably quotes or dealers' valuations). But when the market is disrupted, dysfunctional or unavailable, one must use a different method. For assets whose value drives from their anticipated future cash flaws, the court found the DCF method to be a reasonable method.

The Third Circuit affirmed: “We find the Bankruptcy Court's analysis persuasive. It stated that the market price should be used to determine an asset's value when the market is functioning properly. It is only when the market is dysfunctional and the market price does not reflect an asset's worth should one turn to other determinants of value.” AMH II, 637 F.3d at 257.

HomeBanc Mortgage

HomeBanc and Bear Stearns (Bear) were parties to a repo on residential mortgage backed securities (RMBSs). Bear sent a default notice and termination on Aug. 8, 2007. On Aug. 9, 2007, HomeBanc filed for Chapter 11 in Delaware. Bear conducted an auction of the RMBSs on Aug. 14, 2017, and submitted the winning bid. When Bear filed a claim for damages, the Chapter 7 trustee for HomeBanc's estate objected, arguing, based on the AMH decisions, that the repo collateral should have been valued using the DCF method since the market for RMBSs was dysfunctional and distressed.

The Delaware bankruptcy court denied the objection. First, Bear established that its management “decided that the best measure of value, especially in turbulent, volatile market, was to seek prospective bidders.” Second, the type of securities in question were traded over the counter and prices were available from dealers. Third, the auction method used by Bear, “bids wanted in competition,” was a common method in the industry for sale of RMBSs. Fourth, while the market was declining and volatile, the market was functioning and transactions in these securities were occurring. Finally, the court agreed with Bear that the DCF model produced value that is “far removed from what anyone in the market was willing to pay for the Securities at Issue in August 2007.”

The court also noted the absence of other indicia of market dysfunction: no asymmetrical information between buyers and sellers, no market panic, no high transaction costs, no absence of creditworthy market participants or fraud.

What's Next?

AMH and HomeBanc addressed an identical period of time—August 2007. They involved different assets—mortgage loans in AMH and RMBSs in HomeBanc—but there was no evidence or even a suggestion in HomeBanc that it was a distinction with a difference. In fact, the evidence in AMH established that the mortgage loans could have been sold at 50 percent of value, while in HomeBanc, Bear assigned a value of approximately 46 percent to the collateral it bid for. Yet, the AMH courts found the market in 2007 to be dysfunctional and thus accepted the DCF valuation method, while the HomeBanc court did not.

Could the difference be explained by the quality of evidence submitted to the courts? Maybe. The larger question, however, of what defines a dysfunctional market, one that justifies the application of the DCF method, remains unanswered, leaving investors with continued uncertainty in the valuation of repo collateral in bankruptcy cases. Unless and until courts provide meaningful guidance, the resolution would remain speculative.

Shmuel Vasser is a partner in Dechert's financial restructuring department, resident in the New York office

In 2011, the U.S. Court of Appeals for the Third Circuit (in In re American Home Mortgage Holdings, 637 F.3d 246 (3d Cir. 2011)) (AMH II) affirmed the Delaware Bankruptcy Court's holding in In re American Home Mortgage Holdings, 411 B.R. 181 (Bankr. D. Del. 2009) (AMH I) that, in distressed or dysfunctional markets, the discounted cash flow (DCF) method is an appropriate method to value mortgage loans posted as repo collateral, and therefore, to fix the claim for damages of the non-debtor repo counterparty under §562 of the Bankruptcy Code.

These opinions took investors by complete surprise as the AMH courts accepted a valuation methodology different from the ones customarily provided for in the underlying governing agreements—open market sales or by obtaining quotes from dealers and other market participants. Moreover, the AMH courts did not define or provided guidance as to the parameters of a “distressed or dysfunctional” market, thereby leaving it uncertain as to when the DCF method will be used by the courts.

Six years after AMH II, a Delaware Bankruptcy Court addressed this issue again in In re HomeBanc Mortgage, 573 B.R. 495 (Bankr. D. Del. 2017) with respect to a repo involving residential mortgage backed securities. Notwithstanding that HomeBanc involved the same time period involved in AMH, and similar though not identical underlying assets, it refused to accept the DCF method to value the repo collateral. While the HomeBanc opinion is in line with investors' expectations, it did little to provide certainty to the valuation of repo collateral in bankruptcy.

Issue-Collateral Valuation Under §562

Section 562(a) of the Bankruptcy Code provides that if a repo (and other so called safe harbored contracts) are terminated or accelerated, damages shall be measured as of the earlier of the date of liquidation, termination or acceleration. Section 562(b) provides in turn that if there are no “reasonable determinants of value” as of these dates, damages shall be measured at the earliest subsequent date on which such value exits. Hence the question: What qualifies as a reasonable determinant of value?

American Home Mortgage

In this case, AMH and Calyon were parties to a repo on approximately 5,700 mortgage loans with an unpaid principal balance of about $1.2 billion. On Aug. 1, 2007, Calyon served AMH with a notice of default and accelerated the repo. On Aug. 6, 2007, AMH filed for Chapter 11 in Delaware. In due course, Calyon filed a proof of claim on account of the damages suffered and AMH objected.

Calyon did not liquidate the repo collateral until approximately a year after the acceleration date. It argued (as supported by expert testimony) that it was unreasonable to liquidate the collateral on the acceleration date because (1) defects in the mortgage files would have caused the sale price to be around 10 percent of the remaining principal balance of the loans and (2) the market was distressed such that, even absent the defects in the mortgage loan documents, the price would have been only 50 percent of the remaining principle balance. Calyon argued that the earliest date it could have obtained a reasonable market price for the collateral was Aug. 15, 2008.

AMH argued, however, that the DCF method is a proper method to value assets, like mortgage loans, whose values are determined by their anticipated future cash flows, and that the DCF method could have been (and should be) used to value the mortgage loans as of the acceleration date.

The bankruptcy court held that Calyon established that the repo collateral could not have been sold for a reasonable price on the acceleration date. Turning into valuation of the collateral and the resulting damage claim, the court held that when a sale is unreasonable or cannot take place, one turns to market prices (presumably quotes or dealers' valuations). But when the market is disrupted, dysfunctional or unavailable, one must use a different method. For assets whose value drives from their anticipated future cash flaws, the court found the DCF method to be a reasonable method.

The Third Circuit affirmed: “We find the Bankruptcy Court's analysis persuasive. It stated that the market price should be used to determine an asset's value when the market is functioning properly. It is only when the market is dysfunctional and the market price does not reflect an asset's worth should one turn to other determinants of value.” AMH II, 637 F.3d at 257.

HomeBanc Mortgage

HomeBanc and Bear Stearns (Bear) were parties to a repo on residential mortgage backed securities (RMBSs). Bear sent a default notice and termination on Aug. 8, 2007. On Aug. 9, 2007, HomeBanc filed for Chapter 11 in Delaware. Bear conducted an auction of the RMBSs on Aug. 14, 2017, and submitted the winning bid. When Bear filed a claim for damages, the Chapter 7 trustee for HomeBanc's estate objected, arguing, based on the AMH decisions, that the repo collateral should have been valued using the DCF method since the market for RMBSs was dysfunctional and distressed.

The Delaware bankruptcy court denied the objection. First, Bear established that its management “decided that the best measure of value, especially in turbulent, volatile market, was to seek prospective bidders.” Second, the type of securities in question were traded over the counter and prices were available from dealers. Third, the auction method used by Bear, “bids wanted in competition,” was a common method in the industry for sale of RMBSs. Fourth, while the market was declining and volatile, the market was functioning and transactions in these securities were occurring. Finally, the court agreed with Bear that the DCF model produced value that is “far removed from what anyone in the market was willing to pay for the Securities at Issue in August 2007.”

The court also noted the absence of other indicia of market dysfunction: no asymmetrical information between buyers and sellers, no market panic, no high transaction costs, no absence of creditworthy market participants or fraud.

What's Next?

AMH and HomeBanc addressed an identical period of time—August 2007. They involved different assets—mortgage loans in AMH and RMBSs in HomeBanc—but there was no evidence or even a suggestion in HomeBanc that it was a distinction with a difference. In fact, the evidence in AMH established that the mortgage loans could have been sold at 50 percent of value, while in HomeBanc, Bear assigned a value of approximately 46 percent to the collateral it bid for. Yet, the AMH courts found the market in 2007 to be dysfunctional and thus accepted the DCF valuation method, while the HomeBanc court did not.

Could the difference be explained by the quality of evidence submitted to the courts? Maybe. The larger question, however, of what defines a dysfunctional market, one that justifies the application of the DCF method, remains unanswered, leaving investors with continued uncertainty in the valuation of repo collateral in bankruptcy cases. Unless and until courts provide meaningful guidance, the resolution would remain speculative.

Shmuel Vasser is a partner in Dechert's financial restructuring department, resident in the New York office