A Comprehensive Approach to Forecasting Credit Losses: Triangulating Loss Estimates

Boardroom Forum on Lending

DECEMBER 2011

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Forecasting Credit Losses in Bank Loan Portfolios Acquisition vs. Lending

Challenges:
Deals continue to be competitive multiple bidders. Short time frames and limited data. The credit environment has completely redefined the worst case scenario. Bank transactions leave little margin for error. Key Goals: With respect to NPLs: Quantify true loss severity. For Performing Loans: Estimate default probabilities and loss severities.

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A Comprehensive Approach to Forecasting Credit Losses: Triangulating Loss Estimates

Portfolio analysis is not an exact science; therefore, Bayview employs a three pronged approach to estimate portfolio losses:

Roll Rate Analysis

Portfolio Loss Estimate

Borrower Related Underwriting and Property Level Analysis

Regression Based Models

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A Comprehensive Approach to Forecasting Credit Losses: A Roll Rate Analysis

A Roll Rate Analysis evaluates historical portfolio performance across multiple points in time in order to predict future performance.
This approach tracks the actual migration of (a) current loans to delinquent/default; (b) delinquent to re-performing, and (c) prepayments.
Sample Commercial Loan Pool: 6 Month Illustrative Roll Rate Analysis (February 2011 to August 2011)

Current 30 60+

Current 90.4% 20.9% 7.0%

30 2.9% 16.4% 10.3%

60+ Default Prepay 2.3% 0.1% 4.3% 55.6% 6.4% 0.8% 68.5% 13.9% 0.3%

As of August 2011, the portfolio is approximately 3.1% 60+ days delinquent.

Key Observations: 90.4% of current loans were still current 6 months later; 4.3% paid in full during the period. Only 20.9% of 30 day loans were current 6 months later. Only 7.00% of 60+ day loans were current 6 months later. Assuming the 6 month experience repeats itself: In two years, 13.9% of the portfolio will be 60+ day delinquent. In three years, 17.9% of the portfolio will be 60+ day delinquent. In five years, 23.8% of the portfolio will be 60+ day delinquent.
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A Comprehensive Approach to Forecasting Credit Losses: Roll Rate Analysis

Assuming recent transition rates are at unsustainably high levels, a pure roll rate analysis may reflect a severe case scenario for defaults. In fact, recent experience with residential transition rates provides evidence that default rates burn-out from peak levels.

If we apply the slope of the reduction in subprime transition rates from their peak to the sample pool, it would result in significantly lower 2 year, 3 year, 5 year, and lifetime default rates.
Severe Case 13.9% 17.9% 23.8% 40.3% Subprime Trend Slope 10.1% 11.6% 13.7% 23.2%
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2 year 3 year 5 year Lifetime

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A Comprehensive Approach to Forecasting Credit Losses: Roll Rate Analysis

Benefits of Roll Rate Analysis: Accounts for actual performance of a specific population over a recent period, a key factor not included in any other forecasting tool. Illustrates what the portfolio can be expected to look like at specific points in time if transition rates remain constant. Can accommodate expected changes to transition rates as a result of macro variables, burnout, or servicing practice change. Applicable to most asset classes Roll rate analysis should be performed separately on risk stratified sub-portfolios. Mixing low quality assets with high quality assets in a roll rate analysis can lead to exaggerated default expectations. We recommend analyzing roll rates on sub-portfolios by asset type (Residential, CRE, C&D, etc) and within asset type by loan quality (risk grades, credit score, vintages, etc).

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A Comprehensive Approach to Forecasting Credit Losses: Residential Modeling

A regression based model correlates the performance of approximately 12 key variables to historical data of similar loan populations to predict expected portfolio default probability and severity. Examples of variables which correlate to long term portfolio performance include: Key Model Variables
Occupancy Property Type Geography (Zip code, MSA level) Loan Balance Credit Score Documentation Type Loan Type Loan Age Original LTV Mark to Market LTV Payment History Forward Home Price Projections

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A Comprehensive Approach to Forecasting Credit Losses: Residential Modeling

To test the validity of the model, projected figures are compared to actual results.
Credit Model Validation
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Prepayment Model Validation

Arm Model vs. Actual
1000000

Static Pool Performance by Model FOF Groups

Actual Status at November 2009
(Model run as of EOM July 07 (all current loans) and actual performance data is as of EOM Nov 09)

20

800000

70%
60%

15

600000

Vol CPR

10 Actual CPR
5

400000 Model CPR Sample Size

200000

50%
Default

40%

REO FCL
90+

30% 20% 10% 0%

60 30

Remittance Date

Fixed Model vs. Actual

Projected Frequency of Foreclosure (FOF) Bucket Projected Frequency of Foreclosure (FOF) Bucket at July 2007

25 20

1000000 800000 600000 400000 200000

Vol CPR

15 10 5

Remittance Date

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Loan Count

Loan Count

Sample Size

A Comprehensive Approach to Forecasting Credit Losses: Commercial Loan Modeling

BAM has studied the performance of commercial loan (CRE and C&I) portfolios of banks (over 20,000 loans) to better understand the default probability drivers of these loans. Bank risk scores (adjusted to the BAM underwriting scale), macroeconomic variables, historical loan performance, and certain loan characteristics were found to be primary risk drivers. Based on this study, BAM has developed regression based commercial loan default modeling tool to first establish short-term (6 month) projections of performing loans migrating to a nonperforming status. BAM then employs a cash flow-type modeling tool to take into account prepayments, default timing, and potential improvements in economic conditions to establish a range of default probabilities. Commercial Loan Modeling (CRE and C&I): Model Input Variables
Bank Risk Scoring (Adjusted by BAM) Loan Characteristics Macroeconomic Variables Occupancy (Owner vs. Investor) Proprietary Property Value Index Property or Collateral Type Local Unemployment Levels Loan Seasoning Changes to Unemployment Loan Type (Fixed vs. ARM) Loan Performance (Historical Pay History) Loan Balance Property/Collateral State & Zip Code

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A Comprehensive Approach to Forecasting Credit Losses: Commercial Loan Modeling

CRE Model Performance
4.00% 3.00%

C&I Model Performance

6.00%

C&I Model NPL

Actual Roll to NPL

4.00%
2.00% 0.00%
Portfolio A Portfolio B Portfolio C

CRE Model NPL Actual Roll to NPL

2.00%
1.00%

0.00%
Portfolio A
Portfolio D

Portfolio B

Portfolio C

Portfolio D

Actual vs Model by Predicted Decile (CRE)

20.00% 12.00%

Actual vs Model by Predicted Decile (C&I)

18.00%

10.00% 16.00%

14.00% 8.00%

6Month Roll to 60+

12.00%
6 MonthRoll to 60+

10.00%

prediction

6.00%

Model

actual 8.00%

Actual

4.00% 6.00%

4.00% 2.00%
2.00%

0.00% 1 2 3 4 5 6 7 8 9 10

0.00% 1 2 3 4 5 6 7 8 9 10

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A Comprehensive Approach to Forecasting Credit Losses: Modeling Tools

Benefits of Regression Based Models: Provide an indication of how the portfolio should perform based on characteristics observable about the portfolio. Provide a consistent approach to estimating near-term and lifetime default probability for homogenous and granular portfolios of residential mortgage, CRE, and C&I portfolios Take advantage of BAMs extensive data and research to produce default and loss estimate ranges quickly and with limited data requirements Set a benchmark level of performance that can be reconciled against the roll rate analysis.

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A Comprehensive Approach to Forecasting Credit Losses: Borrower Related Underwriting and Property Level Analysis
While Regression and Roll Rate Analyses provide important data points, there is no substitute for re-underwriting loan files and evaluating the collateral supporting the loans.

For residential and small balance commercial mortgage loans, strength of a guarantor is an important factor in long term performance. Underwriting is focused on evidence in the loan files that the homeowner, investor, or business using the property has strong credit and stable cash flows. Updated property values are obtained using AVMs and BPOs that are reviewed by internal appraisers. For larger balance commercial mortgage loans and C&D loans, property visits by real estate professionals are essential to understanding the status and condition of the property, verifying physical occupancy, assessing the market for vacant space, and incorporating market conditions into an updated valuation.

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A Comprehensive Approach to Forecasting Credit Losses: Borrower Related Underwriting and Property Level Analysis
Benefits of Borrower Related Underwriting and Property Level Analysis: Borrower Related Underwriting is essential for predicting default probabilities: Assesses the accuracy and quality of the original underwriting analysis to help determine the risk profile of each borrower. Helps assure that the data used in the Regression Model is accurate (documentation type, DSCR, LTV). Provides for a re-grading of loans to normalize for institution specific risk grading process. Facilitates comparisons to other portfolios based upon strength of underwriting. Property Level Analysis provides a baseline forecast for portfolio loss severity: Determines the value of the collateral today. Integral to analysis of cash flow stability. Incorporates current and projected market conditions. Evaluates reasons for property value decline: Capitalization rate deterioration vs. decline in property operating income due to vacancy increase.

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Benefits of A Comprehensive Approach: Triangulating Loss Estimates

Roll Rate Analysis
Accounts for actual performance of a specific population over a recent period Illustrates what portfolio can be expected to look like at specific points in time Can accommodate expected changes to transition rates

Portfolio Loss Estimate

Borrower Related Underwriting and Property Level Analysis

Provides for normalizing of risk grades Determines value of the collateral today Assesses the accuracy and quality of the original underwriting analysis and the loan tape data

Regression Based Models

Serves as a benchmark performance baseline Provides indication of future portfolio performance based on observable characteristics Works for homogeneous and granular portfolios
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Benefits of a Comprehensive Approach: Why Risk Grading Alone is Insufficient

Why Risk Grading Alone is Insufficient:
Risk Grades are not uniformly applied. They reflect, in many cases, only relative grades--not an absolute risk metric (i.e. what is a 1, 2, or 3 rated construction loan in a tough market?).

They do not directly translate in loss estimates.

They should, however, be incorporated as inputs in all three approaches to forecasting losses that we have highlighted: Roll rates can be stratified by loan type and risk grade to illustrate how each loan types best and worst risk grades are actually performing. Loans should be re-risk graded through the loan level re-underwriting process. Risk grades, where available, can be included in the Regression Model on a BAMadjusted basis.

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Benefits of a Comprehensive Approach: Reconciling the Three Approaches

Three approaches may not produce a consistent outcome and therefore must be reconciled for financial modeling purposes. Consider the following 3 examples:
A: All Three Approaches Reconcile The Regression model says that loans that have the observable characteristics of the target institutions portfolio should perform well based upon the regression equations that fit the large pools of loans upon which the models were based. Roll rates to delinquency are low over the previous 3 to 6 months. The underwriting and property analysis revealed strong, well documented files signaling high credit guarantors and large commercial properties with stable cash flows. Conclusion: If only all deals looked like this!! B: Roll Rates are Inexplicably Worse than Expected The Regression benchmark suggests that loans should perform well and the underwriting appears sound but over the prior 3 months, the roll rates suggest that the portfolio is declining quickly. Recommendation: Further stratify the roll rate analysis to identify if the deterioration is broad based. Re-underwrite the actual defaults during the period to ascertain whether the defaults are idiosyncratic to certain large borrowers, loan types, or geography. Determine if problem is isolated or widespread.
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Benefits of a Comprehensive Approach: Reconciling the Three Approaches

C: Roll Rates Look Too Good The portfolio appears to be outperforming its observable characteristics. The loan underwriting casts further doubt on the roll rate analysis as the credit culture of the target institution appears weak.

Recommendation: Re-underwrite the loans that appear to be the highest risk in the Regression model. Is the institution rolling due dates as part of an aggressive modification campaign? Confirm payment histories. Conclusions: Loan tapes can have inaccuracies and servicing practices can mask delinquency issues but loans rarely significantly over perform or underperform their loan characteristics without the reasons being observable in the loan underwriting and property analysis. A triangulation approach to credit is essential in the current high risk environment.

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About Bayview

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Bayview has a proven track record and is an industry leader in mortgage investment analytics and loan servicing
Bayview was founded in 1984 and now has 964 employees. Our senior management team has an average of 12 years company tenure.
Bayview Asset Management is minority-owned by affiliates of Blackstone Capital Partners. Since 2008, Bayview has advised many clients on whole bank acquisitions ranging in asset size from less than $200 million to greater than $50 billion.

Bayview services nearly 55,000 loans with an aggregate UPB of approximately $13.0 billion.
Bayview Loan Servicing, whose predecessor was founded in 1999, now has 688 employees in 6 locations (FL (2), TX, PA, IL and PR) and is comprised of teams of experts in asset valuation, loss mitigation, loan workouts, bankruptcy and foreclosure Senior and mid-level managers average more than 21 years of industry experience, with no change in management personnel in the past five years

Bayview has proven success in loss mitigation with a focus on servicing delinquent and high-risk performing loans for itself and third parties.
Bayview Loan Servicing is one of only four servicers with S&Ps highest residential special servicer rating and the only one with the highest rating for small balance commercial

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Bayview enjoys strong institutional support via a non-controlling investment from affiliates of the Blackstone Group

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Bayview Asset Management is a fully-integrated mortgage investment company with expertise in the analysis and management of distressed and performing mortgage assets

Overview of the Bayview Asset Management Organization:

Experience
Founded in 1984, as a leading advisor, valuation specialist, and broker of mortgage servicing rights portfolios
Purchased $20 billion in loans from 2,000 counterparties in 9,000 transactions Sponsored 75 commercial and residential securitization transactions totaling $28 billion in securities sold to 200 institutional investors (including securities issued under Bayviews small balance commercial platform) Raised over $3 billion and manages three opportunity funds of credit-sensitive residential and commercial mortgage loans

Depth
964 employees in six offices
Dedicated teams specializing in:
Mortgage Research and Analytics Loan and Securities Portfolio Management Loan Special Servicing Loan Underwriting and Valuation Real Estate Construction and Development

Stability
Minority-owned by affiliates of Blackstone Capital Partners
Senior management team with an average of 12 years company tenure Flexible infrastructure and strong management has enabled Bayview to successfully navigate the credit market turmoil

Bayview Loan Servicing manages a $13.0 billion mortgage portfolio of proprietary and third party assets 1 of only 4 servicers with S&Ps highest residential special servicer rating and the only one with the highest rating for small balance commercial loans

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Bayview has principal expertise in assessing risk and determining value across the full-spectrum of bank balance sheet assets

Real Estate

C & D Loans
(Residential and Commercial)

Residential Bayviews experience includes both performing and nonperforming loans in the following asset classes:

Raw Land

Commercial

Construction

Multi-family Bayview also has experience in Mortgage and Asset-Backed Securities backed by real estate asset classes

Improved

Mortgage (Residential andand Commercial) Asset-Backed Securities

C & D Loans

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The same functional teams that drive Bayview Asset Managements successful proprietary investment process are available to clients of Bayview Advisory Services

Highly-rated by all rating agencies

Loan Servicing
688 FTEs

Loss mitigation expertise for high risk and distressed assets $13.0 billion portfolio of residential, commercial and C&D loans Servicing $3 billion in loss share assets (9 banks)

Due diligence process created to protect buyers of distressed assets Asset level valuations by staff with average experience between 15 years (residential) and 23 years (commercial) Valuations tracked and analyzed via a proprietary database

Loan Underwriting & Valuation

22 Underwriters 21 Appraisers

Mortgage Research and Analytics

6 Professionals

Dedicated mortgage research effort Proprietary loan-level credit & prepay analytics Extensive database of proprietary and industry data

Seasoned team of loan and securities managers Manage three funds of distressed commercial and residential mortgages ($3 billion capital raised) Active market participants provide detailed information on capital flows and capital markets activity

Portfolio Management
4 Loan and MBS Managers

Real Estate Construction & Development

10 Professionals

Large balance commercial real estate team with expertise in troubled and transitional assets
Team management individuals have an average 21 years of experience in development, legal, valuation, construction, engineering, banking, and property management

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Four core competencies serve as the foundation for the services Bayview delivers to its advisory clients

Credit Loss Forecasts and Asset Valuation Principal Takeout for Problem Assets

Loss Mitigation Solutions

Structured Finance Solutions

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To better understand how Bayview can meet your loan portfolio advisory needs, please contact us:

Jim Dougherty Managing Director Bayview Advisory Services, LLC

Office: 212.259.0630 / Cell: 212.960.8119 jimdougherty@bayviewadvisoryservices.com www.bayviewadvisoryservices.com

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DISCLAIMER:
The information contained herein has been compiled by Bayview Advisory Services, LLC (BAS) solely for use by the intended recipient and for no others. This material is confidential and cannot be reproduced in any manner. By its acceptance hereof, each recipient agrees (in addition to any obligations it may have under any confidentiality agreement with BAS or its affiliates) that neither it nor its agents, representatives, directors or employees will copy, reproduce or distribute to others this presentation, in whole or in part, at any time without the prior written consent of BAS and that it will keep permanently confidential all information contained herein not already in the public domain and will use this presentation for the sole purpose of deciding whether to proceed with a further investigation of, and business engagement with, BAS and/or its affiliates. This presentation shall remain the property of BAS. BAS reserves the right to require the return of this presentation (together with any copies or extracts thereof) at any time. Nothing herein may be relied upon by any person or entity for the purchase of or investment in securities or financial instruments. It is further understood and agreed that BAS, its subsidiaries, affiliates, officers, directors, shareholders, partners, agents and employees shall not be liable to any third party for any cause of action, claims, costs or damages related to the use of any of the information, analysis or reports contained herein. Any warranties, either expressed or implied, contained within the information, analysis and reports is hereby disclaimed to the fullest extent allowed. Neither BAS nor its advisors nor any of their respective directors, partners, employees or advisers nor any other person, shall be liable for any direct, indirect or consequential loss or damages suffered by any person as a result of relying on any statement in or omission from this presentation and any such liability is expressly disclaimed. BAS does not undertake any obligation to update or revise any statements contained herein, whether as a result of new information, future events or otherwise. Except where otherwise indicated, this presentation speaks as of the date hereof. In furnishing this presentation, neither BAS nor its advisors undertakes any obligation to update any of the information contained herein or to correct any inaccuracies. This presentation is for information purposes only and shall not form the basis of any contract.

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