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By Paritosh Bansal and Dan Wilchins
NEW YORK, Dec 19 (Reuters) - Capital One Financial Corp’s (COF.N) agreement to buy regional lender Chevy Chase Bank features a twist that could become increasingly popular: a clause that forces the buyer to pay more if acquired assets perform better than expected.
These “contingent value rights” are hardly new, but they could mean Capital One, which said last month it would pay $520 million in cash and stock for Chevy Chase, will pay more over time. These types of agreements make sense now, when buyers and sellers disagree about the real value of financial assets.
In the case of Chevy Chase, the bank has a $4.15 billion portfolio of option adjustable rate mortgages, or ARMs, which allow the borrowers to decide monthly whether to pay only interest on their mortgages or to pay down some of the principal as well.
These mortgages have proven toxic to some lenders, including Downey Savings and Loan, which was seized by regulators last month, and Wachovia Corp WB.N, which agreed to sell itself after the government intervened.
Capital One, a credit card issuer and bank, is writing down the Chevy Chase mortgages by $1.35 billion. Under the contingent value rights in the deal, if the mortgages end up losing less than $1.35 billion over about a five-year period, Chevy Chase’s prior owners will be entitled to about half of the difference, according to a person familiar with the matter.
For example, if the losses are $800 million, the difference would be $550 million, and about half of that would go to the previous owners of Chevy Chase. Any payments would occur after 2013 and would be on top of the $520 million of cash and stock that Capital One agreed last week to pay for the bank. Some details of the contingent value rights were featured in a footnote in a slide presentation buried in Capital One’s website the day the deal was announced.
Setting up the deal this way made sense because option ARMs are notoriously difficult to value — just ask Capital One.
“The truth is, nobody really knows how option ARM portfolios are going to perform,” Rich Fairbank, Capital One’s chief executive, said at an investor presentation last week.
The valuations for the option ARMs after the writedowns assume that three-quarters of the loans in the portfolio default, and that bad loans result in losses of 45 percent of the principal.
That seems conservative, but losses have been difficult to forecast during this credit cycle. Chevy Chase, a closely held bank based in the affluent suburbs of Washington, D.C., made half of its option ARM loans in 2007. In general, mortgage loans made that year have so far performed poorly.
Valuing financial assets has broadly become a difficult enterprise during the credit crunch. Markets for many instruments and securities have dried up.
Debt products typically mature at some point, which means their real value ultimately becomes clear. But passionate debates have erupted among investors, banks and others over whether market prices of many debt products reflect their likely ultimate value, or instead just the breakdown of financial markets.
Credit Suisse on Thursday told senior executives that it would pay most of their bonuses using illiquid assets, forcing its employees to take on the risk from these instruments.
Contingent value rights work best when the seller is privately owned, because convincing public shareholders to accept these rights can be difficult.
But to the extent that other banks trying to sell themselves also have option ARM portfolios, or other hard-to-value assets, they could look for similar structures.
"It's a reasonable response to the very large degree of uncertainty," said Andrew Senchak, vice chairman of Keefe, Bruyette & Woods, a boutique investment bank focusing on financial companies. (For more M&A news and our DealZone blog, go to www.reuters.com/deals) (Editing by John Wallace)