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Rosetree Mortgage Opportunity Fund (A) Case Solution
Let’s assume that there is an equal probability of each occurrence, it means there are .334 chances of slow economic growth, .334 chances of moderate recession and .334 chances of severe recession. The sum of probabilities in this case becomes 1.002, which is approximately equal to 1. For simplicity we have assumed that there are equal chances of each occurrence. However we can change the probability of the occurrences to our desired situation. This is just an assumption and it can be changed or waived off. For calculating annual expected cash flows two main inputs are needed. One is the probability of each scenario and other is the cash flows for the given scenarios. Now we have both, cash flows are given in the case and probabilities are assumed. Since we are concerned with how much total amount we get so total cash flow amounts given in each scenario will be used for the calculation of annual expected cash flows. Total cash flows for 30 years are given for each scenario. Simply multiply the cash flow in every year by probability of occurrence and add them we get the annual expected cash flows. For example the cash flows for year one are 9901, 8362, 8344. Expected cash flow for year one, which is 2009, can be calculated as SUM of (.334*9901+.8362*.334+.334*8344). Rest of the cash flow calculations are given in the spreadsheet. However one thing should be kept in mind that we have assumed equal probability of each occurrence for the case purpose. Rosetree Mortgage Opportunity Fund should assume other scenarios as well. I could make other scenarios but enough information regarding GDP growth was not given in the case. I have tried to limit myself to the case.
Following questions are answered in this case study solution

In early December 2008, Isabel Villegas and her team at Rosetree Capital Management produced Loan Portfolio Annual Cashflow Projections for three different economic scenarios. For the Slow Economic Growth scenario, their projections assumed that real GDP would be positive from yearend 20082009. Under the Moderate Recession scenario the projections assumed that real GDP would decline by 0.1 percent to 1 percent from yearend 20082009. Finally, under the Severe Recession scenario, their projections assumed that real GDP would decline by 1.1 percent or more from yearend 20082009. Make a recommendation to the Rosetree team on how to calculate the loan portfolio’s expected annual cashflows taking into account all of the three different economic scenarios.?

Recommend how to calculate annual cashflow discount factors to be used to calculate a present value for the loan portfolio’s annual cashflows.?

What price should Villegas offer the selling bank for the pool of mortgage loans?
Case Analysis for Rosetree Mortgage Opportunity Fund (A)
Question 2
Calculating the discount factor is the most difficult part. There are number of ways in which discount factor can be calculated. We know the risk free rate. As rates for US treasury for various periods are given. US treasury rate are considered risk free rate because it has almost zero default risk. However even US treasury bonds have other risks such as liquidity and interest rate risk. We need a discount factor which considers almost all risks. If we uses Capital Asset Pricing Model for calculating the discount factor. We have risk free rate, equity beta for 2005 to 2008, but main problem is which rate to use for market rate. Shall we use the weighted average mortgage rate as a market rate or weighted average life time average mortgage rate? Using weighted average mortgage rate make more sense. And if we use risk free rate plus risk premium for all the potential risk, then we do not know the risk premium. If we assume that weighted average mortgage rate as market rate. We can calculate the discount factor using capital asset pricing model formula for calculating the discount factor. I have used this approach because other approaches could not be used. The calculation is shown in the spreadsheet. In actual scenario Rosetree Mortgage Opportunity Fund could look at the historical discount factor on such portfolios and that discount factor could be adjusted for the portfolio at hand.
Question 3
Once we know the discount factor and cash flows calculating the selling price is very easy. In question one, we have predicted expected cash flows and in question two, we have calculated the discount factor. For calculating the selling price to be offered each expected annual cash flow is discounted to year zero. Adding all the discounted cash flows gives us the price to be offered to the selling bank. According the calculations based on the assumptions of probability and market rate bank should be offered $ 45.9 million.
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