Valuation Of Complex Financial Assets In Illiquid Markets

1. Valuation of Complex Financial Assets in Illiquid Markets
Boris J. Steffen, MM, CPA, ASA, ABV, CDBV
Principal and Director
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2. Overview
» Evolution of the crisis
» The government response
» Accounting for fair value
» Credit risk fundamentals
» The securitization market
» Collateralized debt obligations, credit default swaps and auction rate securities
» CDS, ARS and MBS valuation frameworks
» Conclusion
» Speaker profile
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3. Evolution of the crisis
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4. Factors responsible for the crisis can be traced to suboptimal
regulatory, investing and financing decisions
» Collapse of the U.S. housing bubble
» Readily available credit at low interest rates
» Affordable housing programs
» Excessive use of financial leverage
» Lack of accountability and transparency
» Market participant conflicts and failure to understand risks
» Ineffective risk management and lax corporate governance practices
» Complex financial products
» Unregulated derivatives markets
» Market illiquidity
» Fraud
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5. The collapse of the housing bubble touched-off a self-
perpetuating downward spiral of increasing illiquidity
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6. The government response
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7. Regulatory reforms proposed by the Treasury focus on five
inter-connected objectives
Supervision of
financial institutions
International standards Regulation of
and cooperation financial markets
Government Consumer and
capabilities investor protection
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8. Regulatory reforms aimed at derivatives focus on improved
transparency and cross-border coordination
» The regulation of previously under- and un-regulated markets and systems
along with new agency authority are advised to strengthen financial
market regulation
› Securitization markets
› Over the counter derivatives, which at year-end stood at $680 trillion
outstanding, and credit default swaps, which were valued at $38 trillion
› Payment, cleaning and settlement systems
» Improved international cooperation and heightened international
regulatory standards are contemplated to mitigate systemic risk globally
› Regulatory capital standards
› Global financial markets oversight
› Supervision of institutions operating internationally
› Prevention and management of crises
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9. Review of the TARP indicates that Treasury’s investments
exceeded the value of the warrants and preferred stock it
received in return
Total Estimated Value
Subsidy
Face
Purchase Program Participants Valuation date Value % $
Value
Capital Purchase Program
Bank of America Corporation 10/14/2008 $15.0 $12.5 17% $2.6
Citigroup, Inc. 10/14/2008 25.0 15.5 38% 9.5
JP Morgan Chase & Co. 10/14/2008 25.0 20.6 18% 4.4
Morgan Stanley 10/14/2008 10.0 5.8 42% 4.2
The Goldman Sachs Group, Inc. 10/14/2008 10.0 7.5 25% 2.5
The PNC Financial Services 10/24/2008 7.6 5.5 27% 2.1
U.S. Bancorp 11/03/2008 6.6 6.3 5% 0.3
Wells Fargo & Company 10/14/2008 25.0 23.2 7% 1.8
Subtotal $124.2 $96.9 22% $27.3
311 other transactions(*) $70 $54.6 22% $15.4
SSFI & TIP
American International Group. 11/10/2008 $40.0 $14.8 63% $25.2
Citigroup, Inc. 11/24/2008 20.0 10.0 50% 10.0
Subtotal $60.0 $24.8 59% 35.2
Total $254.2 $176.2 31% $78.0
* Extrapolation of 22% subsidy rate from 8 studied CPP investments
Source: Congressional Oversight Panel – February Oversight report - February 6, 2009 (Dollars in Billions)
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10. Accounting for fair value
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11. Determining fair value when the market for an asset is not active
» ASC 820 10 35-15A discusses principles concerning the determination of the fair
value of a financial asset in an inactive market
•Fair value is equal to the price that would be
What is fair value? received by a holder in an orderly transaction,
and not in a forced liquidation or distressed sale
•Significant judgment is required to assess
Analysis of transactions whether individual transactions represent
forced liquidations, distressed sales or fair value
•A reporting entity may use its own assumptions
Availability of inputs for future cash flows and risk-adjusted discount
rates absent relevant, observable inputs
•Weight given to quotes that rely on models
Treatment of broker price using information available only to the broker
quotes should be less than that reflecting market
information
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12. Determining fair value when market activity levels and volume
have decreased significantly
» ASC 820 10 35-51A provides guidance concerning the estimation of fair value when
market activity levels and volume have significantly decreased, and in identifying
transactions that are not orderly
Qualities of an Interpretation of
What is fair value? Standard of value
orderly transaction market behavior
•Fair value is equal to •An entity’s intention •An orderly •A significant fall in
the price that would to hold an asset or transaction is one market activity and
be received by a liability is not which allows for volume suggests a
holder in an orderly relevant to usual and customary potential increase in
transaction, and not estimating fair value, market exposure, not transactions that are
in a forced which is a market- a forced liquidation not orderly, requiring
liquidation or rather than entity- or distressed sale additional analysis
distressed sale specific measure and possibly
significant
adjustments to
estimate fair value
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13. Determining fair value when market activity levels and
volume have decreased significantly (continued)
» Factors that should be evaluated to determine whether market activity levels
and volume have decreased significantly include
› The number of recent transactions
› Whether price quotes are based on current information
› Variability of price quotes over time and between market participants
› Changes in the degree of correlation between the fair values of assets and
liabilities and related indices
› Increases in implied liquidity risk premiums, yields, or indicators of
performance such as delinquency rates and loss severity for observed
transactions and quoted prices as compared to the reporting entity’s
expected cash flows, taking into account credit market data and other non-
performance risk
› Increased or wide bid-ask spreads
› A decline in or absence of a new issue market
› Lack of public information
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14. Identifying transactions that are not orderly
» Under ASC 820 10 35-51E, It is inappropriate to automatically conclude that all
transactions are not orderly in a market where activity and levels have
decreased significantly
» Factors that should be evaluated to determine if a transaction is not orderly
include whether
› Market exposure was adequate to allow for usual and customary marketing
activities over the period before the measurement date
› Despite a usual and customary marketing period, the asset or liability was
marketed to a single buyer
› The seller was bankrupt, in receivership, or required to sell for regulatory
or legal reasons
› The price of the transaction is an outlier in comparison to comparable
transactions
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15. Identifying transactions that are not orderly (continued)
» The determination of whether a transaction is orderly or not orderly depends
on the weight of the evidence
› If the weight of the evidence suggests that the transaction is not orderly, little weight
should be given to the associated transaction price in estimating fair value or market
risk premiums
› If the weight of the evidence suggests that the transaction is orderly, the amount of
weight given to the associated transaction price in estimating fair value or market
risk premiums depends on facts and circumstances including
‒ Transaction volume, comparability, and timing
» Where it is not possible to conclude if a transaction is orderly, the transaction
price should be considered in estimating fair value or market risk premiums,
but not relied on as the sole or primary basis for the estimate
› Less weight should be afforded price quotes that do not reflect transactions, with
more weight assigned to quotes derived from binding offers
» Risk premiums should reflect the characteristics of an orderly transaction
between market participants as of the measurement date under current market
conditions
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16. Credit risk fundamentals
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17. What is credit risk?
» Credit is money loaned by a creditor to a debtor in exchange for a fee. Credit
risk is the chance of loss in the event that the debtor defaults on its resulting
obligations or liabilities.
» Credit risk can arise in numerous shapes and forms.
» From counterparties…
» Individuals, companies, governments
» …to obligations
» Currency, loans and bonds
» A credit event can be either market driven or company-specific
» Bankruptcy
» Ability-to-pay
» Credit-rating downgrade
» Material adverse change after merger
» Government action or market disruption
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18. The expected loss from credit risk is a function of three
variables: credit exposure, default probability and recovery rate
Expected loss = Credit X Default X 1 - Recovery Rate
exposure probability
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19. The securitization market
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20. Securitization is the process of aggregating, packaging and
distributing illiquid financial assets in the form of securities
4
Credit
Enhancement
1
AAA note
Aggregation of loans 2 AA note
Sale of BBB note
Loan the pool …
Loan of loans
SPV Investors
Originator 5
Loan
Interest +
Loan Cash flow Fee Principal
payment
3
Servicer
Cash flow collection
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21. Mortgages are by far the largest asset class used in
securitizations
» Mortgages account for the lion’s share
of asset securitizations, with $1.4
trillion securitized in 2008, down from
$3.2 trillion in 2003
› Agency deals
‒ Fannie Mae
‒ Freddie Mac
‒ Ginnie Mae
› Non-agency deals Source: SIFMA – Non agency mortgage related
‒ Jumbo issuances
‒ Alt-A
‒ Sub-prime
» Other types of securitized assets
totaled $140bn in 2008 after peaking at
$755bn in 2006
› Auto loans
› Credit card loans
› Student loans Source: SIFMA – Breakdown of US ABS issuances
excluding Mortgage products
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22. Collateralized debt obligations,
credit default swaps
and auction rate securities
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23. The complexity of structured financial assets has increased
dramatically over the past decade
Asset Backed Security Collateralized Debt Structured finance
(“ABS”) Obligation (“CDO”) CDO
• The original form of • A financial asset • A re-securitization
securitization collateralized by technique; CDO-
wholesale, squared: CDOs of
• Collateralized using a
intermediary-level CDOs
single form of retail,
debt
consumer-level debt • Collateralized by
• Instrument of choice subordinated
• Motivated by desire
for arbitrage tranches of RMBS,
to optimize balance
CMBS, CDOs
sheet • Compared to ABSs,
pool of assets is • Generates liquidity
• Structured as pass-
typically smaller and for lower-rated
through or pay-
more diverse tranches
through note or
certificate • May incorporate • Use of increased
synthetic leverage to enhance
technologies arbitrage returns
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24. Including unfunded amounts attributable to the use of levered
synthetic structures, total CDO issuance exceeded $3 trillion by 2007
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25. A Credit Default Swap (“CDS”) is a bilateral derivative contract for
protection from loss on the face value of a liability following a
credit event of the issuer
Protection Protection
buyer Seller
Credit event trigger Credit event trigger
Issuer
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26. CDS growth has been extraordinary reaching nearly $60
Trillion in outstanding amounts in 2007
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27. Auction Rate Securities are bonds or preferred stock with interest
rates or dividend yields that are periodically reset by auction
» ARS provide investors with higher yields
than traditional short-term investments
» Other than ARS issued by corporations Closed End
(i.e., monoline insurers) and CDOs, the funds
three major types of ARSs are 19%
› Auction Preferred Shares of closed-end Other
funds (“APS”) 5%
Student loans
› Municipal Auction Rate securities
26%
(“MARS”)
› Student Loan-Backed Auction Rate
securities (“SLARS”)
» The ARS market experienced strong
growth during the 2000s Municipalities
› CAGR of issuances exceeded 25% 50%
between 1998 and 2007
› ARS issuances peaked at nearly $45bn
in 2004
› ARS outstanding as of February 2008
stood at $330bn
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28. CDS, ARS and MBS valuation examples
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29. Valuation framework for a single-name CDS
Define Expected protection
payments
(function of CDS
price and default probabilities)
Discount cash flows
Define Default model using
(structural interest rates model
or reduced form) and solve
for CDS price
Define Expected pay off
in case of default
(function of default probabilities,
recovery assumptions)
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30. Valuation of a 5-year single name CDS contract
Recovery rates on senior unsecured debt
Historical cumulative 5-year default rates
(Moody’s)
(Moody’s)
Time period A/A1 All rated
1920-2008 1.193% 6.855%
(A)
1970-2008 0.612% 6.344%
(A)
1983-2008 0.679% 7.118%
(A1)
1998-2008 0.823% 7.283%
(A1)
Valuation : Sensitivity analysis
Bp Cumulative 5-year default probability
#### 0.6% 1.2% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%
Recovery
15% 10 21 35 52 70 89 107 126 144 163 183 202
rate
25% 9 18 31 46 62 78 94 111 127 144 161 179
33% 8 16 27 41 55 70 84 99 114 129 144 160
40% 7 15 25 37 50 62 75 89 102 115 129 143
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31. Valuation framework for an Auction Rate Security
Determine
Failed auction rate
(coupon)
Set-up
binomial model
and derive value of the ARS
at the initial node of the tree
Assess
expected holding period
of the investment
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32. Valuation framework for a Mortgage Backed Security
(1) (2) (3)
Expected cash Term structure Simulations
flows of interest rates
Analysis
of the pool of loans
Issuer risk
Term structure
Model for of interest rates
Monte Carlo
prepayment and Interest rate simulation
default expectations model
Analysis of the
liability structure Expected cash flows
of the SPV
Prepayment and default
model
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33. Mortgage backed security cash flow projections (without
default trigger)
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34. Mortgage backed security cash flow projections (with default
trigger)
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35. Conclusion
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36. Lessons from the financial crisis
» The analytical challenges underlying the financial crisis can be expected to
continue and multiply in line with the evolution of financial assets
» In times of unexpected and improbable economic distress, the risks of financial
assets correlate, leading to simultaneous default, the effects of which are
amplified by highly leveraged, derivative structures
» By breaking down the direct relationship between borrowers and creditors,
securitization can create the potential for conflicts of interest
» Financial markets and firms across the globe are increasingly interconnected
and subject to systemic risk
» The market demands a significant premium for liquidity when the value of
collateral and rate of recovery for a financial asset decline
» Independent fundamental analysis, focusing on the underlying collateral,
structure, credit risk and liquidity of a financial asset, is essential to preparing
a relevant and reliable valuation
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37. Speaker profile
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38. Boris J. Steffen
Principal and Director
(202) 538 – 5037
boris.steffen@naviganteconomics.com
» Education
› Master of Management, with specializations in accounting and finance, Kellogg School of
Management, Northwestern University
› Bachelor of Science in Finance and Bachelor of Music in Trumpet Performance, DePaul
University
› Certified Public Accountant; Accredited Senior Appraiser, Certificate in Distressed Business
Valuation
» Experience
› Valuation of businesses, debt, equity and derivative securities, tangible and intangible assets
› Antitrust and competition policy, bankruptcy and insolvency, contracts, intellectual property,
mergers & acquisitions, regulation, securities and international arbitration matters
› Testifying expert in disputes involving acquisition strategy and structure, alter ego, merger
synergies, competitive effects, enterprise and option valuation, fairness of consideration, lost
profits, solvency, stock market efficiency and value impairment
› Public policy, corporate development, and corporate finance roles with the U.S. Federal Trade
Commission, Bureau of Competition, U.S. Generating, Inc., and Inland Steel Industries, Inc.
» Affiliations
› Association of Insolvency and Restructuring Advisors, American Institute of Certified Public
Accountants, American Society of Appraisers, American Bankruptcy Institute, Insol
International, American Finance Association, American Bar Association
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39. Valuation of Complex Financial Assets in Illiquid Markets
DC Chapter of the American Society of Appraisers
Boris J. Steffen, MM, CPA, ASA, CDBV
Principal and Director
February 17, 2010
Page 39