Valuing Hard to Value Assets: Calculating the

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Valuing Hard to Value Assets Calculating the
Fair Value of Structured Credit Assets, with a
Focus on ABS and CDOs of ABS

• Foundation for Accounting Education
• 2008 Banking Conference
• September 25, 2008
• Rick Grove
• Rutter Associates, New York

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Valuing Hard to Value Assets

• Reasons Why Valuation is Important
• To Assist in Making Trading Decisions
• In order to determine the price at which it would
  be a buyer or seller of an asset, an institution
  must have a view of the current value of the
  asset.
• To Assist in Managing Risk
• In order to gauge potential gains and losses from
  market movement and to assess counterparty credit
  exposure relating to an asset, an institution
  must have a view of the current value of the
  asset.
• For Financial Reporting Purposes
• In order to provide investors and other
  stakeholders with a fair view of its financial
  position, and to comply with financial disclosure
  regulatory requirements, an institution must
  place a value on its assets (and its liabilities).

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Valuing Hard to Value Assets

• Valuation Methodologies
• Market Prices
• Best source for valuation of an asset is price of
  a market transaction involving the identical
  asset the price of an exchange traded security
  is an example.
• Using prices for market transactions of
  comparable assets can be a substitute when market
  transactions involving the identical asset do not
  exist an example is matrix pricing whereby the
  price of an asset is determined by its
  relationship to other assets for which prices are
  observable.

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Valuing Hard to Value Assets

• II. Valuation Methodologies (continued)
• Models
• A formula that converts inputs, obtained through
  observation or otherwise, into an output that
  represents the value of an asset.
• An example is the Black-Scholes option pricing
  model, which can be used to determine the price
  of an option on an underlying asset by reference
  to inputs, including the market price of the
  underlying asset, the implied volatility of the
  underlying asset, the time to expiration of the
  option and the term structure of interest rates.

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Valuing Hard to Value Assets

• II. Valuation Methodologies (continued)
• Discounted Cash Flow Analysis
• A methodology by which all cash flows expected to
  be generated by an asset, including interest
  payments and principal repayments, are
  calculated.
• These cash flows are then (a) discounted back to
  present value using an appropriate interest rate
  and (b) aggregated to result in a value for the
  asset.

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Valuing Hard to Value Assets

• FAS 157 and Fair Value Accounting for U.S. GAAP
  Purposes
• FAS 157 defines Fair Value as the price that
  would be received to sell an asset or paid to
  transfer a liability in an orderly transaction
  between market participants at the measurement
  date.
• FAS 157 establishes a hierarchy of three levels
  of inputs from which fair value of an asset may
  be ascertained.
• Level 1 Inputs
• Level 1 inputs are quoted prices in active
  markets for identical assets as the ones being
  valued.
• FAS 157 states that Level 1 inputs are the most
  reliable evidence of fair value and should be
  used except in certain limited situations.

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Valuing Hard to Value Assets

• FAS 157 and Fair Value Accounting for U.S. GAAP
  Purposes (continued)
• Level 2 Inputs
• Level 2 inputs include (a) quoted prices for
  similar assets in active markets, (b) quoted
  prices for identical or similar assets in markets
  that are not active, (c) inputs, other than
  quoted prices, that are observable for the asset,
  and (d) inputs that are derived principally from
  or corroborated by correlation or other means.
• Level 2 inputs should only be used if Level 1
  inputs are not available, but are preferable to
  unobservable inputs (see Level 3 inputs below).
• Level 3 Inputs
• Level 3 inputs are unobservable inputs for an
  asset.
• Level 3 inputs should be used only where
  observable inputs are not available.
• Level 3 inputs must be based on the best
  available information, which can include the
  reporting entitys own data.

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Valuing Hard to Value Assets

• Fair Value Under IFRS
• Current Status
• International Financial Reporting Standards
  (IFRS) adopted by the International Accounting
  Standards Board (IASB) require some assets in
  some circumstances to be measured at fair value.
• Guidance on measuring fair value is dispersed
  throughout the IFRS, is incomplete and is not
  always consistent.
• The existing IFRS guidance differs from FAS 157
  in that FAS 157 defines fair value as an
  exit/selling price, whereas IFRS does not define
  fair value as either an exit or an entry price.

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Valuing Hard to Value Assets

• Fair Value Under IFRS (continued)
• IASB Fair Value Measurement Project
• IASB has undertaken a project to establish a
  single source of guidance for when fair value
  measurements are required and to clarify the
  definition of fair value.
• In formulating its guidance on fair value
  measurement, IASB will consider the requirements
  of FAS 157, but the requirements ultimately
  adopted by IASB may differ from those of FAS 157.
• IASB first published a discussion paper on fair
  value measurement in November 2006 on which it
  received numerous comments from interested
  parties.
• IASB is currently working on an exposure draft
  which it plans to publish during the first half
  of 2009.
• IASBs current plan is to publish an IFRS on fair
  value measurement in 2010.

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Valuing Hard to Value Assets

• Valuing ABS and CDOs of ABS Current Market
  Constraints
• Since the summer of 2007, trading activity in
  many ABS, especially ABS of residential
  mortgages, and most CDOs and CDO2s has decreased
  and almost disappeared.
• With little trading activity, there are few, if
  any, observable prices in the market upon which
  valuations can be based.
• In FAS 157 terms, there are few, if any, Level 1
  or even Level 2 inputs from which fair value can
  be determined.
• The absence of Level 1 and Level 2 inputs means
  that an alternative methodology must be used to
  value ABS and CDOs of ABS.

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Valuing Hard to Value Assets

• VI. Rutter Associates Approach to Valuing ABS
  and CDOs of ABS Using Discounted Cash Flow
  Methodology
• The Easy Part Discerning Scheduled Cash Flows
  from ABS and Choosing an Appropriate Discount
  Rate
• All scheduled payments of interest and principal
  need to be identified this information is
  readily available.
• An interest rate curve with which to discount
  these cash flows needs to be selected the LIBOR
  curve is normally the choice.
• With this information, a cash flow model can be
  constructed and used to discount all scheduled
  cash flows to their net present value (NPV).
• However, there are two complications!

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Valuing Hard to Value Assets

• Rutter Associates Approach to Valuing ABS/CDOs
  (cont.)
• First Complication The Capital Structure of
  ABS
• Most ABS have a tranched capital structure, with
  senior tranches enjoying priority over more
  subordinated tranches.
• The provisions regarding priority of payments
  among the tranches are known as waterfalls
  because cash flows first to the senior most
  tranche until its right to payment has been
  satisfied and then flows down to the next most
  senior tranche until its right to payment has
  been satisfied and so on down the capital
  structure.
• Programming these waterfalls is significantly
  more complicated than creating a model in which
  all holders of interest in an asset share pari
  passu in the cash flow.
• The programming exercise is made even more
  complicated by the fact that there are certain
  triggers in these deals, such as interest
  coverage tests and over collateralization tests,
  which, if not met, can have the effect of
  diverting cash flow that would normally flow
  through the waterfall to a different path in the
  capital structure. Programming theses triggers
  further complicates the task.
• Fortunately, there is an off the shelf solution
  provided by Intex Solutions, Inc. Intex provides
  a cash generation model that can be used to
  generate the cash flows for most U.S. and many
  non-U.S. ABS. That, in and of itself, is not
  particularly remarkable. What makes Intex so
  valuable, however, is that it has assembled a
  library of thousands of deals for which its cash
  flow generator has pre-programmed the waterfalls
  and triggers.

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Valuing Hard to Value Assets

• Rutter Associates Approach to Valuing ABS/CDOs
  (cont.)
• Second Complication The Key Inputs, Other than
  Scheduled Cash Flow and Interest Rates, May be
  Difficult to Discern
• The pools of assets underlying ABS, especially if
  they are home mortgages, do not pay all interest
  and principal as scheduled. They are subject to
  both prepayment of principal and default.
• Prepayment rates, while they may vary over time
  depending on market conditions, are relatively
  easy to discern and can be specified in the cash
  flow model. Moreover, prepayment rates affect
  only the timing of payments and, therefore,
  usually have less of an impact on the value of an
  asset than loss rates.
• Default rates and recovery rates, which together
  determine loss rates, are a different matter
  altogether, both because they are more difficult
  to discern prospectively and because they have a
  greater impact on value.
• Historical loss rates have little predictive
  utility in the market for residential mortgages
  at the moment given the dramatic shift of the
  past two years. The benign default rates that
  prevailed for much of the 1995 2005 period have
  little to tell us about default rates at the
  moment or in the near future.

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Valuing Hard to Value Assets

• Rutter Associates Approach to Valuing ABS/CDOs
  (cont.)
• Second Complication (continued)
• One alternative to the use of historical loss
  rates is to use fundamental analysis of
  observable data, such as home price appreciation
  (or more likely in the current environment, home
  price depreciation) rates, delinquency rates,
  FICO (credit) scores, geographic location and
  loan to value ratios to construct a forecast of
  loss rates. This analysis requires numerous
  assumptions about the relationship between these
  observable data and future loss rates.
• In contrast, Rutter Associates prefers to derive
  loss rates from whatever limited pricing data is
  observable in the market. Market views about
  loss rates are implicit in this pricing data.
  Even in the current market environment there is
  sufficient data available from which to extract
  the market-implied view of loss rates. (Rutter
  Associates has generally not derived residential
  mortgage loss rates from indices such as ABX,
  which, even though they have continued to trade,
  are problematic at best as a source for
  discerning loss rates. Rutter Associates has
  preferred to use other available data, primarily
  other data from Markit Group Ltd.). Using
  market-implied loss rates eliminates much of the
  guess work inherent in the fundamental analysis
  approach to estimating loss rates and keeps the
  analysis grounded to whatever market activity
  exists.

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Valuing Hard to Value Assets

• Rutter Associates Approach to Valuing ABS/CDOs
  (cont.)
• Completing the Valuation
• Once the prepayment rates and loss rates have
  been determined, they can be applied to adjust
  the scheduled cash flows for the asset.
• The adjusted cash flows are then (a) run through
  the cash flow generation model, which takes
  account of the applicable waterfalls and triggers
  and (b) discounted back to present value using
  the selected interest rate curve. The present
  value of the cash flow accruing to each tranche
  of the ABS can then be aggregated resulting in
  the determination of a value for each tranche.

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Valuing Hard to Value Assets

• Rutter Associates Approach to Valuing ABS/CDOs
  (cont.)
• Extending the Methodology to CDOs of ABS
• CDOs are even more complicated to value than ABS
  because CDOs add yet another capital structure to
  the analysis. Like ABS, most CDOs have a
  tranched capital structure with their own
  waterfalls and triggers. Cash must first flow
  through the waterfalls of all of the ABS
  underlying the CDO, make its way up to the CDO
  through the tranche of the ABS held by the CDO
  and then flow through the CDOs waterfall.
• Once again, Intex provides a useful tool, for not
  only are most of the ABS underlying a CDO likely
  to be programmed in Intex, so too are most of the
  CDOs themselves, including their waterfalls and
  triggers. Not that a CDO and its underlying
  ABS could not be programmed if not found in
  Intex, but it would take an extraordinary amount
  of time to do so.
• As with ABS, assumptions need to made as to the
  prepayment rates and loss rates to apply to the
  scheduled cash flows of the asset pool held by
  each ABS underlying the CDO and the interest rate
  curve at which these cash flows will be
  discounted to present value.
• Once these assumptions are applied, the cash flow
  generation model can calculate the cash flow
  accruing to the tranches of the ABS underlying
  the CDO and then further calculate the cash that
  will accrue to each CDO tranche. The result is a
  value for each CDO tranche.

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Valuing Hard to Value Assets

• Conclusion
• In the current environment, characterized by very
  limited trading, prices for most ABS and CDOs of
  ABS are not likely to be found. This means that
  there is almost no chance of finding Level 1 or
  Level 2 inputs on which to base a valuation.
• Fortunately, there are alternatives by which ABS
  and CDOs of ABS can be valued. The discounted
  cash flow model used by Rutter Associates has
  been successful in producing values for hundreds
  of ABS and CDOs of ABS that are not trading.
• One of the keys to the success of this approach
  has been an ability to extract market-implied
  loss rates from the limited data that is
  observable in the market.
• Although the approach relies on Level 3 inputs,
  it has generated results that have been accepted
  by auditors and regulators as fair value for
  the ABS and CDOs of ABS being valued.