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Valuation Of Complex Financial Assets In Illiquid Markets

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Valuation Of Complex Financial Assets In Illiquid Markets

Valuation Of Complex Financial Assets In Illiquid Markets


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  • 1. Valuation of Complex Financial Assets in Illiquid Markets Boris J. Steffen, MM, CPA, ASA, ABV, CDBV Principal and DirectorPage 1
  • 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 profilePage 2
  • 3. Evolution of the crisisPage 3
  • 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 » FraudPage 4
  • 5. The collapse of the housing bubble touched-off a self- perpetuating downward spiral of increasing illiquidityPage 5
  • 6. The government responsePage 6
  • 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 protectionPage 7
  • 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 crisesPage 8
  • 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)Page 9
  • 10. Accounting for fair valuePage 10
  • 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 informationPage 11
  • 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 valuePage 12
  • 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 informationPage 13
  • 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 transactionsPage 14
  • 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 conditionsPage 15
  • 16. Credit risk fundamentalsPage 16
  • 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 disruptionPage 17
  • 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 probabilityPage 18
  • 19. The securitization marketPage 19
  • 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 collectionPage 20
  • 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 productsPage 21
  • 22. Collateralized debt obligations, credit default swaps and auction rate securitiesPage 22
  • 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 returnsPage 23
  • 24. Including unfunded amounts attributable to the use of levered synthetic structures, total CDO issuance exceeded $3 trillion by 2007Page 24
  • 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 IssuerPage 25
  • 26. CDS growth has been extraordinary reaching nearly $60 Trillion in outstanding amounts in 2007Page 26
  • 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 $330bnPage 27
  • 28. CDS, ARS and MBS valuation examplesPage 28
  • 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)Page 29
  • 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 143Page 30
  • 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 investmentPage 31
  • 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 modelPage 32
  • 33. Mortgage backed security cash flow projections (without default trigger)Page 33
  • 34. Mortgage backed security cash flow projections (with default trigger)Page 34
  • 35. ConclusionPage 35
  • 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 valuationPage 36
  • 37. Speaker profilePage 37
  • 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 AssociationPage 38
  • 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, 2010Page 39