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HARD TO VALUE SECURITIES:
CONCERNS ON LEVEL 3 ASSETS
Melissa Brady, CFA
Phone: 212-372-1296
Email: Melissa.Brady@RSMUS.com
Website: www.RSMUS.com
November 15, 2016

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ASC 820 Hierarchy of Inputs to Valuation Models
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Level II Assets
• Less active market OR active market for similar
assets/liabilities. Examples:
- Interest rate swaps
- Restricted Stock
- Currency Swaps
- Residential or commercial mortgage loans
- Mortgage Backed Securities
- Mortgage REITs with quotes or prices
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Thinly Traded Shares
• Thinly traded is broadly defined. Some
definitions include:
- Under $10 million in assets
- 500 or less investors
- Trades less than 20,000 shares a day
- Wide bid-ask spreads – 50 cents or more
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High Yield Bond Example:
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2014 2015 2014 2015
Client's Mark 65.75 60.30 61.00 51.90
Number of trades 210 131 571 222
Average Size of trade 117,110 57,008 145,779 49,045
Average price - simple 60.21 43.43 58.91 31.79
Average price - weighted 61.75 43.92 58.43 33.45
Median 61.36 43.05 59.27 32.00
Standard Deviation 4.50 2.27 3.25 2.17
Company F Company N

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High Yield Bond Example (continued):
• Size of trades & consistency
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Company N Trades of $1MM+
Trade Date Quantity Price
12/17/2015 $1MM+ $34.75
12/17/2015 $1MM+ $35.25
01/04/2016 $1MM+ $34.63
01/04/2016 $1MM+ $34.75
Company F Trades of $1MM+
Trade Date Quantity Price
01/13/2016 $1MM $44.00
01/13/2016 $1MM $44.38

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Considerations for Loans and Bonds
• Fair value vs investment value
• Fair value is based on exit price
• Retail vs. Institutional trades and differences in
prices received
• Stating the market is not active or orderly
• Pricing hierarchy
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SEC Case: AlphaBridge Capital Mgmt
• July 1, 2015 — The SEC charged AlphaBridge
with fraudulently inflating the prices.
• AlphaBridge told investors and its auditor that it
obtained independent price quotes from broker-
dealers for certain unlisted, thinly-traded RMBS
securities.
• AlphaBridge instead gave internally-derived
valuation models to broker-dealer representatives
to pass off as their own.
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SEC Case: Patriarch Partners
• March 30, 2015 — The SEC announced fraud
charges against Patriarch of hiding the poor
performance of loan assets in three collateralized
loan obligation (CLO) funds they manage.
• Nearly all valuations of loan assets have been
reported to investors as unchanged despite
defaults
• Management fees were also inflated due to
inflated valuations.
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SEC Case: KCAP
• November 2012 - KCAP disregarded market
quotes. KCAP made the assumption these
quotes did not reflect fair value and argued
the market was dislocated. This impacted
their debt securities and CLOs.
• SEC claimed that the method did not
calculate for the exit price of a security, as
required by ASC 820, and instead ignored
market activity.
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SEC Case: Yorkville
Yorkville: The SEC alleged that Yorkville overvalued
assets to increase fees. SEC alleged that Yorkville
ignored negative information about certain assets,
withheld information from its auditors, and misled
investors. SEC alleged that Yorkville deliberately
ignored obvious decreases in value of certain
investments.
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SEC Case: Morgan Keegan
• 2010 case against mutual fund adviser
• Involved incorrect valuations of mortgage backed
securities in 2007
• Settled in 2011, finding fraud under Section 206
• Also found violations of compliance
• 2013 SEC issued a cease and desist order.
• Did not follow its written policies and procedures
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SEC Enforcement Remarks
• SEC continues to focus on complex or illiquid
securities
• Concerns over lax valuation, use of side pockets
to hide losing positions, and not following
valuation procedures.
• Concern over market participant perspective not
being fully considered
• Lack of support for discounts and premia
• SEC has rejected the idea of dysfunctional
markets
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SEC Enforcement Remarks
• Valuation committee did not receive notice or
explanation when price confirmations were
ignored. (Price overrides)
• Obtaining price confirmation infrequently or on
only a subset of the fund’s portfolio.
• The board delegates full responsibility to the
valuation committee
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Pricing Services
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• Vendors differ in the type of pricing for various
classes of securities. Contracting with multiple
vendors
• Obtain quotes from more than one vendor
• Provide support and reconcile differences
• Deep dives

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Deep Dives
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• Obtain an understanding of methodology and significant
input assumptions employed by a vendor to determine a
security’s price.
• Example – corporate bond... Was it priced based upon:
1. Transaction data observed via TRACE
2. Broker-dealer quotes
3. Trade/quote data observed for other bonds issued by
same entity (issuer curve)
4. Trade/quote data observed for similar bonds issued
by other entities (issuer curve)

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Inputs By Asset Class – Bonds
Asset Class Methodology Input Assumptions
Gov’t / Corp IG
bonds &
Syndicated loans
Observed
transactions
TRACE data or client trade
tickets
Broker-dealer quotes Dealer runs or trade platforms
(TradeWeb)
HY Corp / Muni
bonds
DCF (Issuer curve) Trade/quote data for other
bonds issued by same entity
DCF (Yield matrix) Trade/quote data for similar
bonds issued by other entities
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Inputs By Asset Class – Structured Products
Asset Class Methodology Input Assumptions
Agency RMBS TBA + payup Relevant TBA price (TRACE / dealer
quoted) + observed market payup
adjustment data + other observed market
adjustment data for security-specific
features
DCF • Prepayment (historical data + future
expectations)
• Yield (selected based on observed
trades/quotes for similar investments)
Non-agency
RMBS and ABS
DCF • Same as above
• Default (historical data + future
expectations)
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Inputs By Asset Class – Derivatives
Asset Class Methodology Input Assumptions
Futures and
options
1
Observed
transactions
Direct feed from exchange
Broker-dealer
quotes
Direct feed from exchange
Black-Scholes &
simulation
Volatility & correlation (observed data for
underlying assets or similar assets), risk-
free or other interest rate
Interest rate
derivatives
Generally, DCF • LIBOR curve (spot + futures + dealer
quotes)
• OIS curve (spot + dealer quotes)
• Volatility smile (implied from observed
cap/floor/swaption prices and quotes)
Credit Derivatives DCF • Spread or default probability (implied
through market prices)
• Recovery rate (data for similar assets)
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1 May refer to equity, currency, or commodity options

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