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Valuation of Complex Financial Assets in Illiquid Markets

Boris J. Steffen, MM, CPA, ASA, ABV, CDBVPrincipal and Director

Overview

» Evolution of the crisis

» The government response

» Accounting for fair value

» Credit risk fundamentals

» The securitization market

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» 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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Evolution of the crisis

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» 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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The collapse of the housing bubble touched-off a self-perpetuating downward spiral of increasing illiquidity

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The government response

Regulatory reforms proposed by the Treasury focus on five inter-connected objectives

Supervision offinancial institutions

Regulation offinancial markets

International standardsand cooperation

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Consumer andinvestor protection

Governmentcapabilities

financial marketsand cooperation

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› 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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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

Purchase Program Participants Valuation dateFace

ValueValue % $

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

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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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Accounting for fair value

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

What is fair value?

•Fair value is equal to the price that would be received by a holder in an orderly transaction, and not in a forced liquidation or distressed sale

•Significant judgment is required to assess whether individual transactions represent

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Analysis of transactions

•Significant judgment is required to assess whether individual transactions represent forced liquidations, distressed sales or fair value

Availability of inputs

•A reporting entity may use its own assumptions for future cash flows and risk-adjusted discount rates absent relevant, observable inputs

Treatment of broker price quotes

•Weight given to quotes that rely on models using information available only to the broker should be less than that reflecting market information

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

What is fair value?

•Fair value is equal to

Standard of value

•An entity’s intention

Qualities of anorderly transaction

•An orderly

Interpretation ofmarket behavior

•A significant fall in

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•Fair value is equal to the price that would be received by a holder in an orderly transaction, and not in a forced liquidation or distressed sale

•An entity’s intention to hold an asset or liability is not relevant to estimating fair value, which is a market-rather than entity-specific measure

•An orderly transaction is one which allows for usual and customary market exposure, not a forced liquidation or distressed sale

•A significant fall in market activity and volume suggests a potential increase in transactions that are not orderly, requiring additional analysis and possibly significant adjustments to estimate fair value

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

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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

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

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› 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

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

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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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Credit risk fundamentals

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

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» 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

The expected loss from credit risk is a function of three variables: credit exposure, default probability and recovery rate

= Default probability

Default probability

X 1 - Recovery RateRecovery RateExpected loss Credit exposureCredit

exposureX

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=probabilityprobability

X 1 - Recovery RateRecovery RateExpected loss exposureexposure

X

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The securitization market

Securitization is the process of aggregating, packaging and distributing illiquid financial assets in the form of securities

AAA note

BBB note

AA note

LoanSale of

Credit

Enhancement 1

2

4

Aggregation of loans

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SPV Investors

BBB note

…Loan

Loan

Loan

Loan

ServicerCash flow collection

Cash flow FeeInterest + Principal payment

Sale of the pool of loans

Originator

3

5

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

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‒ Ginnie Mae

› Non-agency deals

‒ Jumbo

‒ 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 loansSource: SIFMA – Breakdown of US ABS issuances

excluding Mortgage products

Source: SIFMA – Non agency mortgage related

issuances

Collateralized debt obligations,

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Collateralized debt obligations,credit default swaps

and auction rate securities

The complexity of structured financial assets has increased dramatically over the past decade

Asset Backed Security (“ABS”)

• The original form of securitization

• Collateralized using a single form of retail, consumer-level debt

Structured finance CDO

• A re-securitization technique; CDO-squared: CDOs of CDOs

• Collateralized by subordinated

Collateralized Debt Obligation (“CDO”)

• A financial asset collateralized by wholesale, intermediary-level debt

• Instrument of choice

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• Motivated by desire to optimize balance sheet

• Structured as pass-through or pay-through note or certificate

subordinated tranches of RMBS, CMBS, CDOs

• Generates liquidity for lower-rated tranches

• Use of increased leverage to enhance arbitrage returns

• Instrument of choice for arbitrage

• Compared to ABSs, pool of assets is typically smaller and more diverse

• May incorporate synthetic technologies

Including unfunded amounts attributable to the use of levered synthetic structures, total CDO issuance exceeded $3 trillion by 2007

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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 buyer

Protection buyer

Protection Seller

Protection Seller

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IssuerIssuer

Credit event trigger Credit event trigger

CDS growth has been extraordinary reaching nearly $60 Trillion in outstanding amounts in 2007

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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 (i.e., monoline insurers) and CDOs, the three major types of ARSs are

› Auction Preferred Shares of closed-end funds (“APS”)

› Municipal Auction Rate securities Student loans

26%

Other

5%

Closed End

funds

19%

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› Municipal Auction Rate securities (“MARS”)

› Student Loan-Backed Auction Rate securities (“SLARS”)

» The ARS market experienced strong growth during the 2000s

› CAGR of issuances exceeded 25% between 1998 and 2007

› ARS issuances peaked at nearly $45bn in 2004

› ARS outstanding as of February 2008 stood at $330bn

Municipalities

50%

26%

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CDS, ARS and MBS valuation examples

Valuation framework for a single-name CDS

Define Expected protection payments

(function of CDS price and default probabilities)

Define Expected protection payments

(function of CDS price and default probabilities)

Define Default modelDefine Default modelDiscount cash flows

using interest rates model

Discount cash flows using

interest rates model

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Define Default model(structural

or reduced form)

Define Default model(structural

or reduced form)

using interest rates model

and solve for CDS price

using interest rates model

and solve for CDS price

Define Expected pay off in case of default

(function of default probabilities, recovery assumptions)

Define Expected pay off in case of default

(function of default probabilities, recovery assumptions)

Valuation of a 5-year single name CDS contract

Time period A/A1 All rated

1920-2008 1.193%(A)

6.855%

1970-2008 0.612%(A)

6.344%

1983-2008 0.679%(A1)

7.118%

Historical cumulative 5-year default rates (Moody’s)

Recovery rates on senior unsecured debt(Moody’s)

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1983-2008 0.679%(A1)

7.118%

1998-2008 0.823%(A1)

7.283%

Valuation : Sensitivity analysis

Bp

#### 0.6% 1.2% 2% 3% 4% 5% 6% 7% 8% 9% 10% 11%

15% 10 21 35 52 70 89 107 126 144 163 183 20225% 9 18 31 46 62 78 94 111 127 144 161 179

33% 8 16 27 41 55 70 84 99 114 129 144 16040% 7 15 25 37 50 62 75 89 102 115 129 143

Cumulative 5-year default probability

Re

cov

ery

rate

Valuation framework for an Auction Rate Security

DetermineFailed auction rate

(coupon)

DetermineFailed auction rate

(coupon)

Set-upbinomial model

Set-upbinomial model

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binomial modeland derive value of the ARS at the initial node of the tree

binomial modeland derive value of the ARS at the initial node of the tree

Assess expected holding period

of the investment

Assess expected holding period

of the investment

Valuation framework for a Mortgage Backed Security

Analysisof the pool of loans

Analysisof the pool of loans

(1)Expected cash

flows

(2)Term structure of interest rates

(3)Simulations

Issuer riskIssuer riskTerm structure

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Analysis of the liability structure

of the SPV

Analysis of the liability structure

of the SPV

Monte Carlo simulation

Monte Carlo simulationInterest rate

modelInterest rate

model

Term structure

of interest ratesModel forprepayment and

default expectations

Model forprepayment and

default expectations

Expected cash flows

Prepayment and default model

Mortgage backed security cash flow projections (without default trigger)

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Mortgage backed security cash flow projections (with default trigger)

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Conclusion

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

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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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Speaker profile

Boris J. SteffenPrincipal and Director (202) 538 – 5037boris.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

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» 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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Valuation of Complex Financial Assets in Illiquid Markets

DC Chapter of the American Society of Appraisers

Boris J. Steffen, MM, CPA, ASA, CDBVPrincipal and Director

February 17, 2010