Hide Notes 

Slide 1: Valuation of Complex Financial Assets in Illiquid Markets Boris J. Steffen, MM, CPA, ASA, ABV, CDBV Principal and Director Page 1
Slide 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 Page 2
Slide 3: Evolution of the crisis Page 3
Slide 4: Factors responsible for the crisis can be traced to suboptimal regulatory, investing and financing decisions » » » » » » » » » » » Page 4 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
Slide 5: The collapse of the housing bubble touched-off a selfperpetuating downward spiral of increasing illiquidity Page 5
Slide 6: The government response Page 6
Slide 7: Regulatory reforms proposed by the Treasury focus on five inter-connected objectives Supervision of financial institutions International standards and cooperation Regulation of financial markets Government capabilities Consumer and investor protection Page 7
Slide 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 › › › › Page 8 Regulatory capital standards Global financial markets oversight Supervision of institutions operating internationally Prevention and management of crises
Slide 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 Purchase Program Participants Capital Purchase Program Bank of America Corporation Citigroup, Inc. JP Morgan Chase & Co. Morgan Stanley The Goldman Sachs Group, Inc. The PNC Financial Services U.S. Bancorp Wells Fargo & Company Subtotal 311 other transactions(*) SSFI & TIP American International Group. Citigroup, Inc. Subtotal Total * Extrapolation of 22% subsidy rate from 8 studied CPP investments Source: Congressional Oversight Panel – February Oversight report - February 6, 2009 (Dollars in Billions) Valuation date Face Value $15.0 25.0 25.0 10.0 10.0 7.6 6.6 25.0 $124.2 $70 Value % $ 10/14/2008 10/14/2008 10/14/2008 10/14/2008 10/14/2008 10/24/2008 11/03/2008 10/14/2008 $12.5 15.5 20.6 5.8 7.5 5.5 6.3 23.2 $96.9 $54.6 $14.8 10.0 $24.8 $176.2 17% 38% 18% 42% 25% 27% 5% 7% 22% 22% 63% 50% 59% 31% $2.6 9.5 4.4 4.2 2.5 2.1 0.3 1.8 $27.3 $15.4 $25.2 10.0 35.2 $78.0 11/10/2008 11/24/2008 $40.0 20.0 $60.0 $254.2 Page 9
Slide 10: Accounting for fair value Page 10
Slide 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 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 forced liquidations, distressed sales or fair value •A reporting entity may use its own assumptions for future cash flows and risk-adjusted discount rates absent relevant, observable inputs •Weight given to quotes that rely on models using information available only to the broker should be less than that reflecting market information What is fair value? Analysis of transactions Availability of inputs Treatment of broker price quotes Page 11
Slide 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 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 Standard of value •An entity’s intention to hold an asset or liability is not relevant to estimating fair value, which is a marketrather than entityspecific measure Qualities of an orderly transaction •An orderly transaction is one which allows for usual and customary market exposure, not a forced liquidation or distressed sale Interpretation of market behavior •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 Page 12
Slide 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 nonperformance risk › Increased or wide bid-ask spreads › A decline in or absence of a new issue market › Lack of public information Page 13
Slide 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 Page 14
Slide 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 Page 15
Slide 16: Credit risk fundamentals Page 16
Slide 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 » » » » » Page 17 Bankruptcy Ability-to-pay Credit-rating downgrade Material adverse change after merger Government action or market disruption
Slide 18: The expected loss from credit risk is a function of three variables: credit exposure, default probability and recovery rate Expected loss = Credit exposure X Default probability X 1 - Recovery Rate Page 18
Slide 19: The securitization market Page 19
Slide 20: Securitization is the process of aggregating, packaging and distributing illiquid financial assets in the form of securities 4 Credit Enhancement 1 Aggregation of loans 2 Sale of the pool of loans Loan Loan Loan Loan Originator AAA note AA note BBB note … SPV Fee 5 Interest + Principal payment Investors Cash flow 3 Cash flow collection Servicer Page 20
Slide 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 Jumbo Alt-A Sub-prime Source: SIFMA – Non agency mortgage related issuances › Non-agency deals ‒ ‒ ‒ » Other types of securitized assets totaled $140bn in 2008 after peaking at $755bn in 2006 › › › Page 21 Auto loans Credit card loans Student loans Source: SIFMA – Breakdown of US ABS issuances excluding Mortgage products
Slide 22: Collateralized debt obligations, credit default swaps and auction rate securities Page 22
Slide 23: 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 • Motivated by desire to optimize balance sheet • Structured as passthrough or paythrough note or certificate Collateralized Debt Obligation (“CDO”) • A financial asset collateralized by wholesale, intermediary-level debt • Instrument of choice for arbitrage • Compared to ABSs, pool of assets is typically smaller and more diverse • May incorporate synthetic technologies Structured finance CDO • A re-securitization technique; CDOsquared: CDOs of CDOs • Collateralized by subordinated tranches of RMBS, CMBS, CDOs • Generates liquidity for lower-rated tranches • Use of increased leverage to enhance arbitrage returns Page 23
Slide 24: Including unfunded amounts attributable to the use of levered synthetic structures, total CDO issuance exceeded $3 trillion by 2007 Page 24
Slide 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 buyer Protection Seller Credit event trigger Credit event trigger Issuer Page 25
Slide 26: CDS growth has been extraordinary reaching nearly $60 Trillion in outstanding amounts in 2007 Page 26
Slide 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 (i.e., monoline insurers) and CDOs, the three major types of ARSs are Closed End funds 19% Other 5% Student loans 26% › › › Auction Preferred Shares of closed-end funds (“APS”) Municipal Auction Rate securities (“MARS”) Student Loan-Backed Auction Rate securities (“SLARS”) » The ARS market experienced strong growth during the 2000s › › › Municipalities 50% 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 Page 27
Slide 28: CDS, ARS and MBS valuation examples Page 28
Slide 29: Valuation framework for a single-name CDS Define Expected protection payments (function of CDS price and default probabilities) Discount cash flows using interest rates model and solve for CDS price Define Expected pay off in case of default (function of default probabilities, recovery assumptions) Define Default model (structural or reduced form) Page 29
Slide 30: Valuation of a 5-year single name CDS contract Historical cumulative 5-year default rates (Moody’s) Time period 1920-2008 1970-2008 1983-2008 1998-2008 A/A1 1.193% (A) 0.612% (A) 0.679% (A1) 0.823% (A1) All rated 6.855% 6.344% 7.118% 7.283% Recovery rates on senior unsecured debt (Moody’s) Valuation : Sensitivity analysis Bp #### 0.6% 1.2% 15% 10 21 25% 9 18 33% 8 16 40% 7 15 Recovery rate 2% Cumulative 5-year default probability 3% 4% 5% 6% 7% 8% 9% 10% 11% 35 52 70 89 107 126 144 163 183 202 31 46 62 78 94 111 127 144 161 179 27 41 55 70 84 99 114 129 144 160 25 37 50 62 75 89 102 115 129 143 Page 30
Slide 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 Page 31
Slide 32: Valuation framework for a Mortgage Backed Security (1) Expected cash flows Analysis of the pool of loans (2) Term structure of interest rates Issuer risk (3) Simulations Term structure of interest rates Monte Carlo simulation Model for prepayment and default expectations Analysis of the liability structure of the SPV Interest rate model Expected cash flows Prepayment and default model Page 32
Slide 33: Mortgage backed security cash flow projections (without default trigger) Page 33
Slide 34: Mortgage backed security cash flow projections (with default trigger) Page 34
Slide 35: Conclusion Page 35
Slide 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 Page 36
Slide 37: Speaker profile Page 37
Slide 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 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. 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 » Experience › › › › » Affiliations › Page 38
Slide 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