KMV portfolio manager internal presentation

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Valuing Hard-to-Value Assets The Case of
Tranches of CDOs of ABS
Charles Smithson
Prepared for Measuring and Managing Risk in
Innovative Financial Instruments Policy Session
at Financial Innovation Crises Federal
Reserve Bank of Atlanta Financial Markets
Conference May 12, 2009
www.rutterassociates.com
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In March 2004, I made assertions about
hard-to-value assets

• I asserted that hard-to-value assets
• tend to be illiquid, complex assets
• .. are more likely to be credit or fixed income
  than equity or foreign exchange

• I also asserted that three broad valuation
  principles were arising
• Transparency
• Consistency
• Independence

Valuing Assets Held in Investment Portfolios,
(Class Notes ) RISK, March 2004,
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In 2007 2008, I got OJT on valuing
hard-to-value assets

• From the fall of 2007, through the end of 2008,
  Rutter Associates did little else than value
  hard-to-value securities

Type of Client Problem Characteristics of Portfolio
North American Bank No capability to independently value or risk manage in CFO or CRO suites Exclusively US subprime
North American Insurance Regulator Must decide whether to close firm How likely is it that the ins co will have to pay a claim and, if it does, how large will it be? Exclusively US subprime
European Bank Large portfolio for sale -- Board of Directors needed independent valuation and fairness opinion US subprime dominates but, other collateral categories are important
North American Financial Institution Need values for financial statements -- Originating dealers had stopped providing values for tranches of CDOs of ABS US subprime dominates but a significant amount of the subprime exposure is in inner CDOs
European Bank Desire to have a system capable of comparing fundamental and market-implied values Portfolio 1 US subprime dominates but, other collateral categories are important Portfolio 2 No US subprime European collateral dominates Portfolio 3 ? US subprime, ? US RMBS
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The methodology was developed to value tranches
of CDO of ABS
Reference Portfolio Collateral Pool
CDO Structure
CDO Trust
AAA Tranche
Special Purpose Vehicle
Note Coupon (L bps)
Bond Coupons (L bps)
Proceeds ()
Proceeds ()
AA Tranche
A Tranche
BBB Tranche
Equity Tranche
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Approaches being used to value tranches of ABS
CDOs

• Net Asset Value -- Value based on current net
  liquidation value of assets.
• Equity Tranche Market value of CDO reference
  assets (net of CDO debt and other liabilities)
  divided by notional amount of equity issued.
• Debt tranches Use debt coverage ratio as an
  indicator of risk
• Comparables Find priced security with same
  characteristics as security being valued (coupon,
  structure, rating, manager, )
• Cash Flow Analysis
• Bottom Up
• Model CDO and tranche of interest (collateral
  pool, waterfalls and triggers)
• Input projections re default, recovery and
  prepayment to generate cash flows from tranche
  over time
• Discount cash flows to obtain present value of
  security
• Top Down

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• Step 1 Determine Collateral Categories
• Step 2 Specify Parameters for each Collateral
  Category
• Step 3 Generate 25 Scenarios for each Collateral
  
• Category
• Step 4 Value each Security using 25 scenarios

Note that this approach links macro view of
economic scenarios to micro view of the
individual securities
INTEX
A cursory discussion of this methodology appeared
in Valuing CDOs of ABSs, (Class Notes ) RISK,
March 2008
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• Re tranches of CDOs of ABS How do Rutter
  Associates Model Values compare to dealer
  valuations of and to bids actually made for the
  securities?

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In Sep 2008, I listed what I thought were the
most important lessons we had learned about
valuing hard-to-value assets

1. Independent... but not disconnected
2. Indicative quotes fall short in times of stress
3. Look through the security to the collateral pool
4. Structure matters... read the documents
5. Valuation must be transparent
6. Highlight the assumptions and review them
   continuously
7. Challenge the valuations

Valuing Hard-to-Value Assets, (Class Notes )
RISK, September 2008