DERIVATIVE and SECURITY Winter 2009 VALUATION NEWS

DERIVATIVE AND SECURITY Winter 2009 VALUATION NEWS

The bend in the road is not the end of the road unless you refuse to take the turn.

- Anon

Industry Update Trends in Hedge Fund Administration Also Featured Smaller, emerging, or startup fund managers have found that the discovery of so In This Issue many Ponzi schemes in the industry was a bigger hit to business than anything that has happened in the capital markets. These funds are finding that outsourcing, particularly back office activities, is the only real solution in order Valuation Challenges to establish credibility. This trend has been prevalent in Europe where even large Pricing illiquid securities and funds have independent administrators; in the US, traditionally, funds were self alternatives to stale broker quotes administered, but this is now changing as it is nearly impossible to raise capital and counterparty marks unless there are qualified and reputable service providers “looking over your ...... 02 shoulder”. Transparency and disclosure are key for funds to raise capital in this market environment, which includes providing investors detailed written procedures on operations and related risk mitigation. One of the primary areas investors are Regulatory Announcements focusing on is how the administrator values the fund’s portfolios, even though Are CCPs the answer to the the valuation of the fund is ultimately the responsibility of the fund and not the problem? administrator...... 04 Administrators have improved their valuation capabilities in the past year, but the issue of simply taking the manager’s price where it is most imperative to independently determine a valuation is still, particularly in the US, a hot button for the industry. While many administrators market themselves as one-stop What’s New at OTC Val valuation shops with the in-house expertise and systems to value the majority of A major European Bank and global their client portfolios, very few can handle the exotic OTC derivatives or illiquid Inurance Firm select OTC Val for securities, particularly CDOs. As funds are expected to maintain the highest independent valuations of their degree of operational integrity by investors, they are no longer simply relying on exotic portfolios an administrator's brand when selecting an administrator. They are now more ...... focused on ensuring the administrator can independently price their portfolios, 06 have the domain expertise, and are able to adapt to changing market conditions.

Illiquid Securities/Stale Quotes

Even with some liquidity returning to the structured product market, there remain a significant number of issues for which broker quotes and counterparty marks remain stale or are based on very thinly traded data. Pricing these securities based on such quotes, which may be available through data aggregators and evaluated price providers, does not provide an accurate indication of the economic value of such securities and does not allow for a sufficient level of price transparency required for financial reporting purposes. Specific examples include many commercial and residential MBS, European commercial paper, CDOs, and other asset-backed products.

In this environment, market participants are as audit and internal risk compliance requirements for concerned about the assumptions and data behind a securities with no direct market observable prices. As product’s price as the price itself. This implies that any part of the valuation process, one must be sure to valuation method employed must enable a firm to conduct counterparty risk analysis and reasonableness provide the required level of transparency and tests to ensure consistency and accuracy, while utilizing disclosure to pass audit requirements. Some specific [FAS 157 Level II] observable market inputs wherever suggestions are available from the IASB Expert Advisory possible. Panel’s publication titled Measuring and Disclosing the Fair Value of Financial Instruments in Markets that are Whether building an in-house process or outsourcing No Longer Active. the valuations of these securities, the main consider- ations to review include: As there has been limited success in efforts to bring buyers and sellers together through various auction (1) the quality, depth, and breadth of data sources, portals, valuation of these hard-to-value securities has particularly gaining access to inventory runs and been an active topic of discussion. Numerous proprietary indices where required; institutional investors have had to rely upon boutique valuation vendors to help them arrive at a defendable (2) the methodology utilized based on the level of data methodology of price discovery, which often depends or security parameters available (i.e. when will on the data available to calibrate models or otherwise mark-to-market be used versus mark-to-model, or determine relative value. some combination);

When trying to assess the price of an illiquid security, (3) assessing credit quality of a speciﬁc issuer; there are proven fair value estimation and model-based techniques that can be applied to satisfy

Illiquid Securities/Stale Quotes

(4) the price challenge process for sector spreads, bankruptcy haircuts investigating a boutique valuation outliers or dramatic changes in and markdowns, liquidity, and credit vendor with experience in pricing prices, and the resolution process, quality. Further, counterparty credit such securities. particularly when being compared to risk and non-performance risk of the broker quotes. security holder must be incorpo- Some final thoughts we will share rated, as appropriate. surrounding broker quotes: Expanding on (1) above, managing an active and ongoing database of Given the illiquid nature of these • Where a broker is pricing below $1, market information, inclusive of securities, it is reasonable to expect the price may be a real price but may credit histories and prospectuses is that, based on varying sets of valid be signaling an unwillingness to an essential ingredient. As a starting assumptions, the fair value may fall make a market in the security. point, public data sources can be within a range rather than a single used in conjunction with a variety of figure. In instances where a client’s • It isn't uncommon to see very banking resources and government price varies from the one reported by different prices even between sponsored data sites. a vendor, generally these differences brokers, where they may all be can be resolved and attributed to correct, but representing an indica- The general pricing approach should differences in models, data, or tive price versus a market price, and use actual market prices for securi- assumptions. When all parties are reflecting their positions in the ties more actively traded by the open-minded to the existence of market place. issuers along with a mapping process other models, insights, and legiti- applied to market prices of compa- mate viewpoints, these discrepan- • When boutique valuation vendors rable structures of other issuers. An cies are normally resolved during the provide an opinion on the feasible- integral part of the mapping method- proof-of-concept phase or initial set ness of the broker price, they should ology references recently available of valuation reports. look not only at it on an individual information on the issuers from security basis, but also on a portfolio sources such as the SEC, rating If the firm or its auditors are worried basis to compare the price aggregate agencies, and others. Where no about a single broker price, which is a differences. direct or comparable data is avail- valid concern given the lack of trans- able, one can apply a model-based parency and little indication of how approach with market inputs such as stale the quote is, it would be worth

Pricing MBS, ABS, CDOs, CLNs, and other Illiquid Securities Many mortgage-backed securities, commercial paper, corporate debt, collateralized debt obligations, and other asset-backed products have attained illiquid status. Holders can no longer rely on broker quotes because the quotes have become stale, or otherwise fail to satisfy the level of price transparency required for ﬁnancial reporting purposes. OTC Val addresses these data issues through its transparent valuation service that is based on proven fair value estimation and model-based techniques.

We use an active and ongoing database of market information, inclusive of credit histories and prospectuses. Public data sources are used in conjunction with a variety of banking resources and government sponsored data sites. The general pricing approach uses actual market prices for securities more actively traded by the issuers along with a mapping process applied to market prices of comparable structures of other issuers. An integral part of the mapping methodology references recently available information on the issuers from sources such as the SEC, rating agencies, and others. Where no direct or comparable data is available, we apply a model-based approach with market inputs such as sector spreads, bankruptcy haircuts and markdowns, liquidity, and credit quality. Further, counterparty credit risk and non-performance risk of the security holder is incorporated, as appropriate.

If you or your auditors are worried about a single broker price which has no transparency and little indication of how stale the quote is, OTC Val’s evaluated price, which is based on a fundamental bottom-up calculation (inclusive, of course, of market price inputs), can act as an independent and transparent opinion.

CCPs To The Rescue...Maybe

Derivatives has become a dirty word, undeniably linked to topics pertaining to the faltering economy, ensuing bailouts, and the shake-up of the financial industry. Do derivatives deserve the bad rap? It depends on who you ask. Did the use of derivatives and other financial products create the economic storm we are in? While they have rightly received their fare share of attention, they should not be singled out as the sole cause. So how does the financial and corporate community that relies on derivatives stick handle through the current economic crisis, restore investor confidence, improve transparency, and reduce systemic risk? It has been suggested the implementation of central counterparty (CCP) clearing for over-the-counter (OTC) derivatives is one such way and, as expected, has garnered a lot of attention over the last year. Are CCPs the answer to the problem?

Following the credit crisis and all for good reasons, credit default swaps (CDSs) have become a primary focus of regulators and government agencies. A number of exchanges, including the CME, and clearing agencies, including LCH Clearnet, have introduced or will be introducing a clearing solution for CDSs. While these organizations have taken great strides to implement a solution, there are limits to the types of products they can clear. More specifically, for-profit clearinghouses will be limited to clearing a fixed number of standardized products. Furthermore, while most clearinghouses have committed to clearing index trades and some will clear the more liquid single name credit contracts, others, like CME and LCH.Clearnet have said they will not be in a position to clear most single name contracts.

So does this mean that only a limited number of credit and interest rate products can be traded or held? Initially, the House Financial Services Committee, chaired by Barney Frank, motioned to pass the OTC Derivatives Market Act 2009, which proposed that only those products that are standardized and cleared by a CCP would be eligible. However, given this would have hindered non-financial organizations from effectively hedging financial risk through tailored derivative Regulators Will Determine Which Derivatives Must Be Cleared With much debate ensuing about who should be responsible for deciding which derivatives must be cleared and which trades would or could be excluded from or avoid the clearing and trading requirement, further clarifications and guidance are required. In response to concerns about the current bill being subject to manipulation, whether by financial firms or clearinghouses - especially those that have ties to financial entities - Chairman Frank of the House Financial Services Committee issued a letter to Chairman Gensler of the CFTC and Chairman Schapiro of the SEC.

While Chairman Frank stated the responsibility for setting the guidelines for which derivatives must be cleared will reside with the regulators, he called on the CFTC and SEC to assist the Financial Services Committee in drafting amendments to reduce the possibility of market manipulation and avoidance of the clearing and trading requirements. This call to action seems to be in response to Chairman Gensler’s statement that the CFTC was not in a position to take on the added responsibility for determining whether or not a trade can be cleared; which resulted in the clearinghouses being given this responsibility.

Based on the ensuing responses from Chairman Gensler and Chairman Frank to the Nov 4th letter where Gensler stated the CFTC will work with the Financial Services Committee to develop the necessary amendments and Frank stated the committee is committed to working with and empowering the CFTC and SEC with authority to make decisions related to clearing of derivatives, they are far from developing an amenable solution. The debate and merits of who will be responsible for setting the guidelines for clearing trades and what trades will be eligible for clearing will continue well into 2010.

CCPs To The Rescue...Maybe products, the committee revised the hedging purposes, there will be a strated a clear need for non-standard proposal to allow for non- significant number of OTC products, / OTC products. This could signal that standardized products, but with higer including credit and interest rate while all the appropriate measures capitalrequirements to offset poten- derivatives, that fall outside the are being taken to reduce systemic tial default risk. While we under- periphery of standardized and risk and improve transparency, the stand the merits of reducing counter- eligible products. likelihood of non-standardized prod- party risk for non-standard products ucts falling out favor is unlikely. through higher capital requirements, While a CCP model would theoreti- this must be balanced against the cally eliminate bilateral counterparty So are CCPs the answer? While they working capital pressure imposed risk, one must question whether it serve a solid purpose, we encourage upon organizations. Therefore, we eliminates systemic risk. Yes it is true further proposals to ensure the would encourage the House Financial that if a clearing member was to appropriate solutions and informa- Services Committee to reconsider the default, the CCP would absorb the tion is available to all market partici- higher capital requirements. Further- collateral losses and protect the pants to facilitate price discovery and more, we would encourage the market from a wider fallout. How- transparency for all derivatives and Financial Services Committee to pass ever, acting as a central agent to all securities. As the practice of using of a mandate requiring organizations to trades, a CCP model exposes clear- non-standardized products and the use multiple or independent pricing inghouses to systemic risk as they merits of bilateral trades continue to sources to manage capital exposure would need to absorb all potential drive market innovation for solutions requirements imposed by the use of defaults. If CCPs were to become "too and infrastructure to support clear- non-standardized derivatives. big to fail", who would be responsible ing, reduce systemic risk, and for bailing them out? improve transparency, there must be In response to the OTC Derivatives a balance in the number and type of Market Act, some of the largest Despite the fact that the CCP model solutions to foster a healthy OTC derivatives dealers, including Gold- could potentially reduce counter- derivatives market. The credit crisis, man Sachs, JPMorgan, and Deutsche party risk, it is important to acknowl- which exacerbated and exposed the Bank, have agreed to submit 95% of edge the significance and implicit use inherent risks associated with current eligible credit derivative trades to of non-standardized, bi-laterally valuation practices, has visibly dem- central clearinghouses; these houses traded products as a risk manage- onstrated situations of mispricing have with a goal of clearing approxi- ment tool. Because many OTC prod- and lack of valuation transparency. mately 80% of those trades. Dealers ucts, including credit and interest These discoveries have renewed the have also agreed to submit 90% of all rate derivatives, require properly market’s interest in the merits of eligible interest rate derivatives to calibrated models that capture the truly independent pricing sources. clearinghouses; these houses hope appropriate market dynamics to We encourage the regulatory bodies to be able to clear 70% of these accurately determine the price of a to continue to explore and imple- derivatives. This acceptance by the product. it would be an inherent ment independent pricing not simply dealers should come as no surprise as requirement, and potentially an as a best practice, but make it a man- it allows the dealers to maintain their unrealistic expectation, for CCPs to datory requirement to facilitate price price maker role rather than become correctly price, margin, and discovery for all OTC products. price takers under an exchange- ultimately clear all OTC products. traded model. However, given the Additionally, while regulatory bodies valuation and clearing limitations of encourage the use of standardized or clearinghouses and the active role exchange-traded derivatives, it is that dealers play in facilitating currently not mandatory given that tailored products that are used for market participants have demon-

European Bank Outsources Valuations

Several investment management and exotic part of our portfolio for needs, given their rigorous divisions of large multinational which broker quotes are not criteria and thorough due institutions have selected OTC Val readily available or are stale, and diligence process. As a leading in 2009 for independent valua- instruments that our risk depart- provider of independent valuations of illiquid securities and ment requires an independent tions of illiquid securities, deriva- derivatives. In one instance, a price verification source for due tives, and structured products, major European bank now to internal controls, regulations, our clients use OTC Val's service receives daily reports that as a complementary and price are used as a counterparty verification source to existing and broker price verification counterparty and broker service, as well as utilized as Bob Sangha, a founding member at OTC Val price sources where these are part of the bank’s daily NAV comments, “With a heightened awareness available. This bank remains calculations. of credit and counterparty risk, an ahead of coming regulatory increasing number of ongoing collateral developments that have high- Within one week of receiv- calls are being imposed upon organizations, lighted the need for a truly ing the securities portfolio, tying up working capital. As a valuation independent and objective OTC Val conducted an source, we provide our clients another data source of valuations for the individual review of each point on what each investment product is purposes of compliance and security to ensure all worth, independent of their counterparty's market risk management.” relevant market parameters or internal marks. We are pleased to have were reflected in the calcu- been selected as their primary source for the Sangha adds “We are also lated price report generated pricing of their exotic portfolio." very excited to be working by OTC Val. Due to the with ValueLink in providing an dynamic nature of the portfolio, independent valuations solution an automated process was imple- to the bank as a complement to, mented that guarantees a pricing and best practice. There are really and verification of, existing coun- report is delivered to the bank only a handful of providers that terparty and broker price sources within 60 minutes of market can handle these securities and where these are available. In close, via the ValueLink infrastruc- OTC Val stood out for their addition, regulatory develop- ture and directly to the invest- accuracy, consistency, transpar- ments have highlighted the need ment management division. OTC ency, and fantastic service. Given for a truly independent and objec- Val’s independent valuation their integration with ValueLink as tive source of valuations for the report was a seamless addition to a delivery platform, it was very purposes of compliance and the existing counterparty pricing painless to get up and running.” market risk management.” service the bank receives from ValueLink. Bob Sangha, a founding member Stephen Choate, CEO of at OTC Val said “We are very ValueLink said, “We are A Market Data Management proud to have been selected by delighted to be working with Specialist at the bank explains this major European bank for OTC Val in bringing another “OTC Val handles the most illiquid their independent valuation source of independent OTC

European Bank Outsources Valuations derivative valuations to our clients. ValueLink are renowned for helping to reduce operational risk for our users by aggregating and validating many of their existing sources and processes. By presenting independent pricing from OTC Val alongside these sources and our counterparty collection service we are also helping clients to reduce risk and meet their increasingly onerous regulatory commitments.”

Insurance Firm Selects OTC Val

In another instance, OTC Val signed marks. We are pleased to one of the world’s largest providers have been selected as their of life insurance, pensions, and primary source for the investment products. The firm’s pricing of their exotic portfo- investment management depart- lio." ment receives valuation reports for their exotic derivatives and struc- Sangha adds, “Typically our tured product portfolio from OTC clients already handle their Val. These valuations are used for vanilla trades via an in-house collateral management and finan- or third party system given cial reporting purposes and as price the relatively less complex verification of counterparty and nature of these trades. Our front office quotes. focus has always been on exotic derivatives, struc- After a lengthy due diligence tured products, and illiquid process, which included an exten- securities that are priced in sive trial, the investment management department our production system. This approach has selected OTC Val, citing responsiveness and ability allowed us to take advantage of economies of to deliver transparent and custom reports as differ- scale and offer a compelling solution to clients entiating factors in their decision process. The where accurate price verification for that trouble- service complements their in-house system which is some 5 or 10% of their portfolio has not been used to price the remainder of their portfolio. fully implemented.”

Bob Sangha, a founding member at OTC Val comments “With a heightened awareness of credit and counterparty risk, an increasing number of ongoing collateral calls are being imposed upon organizations, tying up working capital. As a valuation source, we provide our clients another data point on what each investment product is worth, independent of their counterparty's or internal

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