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. Derivatives UnderstoodTM ©2009 OTC Valuations Ltd. Winter 2009 Instrument Valuation Challenges 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 Derivatives UnderstoodTM ©2009 OTC Valuations Ltd. 2 Winter 2009 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