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1. cate wrote:

   From the Market, Credit, and Risk Strategies group (MCRS) is a newly formed, separate and independent research team at Standard & Poor’s. The objective of this group is to provide unique financial intelligence by analyzing relationships across multiple asset classes and markets. Enabled with cutting-edge S&P and third-party applications and data, the group offers investors valuable new sources for alpha discovery and “out-of-the-box” thinking through robust data exploration and analysis. The research is delivered through the Market Intellect series that provides investors with actionable and topical market perspectives that can offer innovative ways to leverage credit and risk intelligence.

   Cutting Through The Rhetoric Surrounding The Valuation Of Complex Securities By Focusing On Their Cash Flows, Credit Risk, And “Risk Of Ruin”

   “The difference between carrying a midtier RMBS on the balance sheet at 80 cents on the dollar and less than 10 cents on the dollar can be as little as a 5% difference in assumptions over future default rates,”–Market, Credit, and Risk Strategies team.

   Observations

   A central challenge currently facing global investors is the appropriate and fully disclosed pricing of, and the risks associated with, Level 3 assets, also known as “mark-to-model” assets. This topic has been at the heart of the global credit contagion that has been roiling markets since July 2007. The Market, Credit, and Risk Strategies (MCRS) team believes these assets can be valued in a meaningful and transparent manner that is largely dependent on investors’ perceptions of current and future credit risks. To show how this can be done, we conducted a case study that sheds light on the difficult and complex, but not insurmountable, nature of valuing esoteric structured finance Level 3 assets.

   Key Findings
   Not all RMBS tranches are created (i.e., structured) equally. While some deserve serious consideration by even the most risk-averse money managers, others should be avoided by all but the most sophisticated institutional investors.
   While structured finance assets can be difficult to price due to the multiple input variables that must be considered and modeled, investors can nonetheless price them in a transparent and meaningful way.
   In true “buyer-beware” fashion, investors should individually determine an appropriate valuation for each risk factor associated with a given structure by analyzing multiple factors drawn from a pool of existing market conditions, and assumptions about future conditions in the credit and real estate markets. This is akin to an equity investor determining the appropriate price/earnings valuation assumption that should be assigned to the equity market.
   As in any distressed auction, the bidder with the most optimistic assessment of future valuations will submit the winning bid.

   Underlying Data and Resources
   MCRS generates the data and scenario analysis for this original research from the following Fixed Income Risk Management Services’ (FIRMS) analytic platform:

   ABSXchange/Analytics On Demand (AOD): Runs various hypothetical return and loss scenarios enabling the simultaneous analysis of multiple structured finance deal tranches according to both existing and assumed future market conditions. The applications fully account for all cash flows and waterfall clauses for the individual deal tranches.

   Research Output and Analysis
   This research paper establishes a pricing matrix as part of a case study of a $2 billion residential mortgage-backed security (RMBS) under six separate credit-risk stress scenarios. The case study RMBS is backed by three separate pools of U.S. 30-year adjustable-rate mortgages (ARMs) originated in third-quarter 2006. The RMBS whole loan assets are then sliced and diced into approximately 40 individual tranches under the terms and conditions of the RMBS. The geographic exposures of the core residential mortgages backing this structure are: California 60%, Florida 10%, New York 5%, others 25%.

   This case study RMBS was selected for analysis both for its broad geographic exposure and the fact that it was originated at about the same time that U.S. housing prices started to decline. Approximately 85% of the loans were limited-documentation mortgages, and 15% were full documentation. The mortgages are generally one-month negative amortization option ARMs benchmarked at a reasonable spread of 150 basis points (bps) above one-year MTA.

   The performance characteristics of the $2 billion pool of assets underlying this RMBS are as follows as of September 2008:

   5% annualized prepayment rate currently observed in the underlying pool of assets.
   10% delinquency rate currently observed in the underlying pool of assets.
   5% foreclosure rate currently observed in the underlying pool of assets.
   2% of assets are real estate owned (REO) within the underlying pool of assets.
   Our next step is to outline the terms of the six risk scenarios under which we are pricing the cash flows of the individual tranches. These range from scenario 1, which in our judgment approximates where the market is today, to scenario 6, which we consider a worst-case scenario. All six scenarios assume the immediate liquidation of underlying collateral upon default:

   Scenario 1
   5% prepayment rate

   5% expected cumulative defaults over the next 12 months

   20% loss severity

   Scenario 2
   5% prepayment rate

   10% expected cumulative defaults over the next 18 months

   25% loss severity

   Scenario 3
   5% prepayment rate

   15% expected cumulative defaults over the next 24 months

   30% loss severity

   Scenario 4
   5% prepayment rate

   20% expected cumulative defaults over the next 30 months

   35% loss severity

   Scenario 5
   5% prepayment rate

   25% expected cumulative defaults over the next 36 months

   40% loss severity

   Scenario 6
   5% prepayment rate

   50% expected cumulative defaults over the next 24 months

   50% loss severity

   The cash flows of all tranches are being discounted with a margin of 250 bps to the specific benchmark used to value each RMBS tranche. We selected a 250-bp discount margin because we believe it is an acceptable and sufficient compromise representing the current amount of stress embedded in global credit markets relative to the 10- to 120-bps margin spreads assigned to individual tranches at the time of origination. This additional stress includes market risks above and beyond the modeled anticipated cash flows under different scenarios for defaults and loss severity. Examples of these risks include political risk, issuer solvency risk, and investor confidence in the U.S. financial sector generally.

   We are basically saying that confidence in the credit markets has deteriorated to the point that the riskiest tranches (i.e., +120 bps at origination) should now be discounted at minimum at a rate of +250 bps to one-month LIBOR. Investors could easily assign different discount margins to different RMBS tranches according to market risk, but we have settled on +250 bps for the sake of keeping the focus on other variables such as mortgage defaults and collateral loss severity. Note that the +250-bps discount margin is above and beyond the historically wide credit spreads currently seen in the money market between LIBOR and the Fed funds target rate.

   Under the six scenarios outlined above involving various combinations of mortgage prepayments, defaults, and loss severity, the table outlines the net present value (NPV) for each individual tranche of the RMBS under each hypothetical scenario. We have highlighted in red shading the tipping point where the hierarchal nature of the RMBS investment structure kicks in under each scenario. These are the inflection points where the senior tranche holders obviously begin to benefit at the expense of the expected cash flows of the lower tranche investors due to the shortfall of originally anticipated mortgage payments.

   https://www.ratingsdirect.com/Apps/RD/controller/ArticleCM?id=680792&type=&outputType=print&from=CM&prvReq=&pager.offset=&SIMPLE_SEARCH_TYPE=&CONID=

   Tuesday, November 4, 2008 at 4:09 pm | Permalink
2. cate wrote:

   Relaxing Mark-to-Market Rules Is a Slippery Slope

   by Larry Tabb

   Nov 04, 2008
   URL: http://www.wallstreetandtech.com/showArticle.jhtml?articleID=212000440

   In keeping with the season, Citigroup on Halloween scared its shareholders and the market by moving another $13.3 billion in assets to the Level 3 designation. Level 3 assets have no active market and need to be valued (either partially or fully) by internal model. The assets Citi moved to Level 3, according to MarketWatch, included asset-backed securities, warehouse loans backed by auto lease receivables and credit card securitizations.

   MarketWatch also reported that, according to Citigroup, “$2.9 billion of net additions to those [Level 3] liabilities were offset by $2.9 billion of mark-to-market gains. A portion of the gains was offset by losses recognized for positions classified in Level 2.”

   OK, let’s digest this a bit. So Citi (which probably is somewhat representative) is moving $13.3 billion into the Level 3 category from externally valued to internally valued assets. Included in its Level 3 assets is a profit of $2.9 billion, which was offset by some losses in Level 2 assets.

   So, if I get this straight, the internally marked assets are increasing in value while the externally-priced assets are declining? As Dana Carvey’s Church Lady would say, “Well, isn’t that special?”

   Now, I don’t want to say that Citi is misrepresenting its financial condition — I certainly don’t have the knowledge or insight to say it is wrong. But it does sound funny that their securities with observable valuations took a loss but their internally modeled positions appreciated.

   I don’t have an issue with Level 3 assets, per se. The challenge with Level 3 assets is that they are difficult to value. The problem I have with Level 3 assets is that the banks want to expand the use of mark-to-model valuations for more of these products — embedded in the 2008 Troubled Asset Relief Program, or TARP, is a study of the impact of allowing banks greater latitude in the marking of these troubled assets to model instead of to the latest/last observable price.

   This somewhat minor accounting issue is of course not minor at all. Mark-to-market accounting is critical to the valuation of profits, positions, net capital and, for that matter, bank solvency.

   Banks are worried that during this credit crisis, securitizations and other real estate derivative assets are being liquidated at fire-sale prices and hence not reflective of their intrinsic or steady state value. Banks maintain that if they needed to mark these assets to market values they would reflect significant and unrepresentative losses, which could impact their solvency.

   Now, I am all for bank solvency. In fact, I wrote a scathing commentary criticizing the current Administration for stalling the bailout and getting in the way of bank solvency. However, by softening banks mark-to-market obligations we are fixing a transparency problem (the ability to easily monitor asset-backed securities’ collateral value) with a lack of transparency. By not marking these positions to the value investors are willing to pay for these assets, we are compounding the valuation problem that started this whole credit crisis.

   I’m sure that Citi and the other larger banks have no vested interest in (artificially) keeping these valuations high (well, er …) and that bank solvency, compensation and bonuses have no tie to the value of these assets (um, well …). But the problem with relaxing mark-to-market requirements is that it leads down a very slippery slope. You can start with the very best of intentions, but it gets out of control very easily. A little model tweak, a different reference point, a blind eye — and eventually we are in a very compromising, or should I say, compromised — position.

   Let’s just take our medicine, book some significant loses, use the TARP or whatever to get this toxic waste off the balance sheets, and start anew. That is what our tax dollars are supposed to be paying for. Otherwise, like Japan in the 1980s and ’90s, we will drag this problem out for a decade or more and eventually sap the life out of not only our financial markets but our banking system, as well. Let’s keep the light on our markets and our valuations transparent. That way the ghosts of the past will stay kiddy lore instead of becoming a very scary reality.

   Tuesday, November 4, 2008 at 6:34 pm | Permalink

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