Valuing “Hard-to-Value” Assets: The Case of Tranches of CDOs of ABS

1. 0 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

2. 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 CDO of ABS • I also asserted that three broad valuation principles were arising • Transparency • Consistency • Independence *“Valuing Assets Held in Investment Portfolios,” (Class Notes ) RISK, March 2004,”

3. 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 2

4. The methodology was developed to value tranches of CDO of ABS Reference Portfolio “Collateral Pool” CDO Trust CDO Structure Mtge 10 Mtge 5 Mtge 9 Mtge 4 Mtge 7 Mtge 8 Mtge 2 Mtge 3 Mtge 6 Mtge 1 … … … … … … … … … … Special Purpose Vehicle ‘AAA’ Tranche Mtge 200 Mtge 195 Mtge 199 Mtge 194 Mtge 197 Mtge 198 Mtge 192 Mtge 193 Mtge 196 Mtge 191 ABS Tranche 1 ABS Tranche 2 ABS Tranche 3 ABS Tranche 4 ABS Tranche 5 RMBS Trust RMBS Bonds … … … … … … … … … … ABS Tranche 6 ABS Tranche 7 ABS Tranche 8 ABS Tranche 9 ABS Tranche 10 Mtge 400 Mtge 395 Mtge 399 Mtge 394 Mtge 397 Mtge 398 Mtge 392 Mtge 393 Mtge 396 Mtge 391 Special Purpose Vehicle ‘AAA’ RMBS Note Coupon (L + bps) … … … … … … … … … … ABS Tranche 11 ABS Tranche 12 ABS Tranche 13 ABS Tranche 14 ABS Tranche 15 Mtge 600 Mtge 595 Mtge 599 Mtge 594 Mtge 597 Mtge 598 Mtge 592 Mtge 593 Mtge 596 Mtge 591 Bond Coupons (L + bps) … … … … … … … … … … Proceeds ($) ABS Tranche 16 ABS Tranche 17 ABS Tranche 18 ABS Tranche 19 ABS Tranche 20 Mtge 800 Mtge 795 Mtge 799 Mtge 794 Mtge 797 Mtge 798 Mtge 792 Mtge 793 Mtge 796 Mtge 791 … … … … … … … … … … ABS Tranche 21 ABS Tranche 22 ABS Tranche 23 ABS Tranche 24 ABS Tranche 25 Proceeds ($) Mtge 1000 Mtge 995 Mtge 999 Mtge 994 Mtge 997 Mtge 998 Mtge 992 Mtge 993 Mtge 996 Mtge 991 ‘AA’ Tranche ‘AA’ RMBS … … … … … … … … … … … … … … … ‘A’ RMBS Mtge 1200 Mtge 1195 Mtge 1199 Mtge 1194 Mtge 1197 Mtge 1198 Mtge 1192 Mtge 1193 Mtge 1196 Mtge 1191 ‘A’ Tranche ABS Tranche 86 ABS Tranche 87 ABS Tranche 88 ABS Tranche 89 ABS Tranche 90 … … … … … … … … … … ‘BBB’ RMBS ‘BBB’ Tranche Mtge 1400 Mtge 1395 Mtge 1399 Mtge 1394 Mtge 1397 Mtge 1298 Mtge 1392 Mtge 1393 Mtge 1396 Mtge 1391 ABSCDO Tranche 1 ABSCDO Tranche 2 ABSCDO Tranche 3 ABSCDO Tranche 4 ABSCDO Tranche 5 ‘BBB-’ RMBS … … … … … … … … … … Equity Tranche Residual ABSCDO Tranche 6 Mtge 1600 ABSCDO Tranche 7 Mtge 1595 Mtge 1599 Mtge 1594 Mtge 1597 Mtge 1598 ABSCDO Tranche 8 ABSCDO Tranche 9 ABSCDO Tranche 10 Mtge 1592 Mtge 1593 Mtge 1596 Mtge 1591 … … … … … … … … … … Mtge 1800 Mtge 1795 Mtge 1799 Mtge 1794 Mtge 1797 Mtge 1792 Mtge 1793 Mtge 1796 Mtge 1791 Mtge 1798 … … … … … … … … … … Mtge 2000 Mtge 1995 Mtge 1999 Mtge 1994 Mtge 1997 Mtge 1998 Mtge 1992 Mtge 1993 Mtge 1996 Mtge 1991

5. 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 • FundamentalorMarket-Implied

6. Specify and calibrate a distributionof default intensities at the borrower level Example: Borrowers that make up collateral pools of vintage T that have current delinquency rates of X% to Y% Calibrate to observable prices for assets in the collateral pool of the CDOs being valued Prepayment Scenario Intensity Timing Default Scenario Intensity Timing 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 Recovery Scenario LGD Use consensus from analysts and rating agencies Note that this approach links “macro” view of economic scenarios to “micro” view of the individual securities INTEX Detailed Info on CDO (Collateral Pool) on Tranche (Waterfall & Triggers) Cash Flow Month 5 Cash Flow Month 1 Cash Flow Month 2 Cash Flow Month 4 Cash Flow Month 3 Cash Flow Month 6 A cursory discussion of this methodology appeared in “Valuing CDOs of ABSs,” (Class Notes ) RISK, March 2008

7. In Sep 2008, I listed what I thought were the most important lessons we had learned about valuing hard-to-value assets* • Independent... but not disconnected • Indicative quotes fall short in times of stress • Look through the security to the collateral pool • Structure matters... read the documents • Valuation must be transparent • Highlight the assumptions and review them continuously • Challenge the valuations *“Valuing Hard-to-Value Assets,” (Class Notes ) RISK, September 2008