Foundation for Accounting Education 2008 Banking Conference September 25, 2008 Rick Grove

1. Valuing Hard to Value Assets: Calculating the “Fair Value” of Structured Credit Assets, with a Focus on ABS and CDOs of ABS Foundation for Accounting Education 2008 Banking Conference September 25, 2008 Rick Grove Rutter Associates, New York

2. Valuing Hard to Value Assets • Reasons Why Valuation is Important • To Assist in Making Trading Decisions • In order to determine the price at which it would be a buyer or seller of an asset, an institution must have a view of the current value of the asset. • To Assist in Managing Risk • In order to gauge potential gains and losses from market movement and to assess counterparty credit exposure relating to an asset, an institution must have a view of the current value of the asset. • For Financial Reporting Purposes • In order to provide investors and other stakeholders with a fair view of its financial position, and to comply with financial disclosure regulatory requirements, an institution must place a value on its assets (and its liabilities).

3. Valuing Hard to Value Assets • Valuation Methodologies • Market Prices • Best source for valuation of an asset is price of a market transaction involving the identical asset – the price of an exchange traded security is an example. • Using prices for market transactions of comparable assets can be a substitute when market transactions involving the identical asset do not exist – an example is matrix pricing whereby the price of an asset is determined by its relationship to other assets for which prices are observable.

4. Valuing Hard to Value Assets II. Valuation Methodologies (continued) • Models • A formula that converts inputs, obtained through observation or otherwise, into an output that represents the value of an asset. • An example is the Black-Scholes option pricing model, which can be used to determine the price of an option on an underlying asset by reference to inputs, including the market price of the underlying asset, the implied volatility of the underlying asset, the time to expiration of the option and the term structure of interest rates.

5. Valuing Hard to Value Assets II. Valuation Methodologies (continued) • Discounted Cash Flow Analysis • A methodology by which all cash flows expected to be generated by an asset, including interest payments and principal repayments, are calculated. • These cash flows are then (a) discounted back to present value using an appropriate interest rate and (b) aggregated to result in a value for the asset.

6. Valuing Hard to Value Assets • FAS 157 and Fair Value Accounting for U.S. GAAP Purposes • FAS 157 defines Fair Value as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. • FAS 157 establishes a hierarchy of three levels of inputs from which fair value of an asset may be ascertained. • Level 1 Inputs • Level 1 inputs are quoted prices in active markets for identical assets as the ones being valued. • FAS 157 states that Level 1 inputs are “the most reliable evidence of fair value” and should be used except in certain limited situations.

7. Valuing Hard to Value Assets FAS 157 and Fair Value Accounting for U.S. GAAP Purposes (continued) • Level 2 Inputs • Level 2 inputs include (a) quoted prices for similar assets in active markets, (b) quoted prices for identical or similar assets in markets that are not active, (c) inputs, other than quoted prices, that are observable for the asset, and (d) inputs that are derived principally from or corroborated by correlation or other means. • Level 2 inputs should only be used if Level 1 inputs are not available, but are preferable to unobservable inputs (see Level 3 inputs below). • Level 3 Inputs • Level 3 inputs are unobservable inputs for an asset. • Level 3 inputs should be used only where observable inputs are not available. • Level 3 inputs must be based on the best available information, which can include the reporting entity’s own data.

8. Valuing Hard to Value Assets • Fair Value Under IFRS • Current Status • International Financial Reporting Standards (IFRS) adopted by the International Accounting Standards Board (IASB) require some assets in some circumstances to be measured at fair value. • Guidance on measuring fair value is dispersed throughout the IFRS, is incomplete and is not always consistent. • The existing IFRS guidance differs from FAS 157 in that FAS 157 defines fair value as an exit/selling price, whereas IFRS does not define fair value as either an exit or an entry price.

9. Valuing Hard to Value Assets Fair Value Under IFRS (continued) • IASB Fair Value Measurement Project • IASB has undertaken a project to establish a single source of guidance for when fair value measurements are required and to clarify the definition of fair value. • In formulating its guidance on fair value measurement, IASB will consider the requirements of FAS 157, but the requirements ultimately adopted by IASB may differ from those of FAS 157. • IASB first published a discussion paper on fair value measurement in November 2006 on which it received numerous comments from interested parties. • IASB is currently working on an exposure draft which it plans to publish during the first half of 2009. • IASB’s current plan is to publish an IFRS on fair value measurement in 2010.

10. Valuing Hard to Value Assets • Valuing ABS and CDOs of ABS: Current Market Constraints • Since the summer of 2007, trading activity in many ABS, especially ABS of residential mortgages, and most CDOs and CDO^2s has decreased and almost disappeared. • With little trading activity, there are few, if any, observable prices in the market upon which valuations can be based. • In FAS 157 terms, there are few, if any, Level 1 or even Level 2 inputs from which fair value can be determined. • The absence of Level 1 and Level 2 inputs means that an alternative methodology must be used to value ABS and CDOs of ABS.

11. Valuing Hard to Value Assets VI. Rutter Associates’ Approach to Valuing ABS and CDOs of ABS Using Discounted Cash Flow Methodology • The Easy Part: Discerning Scheduled Cash Flows from ABS and Choosing an Appropriate Discount Rate • All scheduled payments of interest and principal need to be identified – this information is readily available. • An interest rate curve with which to discount these cash flows needs to be selected – the LIBOR curve is normally the choice. • With this information, a cash flow model can be constructed and used to discount all scheduled cash flows to their net present value (NPV). • However, there are two complications!

12. Valuing Hard to Value Assets Rutter Associates’ Approach to Valuing ABS/CDOs (cont.) • First Complication: The Capital Structure of ABS • Most ABS have a tranched capital structure, with senior tranches enjoying priority over more subordinated tranches. • The provisions regarding priority of payments among the tranches are known as “waterfalls” because cash flows first to the senior most tranche until its right to payment has been satisfied and then flows down to the next most senior tranche until its right to payment has been satisfied and so on down the capital structure. • Programming these waterfalls is significantly more complicated than creating a model in which all holders of interest in an asset share pari passu in the cash flow. • The programming exercise is made even more complicated by the fact that there are certain “triggers” in these deals, such as interest coverage tests and over collateralization tests, which, if not met, can have the effect of diverting cash flow that would normally flow through the waterfall to a different path in the capital structure. Programming theses “triggers” further complicates the task. • Fortunately, there is an off the shelf solution provided by Intex Solutions, Inc. Intex provides a cash generation model that can be used to generate the cash flows for most U.S. and many non-U.S. ABS. That, in and of itself, is not particularly remarkable. What makes Intex so valuable, however, is that it has assembled a library of thousands of deals for which its cash flow generator has pre-programmed the waterfalls and triggers.

13. Valuing Hard to Value Assets Rutter Associates’ Approach to Valuing ABS/CDOs (cont.) • Second Complication: The Key Inputs, Other than Scheduled Cash Flow and Interest Rates, May be Difficult to Discern • The pools of assets underlying ABS, especially if they are home mortgages, do not pay all interest and principal as scheduled. They are subject to both prepayment of principal and default. • Prepayment rates, while they may vary over time depending on market conditions, are relatively easy to discern and can be specified in the cash flow model. Moreover, prepayment rates affect only the timing of payments and, therefore, usually have less of an impact on the value of an asset than loss rates. • Default rates and recovery rates, which together determine loss rates, are a different matter altogether, both because they are more difficult to discern prospectively and because they have a greater impact on value. • Historical loss rates have little predictive utility in the market for residential mortgages at the moment given the dramatic shift of the past two years. The benign default rates that prevailed for much of the 1995 – 2005 period have little to tell us about default rates at the moment or in the near future.

14. Valuing Hard to Value Assets Rutter Associates’ Approach to Valuing ABS/CDOs (cont.) • Second Complication (continued) • One alternative to the use of historical loss rates is to use “fundamental analysis” of observable data, such as home price appreciation (or more likely in the current environment, home price depreciation) rates, delinquency rates, FICO (credit) scores, geographic location and loan to value ratios to construct a forecast of loss rates. This analysis requires numerous assumptions about the relationship between these observable data and future loss rates. • In contrast, Rutter Associates prefers to derive loss rates from whatever limited pricing data is observable in the market. Market views about loss rates are implicit in this pricing data. Even in the current market environment there is sufficient data available from which to extract the market-implied view of loss rates. (Rutter Associates has generally not derived residential mortgage loss rates from indices such as ABX, which, even though they have continued to trade, are problematic at best as a source for discerning loss rates. Rutter Associates has preferred to use other available data, primarily other data from Markit Group Ltd.). Using market-implied loss rates eliminates much of the guess work inherent in the “fundamental analysis” approach to estimating loss rates and keeps the analysis grounded to whatever market activity exists.

15. Valuing Hard to Value Assets Rutter Associates’ Approach to Valuing ABS/CDOs (cont.) • Completing the Valuation • Once the prepayment rates and loss rates have been determined, they can be applied to adjust the scheduled cash flows for the asset. • The adjusted cash flows are then (a) run through the cash flow generation model, which takes account of the applicable waterfalls and triggers and (b) discounted back to present value using the selected interest rate curve. The present value of the cash flow accruing to each tranche of the ABS can then be aggregated resulting in the determination of a value for each tranche.

16. Valuing Hard to Value Assets Rutter Associates’ Approach to Valuing ABS/CDOs (cont.) • Extending the Methodology to CDOs of ABS • CDOs are even more complicated to value than ABS because CDOs add yet another capital structure to the analysis. Like ABS, most CDOs have a tranched capital structure with their own waterfalls and “triggers”. Cash must first flow through the waterfalls of all of the ABS underlying the CDO, make its way up to the CDO through the tranche of the ABS held by the CDO and then flow through the CDO’s waterfall. • Once again, Intex provides a useful tool, for not only are most of the ABS underlying a CDO likely to be programmed in Intex, so too are most of the CDOs themselves, including their waterfalls and “triggers”. Not that a CDO and its underlying ABS could not be programmed if not found in Intex, but it would take an extraordinary amount of time to do so. • As with ABS, assumptions need to made as to the prepayment rates and loss rates to apply to the scheduled cash flows of the asset pool held by each ABS underlying the CDO and the interest rate curve at which these cash flows will be discounted to present value. • Once these assumptions are applied, the cash flow generation model can calculate the cash flow accruing to the tranches of the ABS underlying the CDO and then further calculate the cash that will accrue to each CDO tranche. The result is a value for each CDO tranche.

17. Valuing Hard to Value Assets • Conclusion • In the current environment, characterized by very limited trading, prices for most ABS and CDOs of ABS are not likely to be found. This means that there is almost no chance of finding Level 1 or Level 2 inputs on which to base a valuation. • Fortunately, there are alternatives by which ABS and CDOs of ABS can be valued. The discounted cash flow model used by Rutter Associates has been successful in producing values for hundreds of ABS and CDOs of ABS that are not trading. • One of the keys to the success of this approach has been an ability to extract market-implied loss rates from the limited data that is observable in the market. • Although the approach relies on Level 3 inputs, it has generated results that have been accepted by auditors and regulators as “fair value” for the ABS and CDOs of ABS being valued.