Standard & Poor’s Peter Jones looks at the difficulties of valuing asset-backed securities.
Asset-backed securities (ABS) comprise the asset classes most widely blamed for the onset of the 2007-09 financial crisis. Indeed, the beginning of the crisis is often blamed on the flood of redemptions from ABS funds from banks such as Bear Stearns, caused by a loss of confidence in the asset class as defaults in the underlying US sub-prime mortgages spiked.
In August 2007, French investment bank BNP Paribas reported it had no way of fairly valuing its holdings in US sub-prime mortgage securitisations, triggering the hiatus in the inter-bank money markets as banks lost faith in each other’s creditworthiness.
Since then, a key issue has been the requirement of banks to apply fair value or mark-to-market valuation standards as recommended in guidelines from the international accountancy boards for all illiquid financial instruments.
Generally, this has not been a welcome intervention for holders of distressed structured bonds. Banks argue attempting to meet these standards makes it even harder to resume lending and institutional investors with structured finance portfolios understandably have been reluctant to write down billions of dollars on account of what they perceive to be artificial market values caused by forced selling and an illiquid secondary market. The downward-spiralling pricing environment did not, they say, reflect these assets’ intrinsic value.
Toxic assets
The valuation of toxic assets has remained a significant issue for banks and investors ever since. We believe injecting transparency into all the processes involved in a valuation is the key to re-establishing investor confidence in the ABS markets. However, the diversity and complexity of structured finance assets mean structured finance markets have often been characterised by infrequent and less than transparent trading. And although much attention is centred on trading volumes and activity, without the benefit of quantities of openly-available price data, achieving a true market valuation of these assets remains difficult.
Nevertheless, there are a number of techniques used to do so: from individual or composite quotes provided by market participants, to modelled valuations that create relative market values and estimates of intrinsic value under various expected performance scenarios. However, in an illiquid market – such as that still experienced by several classes of ABS instruments – composite quotes may become redundant, while modelled valuation techniques may be complicated by the lack of available, consistent and transparent input assumptions in the marketplace about future conditions.
But it is not impossible. The first step for all participants in the credit market is to take the time to identify and understand the underlying collateral that all the distressed assets’ structures are built upon. With the ability to study the underlying assets and assess how they perform under different credit-stress scenarios, we believe it is entirely possible to value even the most illiquid and complex securities.
The basic need
In addition, the industry needs transparency around the valuation assumptions market participants are inputting into these models. When market participants are aware of the dispersion of these input assumptions they can work towards understanding them better, lessening the problematic information asymmetries. And they can justify input assumptions in an independent and transparent way.
This in turn should increase confidence and encourage participants back into the market. Encouragingly, across all illiquid and complex structured finance asset classes, we are beginning to see increasing demand for greater access to loan level data (ie the underlying assets in a securitisation vehicle) and cashflow projections based on in-depth analysis of the underlying collateral combined with an increasing interest in the input assumptions going into valuations.
Peter Jones is senior director of the valuation & risk strategies group at Standard & Poor’s fixed income risk management services (FIRMS)
