Making The Right Assumptions
by Mark Pearce
Story link: Making The Right Assumptions
In this article, Peter Jones, global head of Valuation Scenario Services at Standard & Poor’s Fixed Income Risk Management Services (FIRMS) division, considers the valuation challenges facing the structured finance markets and shares the results of an ongoing survey into participants’ valuation input assumptions and methodologies
Structured finance markets have predominantly been characterised by infrequent and opaque trading activity, due to the diversity and complexity of structured finance assets.
Despite the attention focused on trading volumes and activity, without the benefit of quantities of openly-available trade price data the valuation of these assets is not straightforward.
A number of techniques are used to meet the market’s varied valuation requirements for activities such as net asset valuation (NAV) for funds, financial reporting and regulatory surveillance.
Techniques range from individual or composite quotes provided by market participants to modelled valuations that create relative market values and estimates of intrinsic/economic value under various anticipated performance scenarios.
However, in today’s illiquid market composite quotes become redundant and modelled valuation techniques are complicated by a lack of availability of consistent, transparent input assumptions in the market place about future credit conditions.
Indeed, the restoration of activity in the structured finance market – so crucial to the restoration of more efficient levels of credit availability for the wider economy – will not be achieved unless investors’ confidence is restored in price transparency. And this means better visibility of the valuation input assumptions used by all market participants in their valuation calculations.
According to a global survey of securitisation market participants conducted in 2008 by the American, Australian and European Securitisation Forums, and the Securities Industry Financial Markets Association (SIFMA), improving confidence in valuation methodologies and assumptions is one of the four central challenges to resuscitating the structured finance markets.
In recognition of the problem, SIFMA and the three industry associations set up a valuation task force in July 2009 to promote collective industry action to improve the valuation process for securitised products.
Restoring investor confidence in the markets is the key aim of this process. Data, cash flow information and analytics are already available to investors via commercial vendors, as are multiple types of valuation offering – for example funds in the US, Europe and Australia already use valuations based on models provided by specialist independent valuations firms, rather than relying on the last traded price, to add credibility to their daily NAV calculations.
Meanwhile, nascent guidelines from the international accountancy boards for the need to apply fair value or mark-to-market valuation standards have not been welcomed by holders of distressed structured bonds.
But with short to medium term uncertainty over the performance of property prices and with many of the world’s major economies still in or recovering from the recession it is a challenge presenting what a bond’s intrinsic valuation actually is – even with access to cash-flow information and analytics.
Indeed, the use of structured finance analytics platforms is spreading, providing access to the collateral and loan-level data behind the securities so that their cash-flows can be stressed under different assumed credit-conditions.
Yet, combining macroeconomic outlooks with input assumptions – such as prepayments, the default rate and loss severity – remains one of the key challenges of scenario testing and, by extension, to the valuation of structured finance assets.
The industry needs transparency around the valuation assumptions that 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 between the buy side and sell side, and justify input assumptions in an independent and transparent way.
Encouragingly, across all illiquid and complex structured finance asset classes, we are beginning to see increasing demand for greater access to loan level data and cash flow projections based on in-depth analysis of the underlying collateral. And we are now seeing much more discussion around the input assumptions going into valuations.
Indeed, one of the major developments taking place today, and for the foreseeable future, is the creation of a set of standards around valuation. The market now knows it needs to form a consensus around all the input assumptions, models and processes involved in a valuation.
In light of this, the Valuation Scenario Services group at S&P is conducting a series of regular Valuation Inputs Consensus surveys, in which structured finance market participants are being invited to quantify the key assumptions they make when stress-testing the underlying collateral behind all classes of UK, European and US RMBS transactions.
The four key valuation inputs being surveyed are Constant Prepayment Rates (CPR), Constant Default Rates (CDR), Loss Severity (LS, the severity of any losses occurring on the collateral in default) and Recovery Lag (RL, the time it takes to recover any monies due).
Over 60 institutions active in the structured finance markets took part in the third quarter survey, split evenly between the buy side and sell side in the US and Europe. Respondents are primarily risk managers and credit analysts from both buy and sell side institutions, plus portfolio managers on the buy side and front office staff on the sell side.
The results collected over the end of September provide a number of useful insights. When compared with the Q1 and Q2 surveys we can gauge investors’ changing expectations for the performance of RMBS collateral and begin to quantify the trends (converging or diverging) in buy and sell side valuation methodologies.
Valuation methodologies
In terms of respondents’ valuation methodologies, when modelling future cash flows as much as 79% of buy side participants in Europe utilize loan-level data when it is available.
On the sell side, however, only half use available loan-level data to model cash flows (52%). Indeed, well over half the buy side considers loan-level data to be “very important” when undertaking valuations versus less than a quarter of the sell side.
Furthermore, nearly half the buyside (46%) claims to have in-house capabilities for cash flow modelling, whereas 81% of sell-side respondents rely on third-party models.
Indeed, there are a number of inconsistencies between the approaches of RMBS buyers and sellers that might suggest the buy side is currently capable of undertaking more sophisticated analysis around structured finance assets, perhaps as a result of the sell side “de-tooling” its securitisation capabilities in the wake of the collapse of Lehman Brothers.
When calculating future default rate assumptions, for instance, 70% of the buy side participants surveyed use inputs that are vectored – rather than flat – compared to 46% of the sell side.
This disparity also applies to the calculation of future loss severity assumptions, with 50% of the buy side using vectored assumptions versus only 18% of the sell side.
There is also a clear disparity between buyers and sellers in the European market when judging the timing of default rates on the collateral pools of RMBS transactions.
Some 90% of the buy side consider defaults take place at repossession while 10% regard delinquency as the point of default; whereas on the sell side 57% consider that default takes place at repossession and only 43% at delinquency.
These figures clearly quantify the disparity between the valuation approaches of each side of the market, and provide little comfort to would-be investors looking for consistency in valuation methodologies.
Input assumptions
In terms of respondents’ valuation input assumptions, broadly speaking, investors now expect better performance from US mortgage collateral and forecast the bottom of the US real estate market within 12 months.
House prices are also expected to trough in the UK within 12 months, but default rates on all European mortgages – which are far lower than those in the US – are expected to increase.
On average, market participants believe UK house prices will decline a further 7% within the next 12 months. This is an improvement from the 10% decline forecast in the Q2 survey.
However, the dispersion of opinions on house price performance is wide, with responses ranging from as low as a further 30% decline over 12 months to a 2% increase.
And – further reflecting this inconsistent view of the real estate market – there is no consensus among participants when the trough in UK house prices will take place.
Asked to forecast in which quarter prices will bottom out, the most popular response – Q1 2010 – garnered less than one fifth of the vote. Indeed, there is an even dispersion of forecasts over each of the next five quarters, from Q4 2009 to Q4 2010.
However, while house price declines are broadly expected to stabilise some time over the next 12 months, respondents are not confident about default rates on the mortgages behind UK Non Conforming Loan (NCL) and Prime RMBS transactions.
In the short term, market participants expect default rates to stabilise – average expectations for ongoing default rates from the Q3 survey are very similar to expectations provided in the Q2 survey (now 9% for NCL and 2% for Prime).
However, default rate forecasts across all UK NCL vintages surveyed climb from 8.2% over the next six months to 9.8% in 12 to 18 months’ time (see table), and from 1.8% to 2.2% in the same time periods for all vintages of UK Prime mortgages (see table).
Likewise, respondents are forecasting default rates on the mortgages behind Spanish RMBS to climb from 1.7% over the next 6 months to 4% in 18-24 months’ time (see table).
Trying to validate internal assumptions used for the valuation of structured finance assets is certainly one of the central challenges for investors and money managers today.
Nearly every investor we have spoken with over the past year agrees there is a need for change in the discipline of credit and risk valuation as it relates specifically to price and price risk.
At the same time, however, it has been difficult to combine all the elements necessary to deliver truly comprehensive methods for security and portfolio valuation.
Addressing this difficulty is the next step the market needs to take. As we invite more market participants to take part in the survey – with the next one to be conducted in January 2010 – it is hoped the increasing volume of data received will help create a benchmark of input assumptions for the benefit of investors, those responsible for monitoring pools of ABS assets and other market participants.
