Lessons of the Subprime Crisis for Corporate Governance, Risk Management and Valuation

Transcription

1 for Corporate Governance, Risk Management and Valuation Conference on the Future of Credit Default Swaps Sponsored by Atlantic Legal Foundation and Pillsbury November 6, 2008 Rick Grove CEO, LLC

2 I. Corporate Governance Boards of directors and senior management should include people with risk management experience and should consult frequently with risk management advisors Information flowing to management must be sufficiently granular for management to be able to assess business risk Importance of exercising independent judgment, without undue reliance on ratings Importance of reading and understanding deal documentation 1

3 II. Risk Management Risk management and control functions should be independent of business Risk management should be involved in business planning Firms need to have means to value positions independent of front office Observable market data and indicative dealer quotes are likely to be inadequate in times of stress valuation methodology should be developed in advance Valuation methodology and assumptions should be transparent 2

4 III. Valuing Hard to Value Positions and Assets A. Contexts in which Valuation is Important Risk Management Regulation Trading Financial Accounting (FAS 157 Fair Value ) Litigation 3

5 Different clients have faced different problems and have had different types of portfolios Type of Client Problem Characteristics of Portfolio North American Bank North American Insurance Regulator European Bank North American Financial Institution European Bank No capability to independently value or risk manage in CFO or CRO suites Must decide whether to close firm How likely is it that the ins co will have to pay a claim; and, if it does, how large will it be? Large portfolio for sale -- Board of Directors needed independent valuation and fairness opinion Need values for financial statements -- Originating dealers had stopped providing values for tranches of CDOs of ABS Desire to have a system capable of comparing fundamental and marketimplied values Exclusively US subprime Exclusively US subprime US subprime dominates; but, other collateral categories are important US subprime dominates; but a significant amount of the subprime exposure is in inner CDOs Portfolio 1: US subprime dominates; but, other collateral categories are important Portfolio 2: No US subprime European collateral dominates Portfolio 3: ⅓ US subprime, ⅔ US RMBS U.S. law firm representing investment bank Plaintiff argued that valuation used in closeout of failed repo agreement was unfair US RMBS 4

6 III. Valuing Hard to Value Positions and Assets B. Approaches Being Used to Value Tranches of CDOs of ABS Market Price Not feasible in current environment little, if any, trading in CDOs Net Asset Value Value based on current net liquidation value of assets Comparables Find priced security with same characteristics as security being valued (coupon, structure, rating, manager, ) Analysis 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 5

7 Overview of the Methodology Prepayment Intensity Timing Default Intensity Timing Recovery LGD Specify and calibrate a distribution of 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 Use consensus from analysts and rating agencies INTEX Detailed Info on CDO (Collateral Pool) on Tranche (Waterfall & Triggers) Month 6 Note that this approach links macro view of economic scenarios to micro view of the individual securities Month 5 Month 4 Month 3 Month 2 Month 1 6

8 III. Valuing Hard to Value Positions and Assets C. Determining Default Rates Historical Experience Fundamental Analysis/Econometric Models Market-Implied 7

9 Key Features of Methodology: Prepayment Intensity Timing Default Intensity Timing Recovery LGD Independence does not have a book and has worked for different types of client Transparency -- The logic of the process is transparent and the output at each step (and sub-step) is observable Experience has had to deal with a myriad of implementation issues (e.g., deals not in Intex, deals with more levels of reference than Intex can handle). We have been able to come up with innovative solutions that provide good approximations in a timely fashion Consistency -- Valuations are consistent with the way the market (and specifically, Markit) values the collateral in the pools underlying the CDOs Detailed info on CDO (Collateral Pool) Tranche (Waterfall & Triggers) Month 6 Month 5 Month 4 Month 3 Month 2 Month 1 8

10 IV. Conclusion Economic rationale for OTC credit derivatives remains Regulatory environment should, and will, be reconsidered Review should proceed deliberately Review should take into account the many lessons to be learned from the experience of the past 18 months Industry self-reform should take place in tandem with regulatory reform Corporate governance Risk Management Valuation 9

11 Annex A: Additional Reading Observations on Risk Management Practices during the Recent Market Turbulence by the Senior Supervisors Group (March 6, 2008) Interim Report of the IIF Committee on Market Best Practices by the Institute of International Finance (April 2008) Shareholder Report on UBS s Write-Downs by UBS (April 2008) Report on the Subprime Crisis by the International Organization of Securities Commissions (IOSCO) (May 2008) Containing Systemic Risk The Road to Reform by the Counterparty Risk Management Policy Group (August 6, 2008) Valuing Hard-to-Value Assets: Lessons Learned from the Crisis by Charles Smithson in RISK (September 2008) 10