“The price of senior tranches in asset-backed securities tends to go up as the default rate, and the severity of the defaults, increases,” Daniel Kahn (National Leader, Complex Securities Valuation, Ernst & Young) told attendees at the NYC ASA Business Valuation Conference last week. “This seems illogical, but the senior tranches are not exposed to reasonable losses, so they actually benefit by the early wrapping up of the risk, because of the time value of money.”
Obviously, this makes valuing, and explaining the value of, asset-backed securities more challenging–and it’s one reason many certified business appraisers steer clear of this market segment. In fact, Kahn demonstrates that at reasonable default and “severity” levels (say 10%), even most of the subordinated tranches see price increases. In a case study Kahn prepared for ASA attendees, he showed that even at a 40% loss (severity) rate, junior tranches retain most of their value. Beyond that, they lose value very rapidly.
Where do you go to get “observable market data” to support this rapid change in value, as required by FASB? You can often look at a particular trust in Bloomberg or similar service, Kahn advises. If you can’t find public information, you’re looking at average pricing and yield data from Merrill Lynch or similar institutions. Or, if the underlying collateral is student loans, Sallie Mae has some sources. “The challenge in valuing these securities is to infer market support since it’s often hard to directly observe market prices as FAS 157 would prefer,” Kahn says. So, finding observable market data is a first challenge for appraisers.
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