“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 today’s NYC ASA Business Valuation Conference. “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. Even as loans are failing to pay, prices go up. 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 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.
What are typical valuation mistakes? First, appraisers can be tempted to group prices under vintage, credit loss protection enhancements, or collateral type (option ARM, subprime, etc.). But these comps derived from similar buckets “often ignore information we may have regarding the contractual features of the bonds, or the key valuation assumptions about default rates or the severity of writeoffs.” Kahn says that coupons, maturities, distribution structures, payoff triggers, and other factors have a significant impact on the valuation--so grouping comps is very dangerous.
Yields, not prices, should be the basis for determining value, he argues. “Two bonds, identical in all respects except for the geographic distribution of the collateral, will be assigned the same value” using this method for pricing, Kahn says, even though they obviously perform differently. The solution is to “use yields, and not prices” to capture the terms and characteristics of each bond, such as geographic distribution of the collateral, coupons, or triggers, Kahn advises.
Yields aren't a perfect measure, either. Using yields can also lead to problems, if used in the wrong way, however. That’s because “there’s a distinction between the distribution of cash flows, and the expected cash flows,” says Kahn. That’s because expected cash flows capture a lot of information but the don’t capture credit protections or supports.