Duff & Phelps' alternative asset advisory practice head Warren Hirschhorn and US complex asset solutions group head Jim Finkel answer SCI's questions

Q: How and when did Duff & Phelps become involved in structured finance?
WH: Duff & Phelps established a group to handle valuations of complex securitisations in 2005. But we had been outsourcing some projects to Dynamic Credit Partners for a number of years, so the acquisition of Dynamic's US consulting business (see SCI 16 December) was strategic. Jim - who co-founded the business - is currently integrating it with our international platform, which includes groups in London, Washington, DC, and California that specialise in the valuation of complex securities.

JF: Dynamic joined Duff & Phelps because of our successful working relationship. We found we weren't being hired for large projects because our platform wasn't perceived to be deep or broad enough. Duff & Phelps has provided us with a brand and the capacity to handle large mandates - within a month of being acquired, we've been invited to pitches that I could only dream about before.

Q: Which market constituent is your main client base?
JF: The primary demand for Warren Hirschhorn                                    our services has been from hedge funds and financial institutions, which are concerned that they're not getting reliable mark-to-market valuations. We're also advising on portfolio optimisation and best practices, as well as providing regulatory capital assessments as Basel 3 comes online.

Q: What are your key areas of focus today?
JF: We're doing more than just straight valuations now. For instance, we have plenty of work in dispute resolution, arbitration and litigation, where lawyers need expert testimony and quantitative work. Many cases that were generated in 2007 and 2008 are now maturing, causing a more immediate need for experts.

We're also working on ratings migration and surveillance projects. Ratings exhibit cliff risk: they tend to be downgraded by six notches at a time. From a risk management perspective, we help investors holding 'cuspy' tranches to identify and prepare for subtle changes, which could mean that the tranche suddenly moves from current pay to zero pay.

Further, CMBS suffers from thin levels of subordination and larger collateral concentrations, so a default of one loan could wipe out an entire AJ or AM tranche. We test for the tipping point by looking at the collateral on a loan-level basis and running a number of discrete scenarios.

Another area of expertise is helping clients package up assets for risk transfer, in terms of sizing the optimal amount and then pricing the transaction. We'll collate hard-to-manage data and information about the portfolio to help the negotiation process.

One of the newest opportunities has been advising on structured repo transactions, which are becoming alternative financing arrangements to shadow banking. These deals involve a bank borrowing from, for example, a pension fund under a secured lending agreement - where the fund needs an independent valuation.

Q: How do you differentiate yourself from your competitors?
WH: Our global reach, deep technical knowledge and market-facing capabilities differentiate us from our competitors.

JF: We've learnt over the years that many valuations providers either have  Jim Finkel                                                  analytic strength or market experience - not both, like the combination of Dynamic and Duff & Phelps has. Many approaches are model-driven, while others don't have the technical and/or market data.

Dynamic's analytics platform was initially built to support our specialised investment activity. We amassed a huge amount of market data and built a strong team, converting the firm into an advisory business in mid-2007.

We've worked on large, high-profile projects - such as a US$39bn RMBS mandate for the Dutch government or a report on Lehman Repo 105 transactions for the independent examiner - which give clients a lot of confidence. There are few groups that have had such marquee mandates. These projects helped us build a talent pool with significant experience.

Q: Which challenges/opportunities does the current environment bring to your business and how do you intend to manage them?
WH: The market has changed dramatically in recent years: investors typically used to go to dealers for a price. While dealer marks remain a useful data point, the onus now is on investors to source independent, third-party valuations.

Some asset classes have come back post-crisis, but there is still some disjointedness in the market. In addition, the Dodd-Frank Act and other new regulations are driving increased transparency, which again necessitates third-party valuations.

JF: The demand for valuations services has changed since the height of the crisis: now it is more a case of the level of service given to the holders of risk. There are many cases where we become a trusted advisor for one part of a client's book and are subsequently asked to look at other parts.

Such demand has driven consolidation among valuations providers. Some large firms found they lacked certain specialised units and chose to acquire another team, rather than build their own. There is always competition for mandates and some clients are willing to pay more for differentiated skills or a certain suite of solutions.

But, as the market has moved, so have perceptions of risk. Models need to be modified as the paradigm changes.

For example, we retooled our RMBS approach to take into account US mortgage forbearance and modification programmes and the impact they would have on prepayments. We also tweaked our assumptions to reflect the deceptive characteristics that modifications create in pools: a modified loan gets presented as current, but most models don't pick up that it is a legacy problem credit and there is a high rate of it lapsing back into delinquency.

Q: What major development do you need/expect from the market in the future?
JF: There is more optimism in the industry now than there has been for a long time, but it still isn't matched by primary activity. Spreads are way off their post-crisis wides - they're not as tight as they were pre-crisis, but they're at a healthy level.

There is a lot of trading activity in secondary, but a lack of assets, meaning that technicals have outweighed fundamentals. Yet fundamental risks remain, especially as issues with legacy positions are finally beginning to bubble up or the refinancing wall in leveraged loans approaches.

A broader trend is the impact of consolidation in the banking and asset management industry. This has to be worked through before financial institutions begin operating fully again. Once the organisational side is rationalised, they can better shed risk, raise capital, extend credit and hopefully begin securitising again.

In particular, there is a need for refinancing options for non-conforming loans. At present, the GSEs are responsible for 80%-90% of mortgage refinancing, which is obviously unattractive for private-label securitisation.

CS