Structured finance and derivatives valuation issues discussed

The 2010 SCI Guide to Pricing and Valuation. As with the highly popular 2009 Guide, the 2010 edition is downloadable in PDF form from the SCI website here; however, SCI subscribers will receive a printed copy as part of the October issue of the SCI magazine (current and former triallists can download a PDF of the magazine here). The in-depth fully illustrated and referenced 24-page guide contains articles from four leading participants in the pricing and valuation space for structured credit and ABS.

The first article, written by Mike Li of Dynamic Credit Partners Europe, looks at the valuation applications of loan-level data for European RMBS. Li explains that unlike in the US, where non-agency mortgage loan disclosure for investors has been fairly transparent, loan tapes have not commonly been provided by issuers in Europe due to privacy and competitive concerns, while overall strong loan performance (and bank support for their issuance programmes) mitigated investor need for this information. As a result, while US RMBS can be analysed at the loan-level due to the availability of such data, for all practical purposes, European RMBS can only be run at the pool level, he says.

As Li concludes: "Although loan-level data is still not available for the vast majority of European RMBS transactions, continuing investor and regulator demands for additional disclosure may hopefully address this in the near future... In the end, investors, regulators, rating agencies, originators and arrangers/underwriters can all agree that increased transparency leads to higher quality valuations, which in turn increases investor knowledge of and interest in European RMBS, leading it to become a more mainstream investable fixed income asset class."

The second article - by David Ellis, Sarah Cannon and Hugo Watson Brown of Navigant Capital Market Advisers - looks at the issues surrounding OTC derivatives close-outs. In particular, it discusses the valuation challenges as a consequence of early termination of contracts in the aftermath of the Lehman bankruptcy.

The authors suggest that the ability to reconstruct market data for the period surrounding the close-out date is crucial; this data represents the building blocks from which the valuation is built. "The scope of the data reconstruction depends on the nature of the asset being valued," they say. "The ability to marry the reconstructed market data with the right model and a reasonable set of assumptions will minimise the incidence and degree of valuation disputes."

The application of advanced Monte Carlo methods to valuations, meanwhile, is the topic addressed by Dan Rosen of R² Financial Technologies. He notes: "The role played by the mispricing of structured credit securities in the lead-up to the recent financial meltdown leaves little doubt that the development of better methods for pricing, hedging and risk management of these instruments is an important priority. The modelling of these products presents significant challenges for industry participants today, given the complexity of their structures and underlying risks (market, credit and liquidity)."

Rosen finds: "Full-scale scale Monte-Carlo approaches for valuing structured credit products have only been considered recently and seem computationally demanding, owing to the requirements of simulating the performance of underlying collateral and the cashflow waterfall. In particular, the weighted Monte Carlo methodology provides a practical solution, which effectively models the intertwined market and credit risks in these structures."

Last is an interview with David Pagliaro and Peter Jones of S&P Valuation & Risk Strategies, in which they discuss their firm, their clients' needs and the European structured finance market The interviewees observe that regulation is the current driving force in the market. Not all the proposed rules are yet finalised, but they believe the implications are clear.

"Investors will be expected to perform their own credit and cashflow analysis. In order to do this in compliance with the requirements of the new regulatory regime, investors will need access to loan level data on an ongoing basis; they will need to undertake their own stress testing using their own assumption sets and independent cashflow models; and they will need to have a thorough understanding of structural features, including waterfalls, deal triggers and the like."