Credit Market Turmoil Makes Securities Valuation Key

• Author: Manmohan Singh and Mustafa Saiyid
• Position: IMF Monetary and Capital Markets Department
• Pages: 24-25

Page 24

Following the collapse of the U.S. subprime mortgage market in mid-2007, market concerns about the exposure of structured securities to subprime loans dramatically slashed liquidity.

As trading volumes declined, many market participants were forced to value the securities in their portfolios using pricing models that relied on historical data rather than current prices. However, the recent performance of some of these subprime loans has been much worse than the record would have suggested. This has caused valuation models to break down.

How is valuation done?

Market participants commonly use three types of valuation techniques, often described as mark-to-market, mark-to-matrix, and mark-to-model.

Mark-to-market refers to the use of quoted prices for actively traded, identical assets. Mark-to-matrix is a technique used for less actively traded assets, such as emerging market securities, municipal bonds, and asset-backed securities (ABS). It involves estimating the value of the asset by relating it to a more actively traded instrument that can be priced easily.

The third method of pricing is the mark-to-model technique that market participants are often forced to use for the least liquid assets, including real estate, private equity investments, and complex structured securities such as certain tranches of collateralized debt obligations (CDOs). Mark-to-model assigns prices based on statistical inference.

Why is valuation an issue?

Valuation became a problem because certain types of structured securities became relatively illiquid following the subprime crisis. The absence of market quotes forced market participants to rely more heavily on mark-to-model as opposed to mark-to-matrix techniques.

Some types of structured securities were inherently illiquid at the time of issuance. This included most CDOs because each debt tranche had different levels of credit enhancement and the composition (and quality) of the underlying collateral varied from one deal to another. The size of the global asset-backed CDO market is no more than about $400 billion, whereas the subprime market is about $1 trillion.

The illiquidity of complex structured securities was compounded by a lack of transparency about the exposure to underlying nonprime mortgage loans and to uncertainty...