VALUATION

A Tale
of a Looking back at the global financial crisis
starting in 2007, many have observed

Two-
that certain financial assets were
overvalued because the market
underpriced risk. The dislocation in global
financial markets around that time served
to highlight this to market participants. In
hindsight, these observations may be

Sided
clear. But, looking forward, what lessons
can we draw from this experience?
One critical lesson is that risk
management and valuation are
interrelated, and that risk managers need

Coin
to have a thorough understanding of the
drivers of value in order to manage risk.
Many firms, most notably hedge funds
(especially the
smaller ones), may not have had
One of the most processes as thorough as some of their
larger counterparties (e.g., bulge-bracket
important lessons to investment banks), and may have been
more susceptible to valuation-related
be drawn from the problems. However, even some of the
largest financial institutions are the
global financial crisis is subject of lawsuits accusing them of
artificially inflating asset values on their
that the market had books. If we have learned anything, it is
that the valuation aspect of risk
mispriced the risk. A management
carefully.
should be addressed

firm that cannot Of course, even the best risk

management practices may not have
properly value its protected firms from the recent
downturn: while a rising tide may lift all
assets cannot boats, a falling tide lowers them.
However,
effectively manage its a risk management program that
effectively addressed valuation issues
risks. But valuation may have led to better outcomes
financially, and also helped prevent some
and risk management of the litigation and regulatory actions
that have inevitably followed the
are really two sides of enormous drop in global wealth.
the same coin: both Risk managers often have focused on
issues such as financial diversification,

disciplines require security of information technology and

other safeguards; all are important

similar skills and issues. But the exotic financial

instruments that were at the center of the

knowledge to be crisis, including derivatives

structured products, are the financial
and

accurate and effective. instruments that were hardest to value.

As more complex financial products were
deployed, the risk of inaccurate or flawed
valuations grew. Continuing uncertainty
By Cindy W. Ma and illiquidity in the markets have
compounded this risk.
Unfortunately, in many cases, risk management is seen as separate from the
valuation function, resulting in an apparent disconnect between the two. Risk
managers must be cognizant of the important role that valuation plays in risk
management, have a strong grasp of how assets and liabilities are being valued,
and fully understand the linkage between the key valuation drivers and the major
risk factors.

One long-term positive implication of the recent financial crisis may be the
exposure of deficiencies in valuation practices. For certain large financial
institutions, risk management and valuation tend to be highly
compartmentalized. Independent groups often check models and assumptions
for risk management and for financial reporting (valuation) purposes.

On the other hand, small investment funds may not even have the infrastructure
to conduct the model testing, scenario analyses and fundamental analysis that
are critical to good valuation risk management. Oftentimes, risk managers are
not empowered by their organizations to go up against powerful portfolio
managers to challenge the assumptions behind their valuations.
At both ends of the spectrum, independent third-party valuation can help provide
the analytical support, independence and political leverage to deliver positive,
proactive risk management results. Since portfolio managers’ compensation is
often tied to investment performance, the independence of the analysis becomes
even more critical.

A Critical Component of Risk Management

Valuation and risk management have much in common. For example, Monte
Carlo simulations and scenario analysis are common ways of approaching both
valuation and risk management; the skills and knowledge of the practitioners are
similar.

The objective of risk management is to safeguard the enterprise value. If one

cannot value an asset or liability, one cannot manage its risk. Developing a risk
management program without first properly understanding the value of assets to
be protected is like building the top floor of a house without first establishing a
solid foundation. Efforts to mitigate risk often focus on processes, internal
controls, compliance and guarding against failure of information technology
systems and other disasters. In a 1998 definition of operational risk, the Basel
Committee on Banking Supervision identified breakdowns in internal controls and
corporate governance as the most serious issues. “Such breakdowns can lead to
financial losses through error, fraud, or failure to perform in a timely manner, or
cause the interests of the bank to be compromised in some other way, for
example, by its dealers, lending officers or other staff exceeding their authority
or conducting business in an unethical or risky manner,” the committee wrote.

In recent years, however, it has become clear that valuation risk is one of the
most significant risks within financial institutions. The push toward greater use of
market data in financial reporting illustrates the recognition of the importance of
accurate valuations and the ongoing move toward more transparency in
valuation issues. The most prominent example of this trend is the Statement of
Financial Accounting Standards Number 157 (now Accounting Standards
Codification Topic 820). Unveiled by the Financial Accounting Standards Board in
2006, this regulation established a framework for assessing the fair value of
liquid as well as illiquid instruments for financial reporting purposes. The financial
crisis also played a major role in illustrating the importance of valuation, as it
exposed the vulnerability of complex financial products to valuation risk.
Numerous allegations were made that financial firms might have overvalued
securities and loans. In addition, more entities have been exposed to valuation
risk through securitization, greater exposure to home value changes as the
mortgage market has expanded, and the growing complexity of innovative
financial products (such as equity-linked credit).

Valuation and lack of transparency have been at the heart of many recent
financial meltdowns. For example, from late 1997 until its collapse in October
2001, the primary motivations for Enron’s accounting and financial transactions
seem to have been to keep reported income and reported cash flow up,
asset values inflated and liabilities understated (as they were
off the books).

In 2008, Bernard Madoff admitted to defrauding investors through a massive

Ponzi scheme while portraying his seemingly stellar investment results as the
product of a legitimate “split strike conversion” options strategy. While the
pricing for the options and underlying assets could be obtained from exchanges,
all but a few investors overlooked the market volume that would have had to
exist to support the profits Madoff claimed. Proper valuation analysis would have
taken into consideration the value of the assets as well as the depth of the
relevant market. Valuation failures have also surged through the banking
industry and humbled the investment portfolios of endowment funds and
municipalities. Ideally, an independent risk management function should be
suited to managing valuation risk, bringing a structured approach to establishing
valuation policies and procedures and enforcing compliance with them. That said,
the valuation of assets and liabilities is often more art than science, especially
when using unobservable data to assess the worth of illiquid investments. While
rules of thumb and quantitative studies can and should be used to help guide the
professional, it is also critical to incorporate human judgment and an
understanding of the drivers of value into the process.

Risk management must allow for a holistic view of valuation drivers and a
balance between transparent valuation procedures and the application of sound
judgment.
Understanding the Valuation and Risk Link

Various risks come into play when valuing investments. One is model risk. While
models are necessary to assess the worth of illiquid securities and sometimes
even liquid securities, the models’ limitations must be understood and evaluated.
For example, complex statistical models may assume a normal distribution of
asset returns, which may not be appropriate for certain, assets. On the other
hand, models that rely on risk-neutral frameworks are often predicated on the
ability to construct a replicating portfolio, which may not be feasible for highly
illiquid securities.

In addition, financial models can sometimes be incredibly complicated. The more

complicated the model, the less transparent it is and the more easily its results
can be manipulated. When models become problematic, sometimes
supplementing a valuation analysis with an alternate model that does not share
the limitations of the primary model can help assess the model risk. Risk
managers should ensure that proper documentation and training are provided to
allow reviewers to understand fully the assumptions and workings of a given
model. Once a model is chosen, input assumptions for that model must be
developed with care, with close attention paid to both historical behavior and the
real-world economic environment. Assumptions are estimates, and estimates are
always subject to error, no matter how painstaking the process used to develop
them.

Additionally, assumptions may also be subject to manipulation. Therefore, it is

important to provide backup documentation and support for each assumption, as
well as to have strong review procedures to be able to validate the
appropriateness of the assumptions. It is especially important in this case to deal
with any conflicts of interest, particularly when the managers who provide input
to the valuation and risk management process are compensated based on the
value of the portfolio. Models and assumptions also should be subjected to stress
testing to determine how a position or portfolio may react under extreme market
conditions, such as greater price volatility, decreased liquidity or changes in
asset correlations. For example, what would the impact be if the correlation in
defaults were to rise significantly? Or, for instance, what would be the result if
home prices were to fall dramatically? Simulations and scenario-based stress
testing are two examples of good practices among risk managers.
Liquidity risk is another key issue. Risk management practices should differ for
liquid and illiquid assets. Liquid assets, such as equities traded on exchanges, are
generally much easier to value. Their worth can usually be determined based on
observed transactions that occur between willing buyers and sellers. Illiquid
assets are difficult to value because of the absence of transaction data. A
fundamental analysis of the value of an illiquid asset is necessary. While liquidity
risk is well understood and accepted even from a common-sense standpoint, its
full impact is not always recognized in valuations. For example, the term
“liquidity risk” can be applied both to asset liquidity risk (i.e., the risk of not being
able to sell an asset because of a lack of volume in the market) and funding
liquidity risk (i.e., the risk of a company being forced to liquidate assets because
of a lack of available funds).
Funding liquidity risk can come into play with leveraged investments, which may
draw a margin call when valuation levels fall. Faced with a margin call, an
investor is forced to put up cash or sell the investment, sometimes at a
considerable loss. The two forms of liquidity risk are intertwined. Declines in one
form of liquidity can lead to declines in the other. This was seen vividly during
the global credit crisis, when market participants were painfully on the “misery-
go-round” — i.e., (1) asset values dropped quickly, causing an upheaval among
banks, structured investment vehicles and much of the securitization market; (2)
leveraged entities were forced to liquidate assets to meet margin calls; (3) the
resulting excess supply of assets drove down their values further; and (4) lower
asset values
forced further margin calls. Even companies that avoid leverage can face funding
risk. When other counterparties cannot finance the purchase of assets through
capital markets, demand for the assets can fall, leading to declines in asset
values.

Best Practices to Mitigate Valuation Risk

One potential change that is currently under debate is changing firms’

compensation structures so that compensation is linked not only to performance,
but also to risk, so that incentives would be changed to discourage excess risk-
taking. Additionally, capital ratio limits and other broader reforms are often
suggested as useful preventative measures. Market watch groups and policy
setters have also advocated as best practices the inclusion of independent
parties in the valuation and risk-management processes. Independence is a
critical factor in dealing with valuation risk. Independent parties can provide
comfort that a model and the assumptions that are used with that model are
appropriate; independent parties can also mitigate the risk of deliberate
manipulation of values through complex modeling.

Large financial institutions often have dedicated groups that provide independent
risk management services within the organization. However, as described earlier,
when risk managers disagree with business managers, political struggles can
ensue. Smaller financial institutions often do not have the scale to invest in a
dedicated risk management group. In both of these situations, obtaining third-
party support is an industry best practice. Most often, third parties are engaged
to provide a written opinion as to the value of a particular investment. However,
not all third-party opinions are equal. Different forms of opinion can include
“negative assurance,” “positive assurance” and full independent valuations.
Negative and positive assurance opinions typically make use of limited
procedures, in contrast to full valuations, which are usually more comprehensive
and rigorous. In a negative assurance opinion, a third party renders the opinion
that an entity’s determination of value “does not appear unreasonable.” In a
positive assurance, which is similar, a third party concludes that a firm’s
valuation “appears reasonable.” In both cases, the third party is simply reviewing
its client’s own internal valuations, as opposed to developing its own
independent opinion of value. When starting with someone else’s valuation
analysis, it is easy to overlook broader questions of whether a model is
appropriate; also, biases can affect the evaluation of model input assumptions. A
full independent valuation provides the highest degree of independence of the
three forms of opinion. In addition,
full independent valuation is the subject of many professional standards:
business valuation and real estate appraisal standards are widely known. In
contrast, determining whether a given valuation is “reasonable” is highly
qualitative, and there are no industry standards or valuation guidance to set the
scope and the boundary for reasonableness. When third-party opinions are used,
management should take steps to understand what type of valuation is being
done, and what methodologies, inputs and assumptions are being used. Investors
also should be aware of what form of valuation opinion will be delivered.

Closing Thoughts

One of the most important lessons to be derived from the global financial crisis
and its aftermath is that valuation is fundamental to risk management. In today’s
investment world, the growth in complex financial products has made analyzing
investments more challenging, while making valuation even more vital than in
the past.

Valuation is a key and integral element of risk management, and will only grow in
importance. As professionals involved in the valuation and risk management
processes, we must be aware of this trend and use our understanding to manage
risk appropriately.
VALUATION is the critical component of risk management.