Some special, and so riskier, asset classes require a specialized knowledge
by Timothy Bernstein, NewOakNewOak is an independent financial services company, which provides strategic counsel and services around structured credit, complex asset valuation, enterprise risk, and regulatory compliance. Our offerings are built on four distinct but complementary businesses: Financial Services and Litigation Consulting; Financial Technology Solutions; Capital Markets Advisory & Asset Management. Reprinted with permission. Visit newoak.com
Examples of hard-to-value—or Level II/Level III assets—include certain types of real estate, foreign exchange derivatives, aircraft, or insurance-related securitizations, among others. While these assets can be used as investments, such as a privately owned passenger jet licensed for client usage, or a property for rent, there are significant challenges inherent in their management.
Commercial real estate, as the Office of the Comptroller of the Currency (OCC) Handbook points out, presents a possible environmental liability. What’s more, these assets can be contrasted with others, such as stocks and corporate bonds, whose values can be promptly determined. Compared to the tradability of these securities, the specific qualities of a Level II/Level III asset—particularly its degree of illiquidity—can affect both its value and its ability to be bought and sold easily.
Level II/III assets increase a holder’s risk significantly, mainly because they require specific or specialized knowledge to manage, and are often, as one would imagine, extremely hard to value. A bank’s inability to manage hard-to-value assets wisely, and within legal constraints, can substantially add to it level of enterprise risk, which can have a negative impact on the bank’s available capital and total revenues.
Every financial institution that manages Level II/Level III assets must, at minimum, institute strict policies to manage risk. Ideally, this would include periodic appraisals of all such assets under management, as well as a documented set of policies, processes and procedures for valuation methods. Firms will also need procedures in place to ensure that they can keep tabs on cash inflows from these assets and make sure that all involved parties receive payments when they need to. Compliance assessments are also necessary to certify that the institution follows its own rules.
In addition to the above measures, it is also essential for firms to routinely and systematically evaluate its risk profile in order to distinguish particular risks and gauge their severities. Specifically, risk controls should involve a set of standards for the categories and amounts of hard-to-value assets under the firm’s management. This tolerance should involve a set limit on the size of a portfolio that the firm can manage. As the OCC Handbook points out, monitoring is also a key element here, particularly for tracking and reporting exceptions to ensure that any corrective action deemed necessary is completed.
None of these risk measures, however, will mean anything without access to the specialized knowledge needed to analyze, manage, and value these types of assets. The increased risk profile that firms carry by owning Level II/III assets in the current, highly regulated environment not only impacts banks from a risk, Comprehensive Capital Analysis and Review (CCAR), liquidity and regulatory compliance perspective, but non-dealer entities from potential litigation, investor liquidation and reputational risk stemming from non-defensible valuation practices. This is where an expert, independent third-party advisor with deep experience in the valuation and risk analysis of asset-backed and structured products can help.
For further insights on this issue, NewOak Managing Director Matt Lewis will be a featured panelist at SCI’s 8th annual Pricing, Trading & Risk Seminar Wednesday, October 7, at Bank of America, 250 Vesey Street, third floor, New York. The panel, “Regulations: Pricing and Valutions”, is at 2:20 p.m. and will focus on:
- Unintended/unexpected consequences of new regulation on pricing
- How are regulations creating relative value opportunities for investors? (E.g. Volker Rule leading to bank sell-off of certain CLOs)
- Liquid versus illiquid securities – where do the pricing challenges lie
- Data sources – do we need more? Do we have too many?
- For more information, please visit NewOak’s Events page