Fifth in a series of interviews with technology leaders whose views are relevant to AMG members.

Interview with JR Rieger of Standard & Poor’s Securities Evaluation Group

Asset Management Group: Could you describe S&P's Securities Evaluations Group and discuss some of the Group's major focus areas?

JR: Standard & Poor’s Securities Evaluations is a terms and conditions data provider as well as a mark-to-market pricing provider for end-of-day prices for institutions. On the sell side, those marks are used in statement accounts to value individual positions, they are used to calculate margins, and they are used in risk measurement and risk analysis tools. On the buy side, our prices are used to calculate net asset values (NAVs), performance measurement and to conduct attribution analysis. There is a need by asset managers to have a value determined at the end of each business day that correlates with their fair value responsibilities and that represents the current market conditions for those assets and liabilities that need to be marked. That is the service that we provide.

Our focus areas are driven by our customers who have come to us over the last year with new challenges and issues that keep them up at night, particularly around complex structures - instruments like credit default swaps (CDS), CDS of asset-backed securities, and other contract structures like swaps and FX options. The back office, who is our customer, is now dealing with two sets of problems. One problem is the database set-up of these new instruments and their complexity as well as the daily mark-to-market responsibilities of these complex instruments. We have been rapidly adapting to that market to cover more instruments, in response to that need for independent observation for the value of these securities. Historically, the buy side has relied upon counter-parties to generate mark-to-market values for these complex instruments. In this current environment of regulatory scrutiny and in light of new accounting standards, the counter-party mark may not be solely sufficient to satisfy these standards. Therefore, there is a need for mark-to-market in the complex world, and that's where we've been focusing our efforts for the last year.

Asset Management Group: Speaking about mark-to-market, what are some of the major drivers of change in fixed income and other financials?

JR: In the U.S. as well as in Europe, one of the major drivers is regulatory scrutiny. Another driver is recent accounting rule changes - for example, FASB 157 which clearly defines the fair valuation process. The words “fair value” have been in accounting standards for quite some time without any real guidance as to how to go about the fair value process. FAS 157 better defines the fair valuation process - it says the foundation of valuation theory is to use a market approach. It seems that international accounting standards are migrating more towards the US federal accounting standards and that terminology and direction by the FASB on “fair value” are driving a lot of change with regard to mark-to-market.

Another driver of change is the January 2007 Interagency Statement on Sound Practices Concerning Elevated-Risk Complex Structured Finance Activities by the Federal Reserve, the Treasury, the SEC and other agencies on complex structured financial instruments and transactions. This Statement clearly defines the responsibilities of institutions and outlines three areas, or steps, that each financial institution needs to take if they are aware that they may have complex structured financial transactions. Those three steps include 1) the identification, due diligence and approval process for having the exposure to these instruments, 2) the documentation around those instruments and 3) general risk management principles for elevated-risk structured financial transactions.

The mark-to-market piece to that puzzle is very simple. If the independent mark is very different from the mark used internally on these complex structures, that could be a sign that there’s something different in that valuation process and that can be used as a way to identify potentially elevated risk of complex structured financial transactions. The way I view it, if an independent service can’t readily determine the value on a complex structure, that instrument or transaction may in and of itself be elevated risk.

Mark-to-market risk clearly is a component of owning complex and illiquid instruments, and that risk can be real if there isn’t a robust and rigorous process to review how the values are created and who's creating those values. That to me is an obvious area where institutions should be focusing so that they meet the obligations of this interagency statement.

Asset Management Group: What is your vision of the valuation practices in the derivatives markets?

JR: Standard & Poor’s Securities Evaluations views the role of marking to market any instrument as one entire process. It does not matter whether it is a derivative or a security or a simple, non-callable bond. The process should be consistent in application. The goal is to apply a consistent market approach methodology, and that market approach is focused on what has sold in the marketplace in the recent market environment.

In order for us to price an institution’s portfolio, it must provide us with transactional data. This transactional data, when confirmed by an independent pricing provider, becomes terrific market data for us to use in our valuation process. Add to that the new structures and securities that are sold to the marketplace, and you've got your highest level of valuation data - the highest quality valuation data we can use - real transaction data. The next layer down in our market approach to valuation is real, executable bids. The next layer of information we collect is two-sided, both very valuable to us. A two-sided quote means that somebody out there, an institution of some sort, is willing to buy or sell at those levels.

And finally, on the lowest end of the hierarchy is what we call dealer quotes. Dealer quotes are provided by the dealers to their customers on a regular basis on lists of securities that customers have asked them to value. And we put that on the lowest end of the hierarchy simply because we’re not sure when those values were created, and who at the dealer organization, created those values. In other words, was it the trader or was it a trader’s assistant or a sales person or a quant or a mathematical model? It is important information to know, whether that quote on the individual instrument or security is really at an executable level (where that dealer is willing to transact) or whether that quote is really just somebody's opinion as to what the security is worth, given their knowledge of the marketplace.

The combined set of market data gives us a very good picture as to what instruments are worth. Relating it to derivative securities, the consistency in the approach is absolutely critical. When valuing instruments that are illiquid, where do you look for observable inputs in the marketplace (e.g. the benchmark Treasury curve) is important. When we're applying a consistent market approach to valuation, we can assist that customer in understanding the inputs that we use to generate that value in a consistent approach.

Asset Management Group: How has the valuation process changed for illiquid securities?

JR: In two ways. Technology continues to evolve and as technology evolves, the tools that are available to pricing analysts become more and more robust. Couple that with a dramatic increase in the amount of information available to pricing analysts, and you have got an evolving process. I would say two years ago, the pricing analysts really were grinding away trying to collect information on individual segments of the market, gathering information by fax and hard copy. I think those days are waning because of the efforts by the marketplace and associations like SIFMA that are driving change toward electronic transfers of information to assist the information flow from front office to back office, to clearing agents and in some cases to information providers.

Asset Management Group: Previously, you mentioned recent regulatory change and new accounting practices. In your view, how have clients’ needs been changing in light of these regulatory changes and accounting practices? And how has that impacted their mark-to-market responsibilities?

JR: I do believe that the scrutiny and the accounting statement changes that made in the U.S. as well as internationally have put more of the focus on the mark-to-market process at our customer base than ever before. The customers have always had the responsibility of approving the pricing they’re using, particularly when calculating the NAV. They’ve always had that responsibility but because of the complexity and the relative illiquidity of the instruments on their books, it gets very difficult for the buy side to validate the pricing used by a third party without having additional information around how that price was created. And if we use the structured finance market as an example, we deliver a price and a yield; it’s very important for the customer to have. However, for the customer to understand that data they really should also be getting the weighted average life, the weighted average maturity, the weighted average coupon, and some of the analytical calculations like duration to help them understand how that price was generated. That will help them when they go and take that validation step, when they go out to another party (for example, whether it be their front office or their trading desk) to validate or whether they go to a dealer to validate, they have a robust picture of how that price was created.