Showing posts with label Prices and Valuations. Show all posts
Showing posts with label Prices and Valuations. Show all posts

Wednesday, September 24, 2014

Securities Price Shopping

We've all heard about how Michael Lewis' book (Flash Boys) has brought a flurry of attention to the (real) movements of stocks, but his work seems also to have spurred on a host of other initiatives that were already in the works.

Importantly, the "authorities" have been paying attention to the all-important consideration of pricing (of securities).  In short, we think it's problematic that each party (fund, company, investor) gets to price its own assets. Two different banks can hold the same amount of the same investment, have the same auditor and the same regulator, and price the investment yards apart -- based on the application of different assumptions. We have a number of solutions to this problem, but have been arguing for pricing transparency (where are these prices coming from, and upon what assumptions are they based) for many years.

The SEC had previously found troubling pricing practices ("violations of law or material weaknesses in controls") in the world of private equity.  Now it has announced it found serious deficiencies in valuation processes used by hedge funds:
...regulators have discovered some funds engaging in what he called "flip-flopping," boosting valuations by changing the way they measure holdings several times a year. In some instances, the funds chose the measurement with the highest value or intentionally classified certain assets in a way that gave the fund manager more flexibility to inflate the price of the fund's holdings. (Source WSJ)
FINRA recently fined Citi upon finding that "one of Citigroup's trading desks employed a manual pricing methodology for non-convertible preferred securities that did not appropriately incorporate the National Best Bid and Offer (NBBO) for those securities." According to FINRA, "Citigroup priced more than 14,800 customer transactions inferior to the NBBO." FINRA also notes, as if it comes straight out of Flash Boys which focuses on exchange execution and the NBBO, that...
"Citigroup priced more than 7,200 customer transactions inferior to the NBBO because the firm's proprietary BondsDirect order execution system (BondsDirect) used a faulty pricing logic that only incorporated the primary listing exchange's quotation for each non-convertible preferred security."
For a list of pricing "issues" and disagreements, click here. For our other coverage on high frequency trading (HFTs), click here.

Meanwhile, we've been tracking dark pool trading flow after the recent investigations.  In an earlier blog we tabulated recent trading levels, showing the reported, dramatic, drop in trading at Barclays' dark pool.  Since then, the flow within Barclays' has stabilized and gone up just a touch in August, while overall ATS trading levels have stabilized somewhat.  This is despite any seasonality component, with general trading levels on exchanges down roughly 9.5% since June (i.e., comparing August to June).

Friday, April 4, 2014

High Frequency (Non) Trading

This week's release of Michael Lewis' new book, Flash Boys, has renewed focus on a little understood area of the market, an area that has garnered the recent attentions of market regulators, New York's Attorney General, and more recently the FBI -- but never as much attention as it garnered from Michael Lewis' interview on 60 Minutes on Sunday, with his book pending release the following day.

Without going into too many specifics, one of the central themes that Lewis discusses is the potential for high frequency traders (or HFTs) to take advantage of certain market information -- like bids and offers -- that are unknown to many other market players.

Defenders of HFTs have come out aggressively, with claims that HFTs increase market activity and liquidity, and have lowered trading costs.  The WSJ published an extensive opinion editorial by hedge fund guru Cliff Asness and his colleague Michael Mendelson of AQR, which energetically claims that much of what HFTs do is "make markets" and that they do it best because "their computers are much cheaper than expensive Wall Street traders, and competition forces them to pass most of the savings on to us investors."

Of course this sounds altogether too convincing.  Unfortunately, Asness and Mendelson provide little or no evidence (although their business as long term traders relies heavily on evidence, and they claim in the article to spend considerable energies looking into their trading costs) and they admit that they actually don't have too much conviction in the premise of their exposition:
"We think it helps us. It seems to have reduced our costs and may enable us to manage more investment dollars. We can't be 100% sure. Maybe something other than HFT is responsible for the reduction in costs we've seen since HFT has risen to prominence, like maybe even our own efforts to improve." (emphasis ours)
But this aside, no doubt all forms of HFTs bring liquidity.  They're a good thing.  Let's focus our attention elsewhere.  

Or not?

Might there be another type of HFT, that doesn't always bring liquidity for the greater good of the market ...  perhaps a type that uses obscure mechanisms to change the look and feel of the market -- to make people think there is a bid, think there is an offer, without there being one?  

This is what Flash Boys, and the interest it has invigorated in HFTs, really concerns itself with -- understanding market maneuvers like spoofing or pinging: the submission of phantom orders, immediately cancellable, that have the potential to create a false impression of market levels.

Are we creating a whole lot of (potentially fictitious) orders, but not a whole lot of activity?  Are there high-frequency non-traders?  Are we mis-marking our portfolios as a result? We continue to investigate.  But we couldn't help but bring you back to a 2013 chart from Mother Jones, which highlights the growing contrast between actual trades (in orange) and quotes/orders (in red).

Tuesday, July 3, 2012

LIBOR and Transparency

Americans obsessing over last week’s healthcare decision or zoning out ahead of July 4th may have missed the latest episode in the financial industry corruption soap opera. Last week. Barclay’s agreed to pay a $453 million fine for misreporting the rates at which it borrowed funds to the British Bankers Association, thereby distorting the value of the London InterBank Offer Rate (LIBOR). The bank’s Chairman and COO have both stepped down.

This instance of financial industry malfeasance appears to lack the compelling narrative needed to upset the general public. For those advocating on behalf of the “little guy”, this scandal may lack appeal, since most of the LIBOR manipulation appears to have been downward -thereby lowering mortgage rates paid by ordinary borrowers. Financial industry critics seem less concerned by the fact that many “little guys” who directly or indirectly invest in LIBOR-based vehicles were cheated out of some income. Journalists and bloggers have thus focused their ire on the rich and powerful individuals who have been caught cooking the books. This is unfortunate, because chopping off a few heads is not the real solution. As we will see in the coming days and weeks, misreporting of bank borrowing rates was pervasive. It is simply too tempting for most of us mortals in the financial industry to resist.

Rather than focus on the people involved or expect bank executives to morph into Mother Theresa, we should instead direct our attention to fixing the institutional framework. The problem is with how LIBOR and many other financial market prices and rates are estimated and reported. The systems we have are too easy to game and the benefits of gaming them are simply too great to resist.

In the case of LIBOR - as with bank loan prices and CDS spreads - the mechanism involves dealers reporting their bids and offers to a data aggregator, like Thomson Reuters or MarkIt. The aggregator then averages the reported quotes, often dropping the highest and lowest marks from the composite. As we’ve now seen, these dealer quotes are subject to manipulation. In less liquid markets, they may not be updated regularly since the dealer does not see new bids or offers. In either case, the composite marks reported by the aggregator do not reflect actual value.

This should concern everyone (who pays taxes to bail out banks), because it means that we don’t really know what most bank assets are worth. A better alternative would be to require all bank transactions to be reported and made publicly available. Reporting should be real time, easily accessible on the internet and as detailed as possible. Specifically, consumers of the data should be able to identify inter-dealer trades that may be executed for the purpose of manipulating mark-to-market prices.

Comprehensive transaction reporting will not be welcome by many in the financial industry. Although the major complaint may revolve compliance costs, these should be minimal, since banks already have to collect all of the transaction data for their internal systems. The real concern will be the loss of income suffered by traders, who realize significant gains from the opaqueness of many markets. Of course, that issue is much less of a concern for the rest of us.

With a few spectacular exceptions, prices of equities and other exchange traded products have proven trustworthy because of their relative transparency. By making markets for bank funding, asset backed securities, derivatives and exotic fixed income instruments more transparent, we can restore trust in quoted prices, enhance liquidity and increase the stability of our financial system.

Rather than simply scapegoating those who were caught, let’s use the LIBOR scandal as an opportunity to provide more transparent and reliable pricing not only to the market for short term bank financing, but to all markets touched by our “too big to fail” financial institutions.

Wednesday, April 4, 2012

Multiple Rating Scales: When A Isn’t A

Philosophers from Aristotle to Ayn Rand have contended that “A is A.” Apparently none of these thinkers worked at a credit rating agency - in which “A” in one department may actually mean AA or even BBB in another. While the uninitiated might naively assume that various types of bonds carrying the same rating have the same level of credit risk, history shows otherwise.

During the credit crisis, AAA RMBS and ABS CDO tranches experienced far higher default rates than similarly rated corporate and government securities. Less well known is the fact that municipal bonds have for decades experienced substantially lower default rates than identically rated corporate securities – and that the rating agencies never assumed that a single A-rated issuer ought to carry the same credit risk in both sectors. This discrepancy was noted in Fitch’s 1999 municipal bond study and confirmed by Moody’s executive Laura Levenstein in 2008 Congressional testimony on the topic. Later in 2008, the Connecticut attorney general sued the three major rating agencies for under-rating municipal bond issues relative to other asset categories. (The suit was recently settled for $900,000 in credits for future rating services, but without any admission of responsibility). Last year, three economists – Cornaggia, Cornaggia and Hund – reported that government credit ratings were harsher than those assigned to corporates, which, in turn, were more severe than those assigned to structured finance issues.

One might ask why it is important for ratings in different credit classes to carry the same expectation in terms of either default probability or expected loss? Perhaps we should accept the argument that ratings are intended to simply provide a relative measure of risk among bonds within a given asset class.

There are at least two problems with this approach. First, it is unnecessarily confusing to the majority of the population that is unaware of technical distinctions in the ratings world. Second, it creates counterproductive arbitrage opportunities.

If an insurer is rated AAA on a more lenient scale than insurable entities in another asset class, the insurer can profitably "sell" its AAA rating to those entities without creating any real value in the process.

Municipal bond insurance is a great example. Monoline bond insurers like AAA-rated Ambac, FGIC and MBIA insured bonds issued by states, cities, counties and other municipal issuers for three decades prior to the 2008 financial crisis. In some cases, the entities paying for insurance were of a stronger credit quality than the insurers. As it happened, the insurers often failed while the issuers survived, leaving one to wonder why the insurance was necessary.

During this period, general obligation bonds had very low overall default rates. According to Kroll Bond Rating Agency’s Municipal Default Study, estimated annual municipal bond default rates by issuer count have been consistently below 0.4% since 1941. Similar findings for the period 1970-2010 are reported in The Bloomberg Visual Guide to Municipal Bonds by Robert Doty. This 0.4% annual rate applies to all municipal debt issues, including unrated issues and revenue bonds. The annual default rate for rated, general obligation bonds is less than 0.1%.

Given this long period of excellent performance, one might reasonably expect that most states and other large municipal issuers with diversified revenue bases to be rated AAA. No state has defaulted on its general obligation issues since 1933, and most have relatively low debt burdens when compared to their tax base. Despite these facts, the modal rating for states is typically AA/Aa with several in the A range. (This remains the case despite certain rating agencies’ claims that they have recently scaled up their municipal bond ratings to place them on a par with corporate ratings).

The depressed ratings created an opportunity for municipal bond insurers to sell policies to states that did not really need them. For example, the State of California paid $102 million for municipal bond insurance between 2003 and 2007. Negative publicity notwithstanding, the facts are that single A rated California has a Debt to Gross State Product ratio of 5% (in contrast to a 70% Debt/GDP ratio for the federal government) and that interest costs represent less than 5% of the state’s overall expenditures. While pension costs are a concern, they are unlikely to consume more than 12.5% of the state’s budget over the long term – not nearly enough to crowd out debt service.

California provides but one example. The Connecticut lawsuit mentioned above also cited unnecessary bond insurance payments on the part of cities, towns, school districts, and sewer and water districts.

Meanwhile, AAA-rated municipal bond insurers carried substantial risks, evident to many not working at rating agencies. For example, Bill Ackman found in 2002 that MBIA was 139 times leveraged. As reported in Christine Richard’s book Confidence Game, Ackman repeatedly shared his research with rating agencies – to no avail.

This imbalance between the ratings of risky bond insurers and those of relatively safe municipal issuers essentially created the monoline insurance business – a business that largely disappeared with the mass bankruptcy and downgrading of insurers during the 2008 crisis.

Inconsistent ratings across asset classes thus do have real world costs. In the US, taxpayers across the country paid billions of dollars over three decades for unneeded bond insurance. Individual municipal bond investors, often directed by their advisors to focus on AAA securities only, missed opportunities to invest in tens of thousands of bonds that should credibly have carried AAA ratings, but were depressed by the raters’ inopportune choice of scale.

We believe that one reason for the persistent imbalance between municipal, corporate and structured ratings is the dearth of analytics directed at government securities. Rating agencies and analytic firms offer models (and attendant data sets) that estimate default probabilities and expected losses for corporate and structured bonds. Such tools are relatively rare for government bonds. Consequently, the market lacks independent, quantitatively-based analytics that compute credit risks for these instruments. This lack of alternative, rigorously researched opinions allows the incorrect rating of US municipal bonds to continue, without the alleviation of a positive feedback loop.

Next month, PF2 will do its part to address this gap in the marketplace with the release of a free, open source Public Sector Credit Framework, designed to enable users to estimate government default probabilities through the use of a multi-period budget simulation. The framework allows a wide range of parameterizations, so you may find it useful even if you disagree with the characterization of municipal bond risk offered above. If you wish to participate in beta testing or learn more about this technology please contact us at, or call +1 212-797-0215.

Contributed by PF2 consultant Marc Joffe. Marc previously researched and co-authored Kroll Bond Rating Agency’s Municipal Default Study.

Thursday, December 1, 2011

The Art of Pricing (and the Heart of the War)

The fight for transparency in the financial markets is gaining traction.

Even maverick Judge Rakoff, in his SEC v. Citi settlement ruling, got in on the act with commentary that resonates: “In any case like this that touches on the transparency of financial markets whose gyrations have so depressed our economy and debilitated our lives, there is an overriding public interest in knowing the truth.”

The recent media coverage on the transparency issue is particularly acute as it pertains to asset pricing transparency, which is becoming ever more important as the market seeks alternatives to ratings-based capital allocations, per the requirements of Dodd-Frank.

The problem is that while each asset has only one rating (from each rating agency), there’s no consistency of pricing from one bank to the next. We fear that absent a centralized or standardized solution, any mark-to-market pricing will continue to cause headaches in markets where assets aren’t actually traded (there’s no ready or visible price).

Floyd Norris explains in a recent piece that “[under] the [accounting] rules, banks have a choice of three ways to report the value of identical securities. Even if two banks are using the same valuation method for the same security, they can come up with different values, and it is very difficult for an investor to get any feel at all for just how optimistic, or pessimistic, a bank’s estimates might be.”

He also brings in a quote from former FASB member Ed Trott, explaining that “’we are moving back to the past’ by increasing the ability of banks to massage their numbers as they wish.”

This revelation (unfortunately) jibes well with Gretchen Morgenson’s commentary in her piece entitled Slipping Backward on Transparency for Swaps. Gretchen explains that “[right] now, many swaps are traded one-on-one, over the telephone. The price is usually whatever the dealer says it is.” (Recall in Michael Lewis’ The Big Short, when Scion Capital’s Michael Burry warns that “[whatever] the banks’ net position was would determine the mark,” and that “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”)

And the problem isn’t limited to the comparability of asset valuations at the Big Banks. The Big Auditors are also coming a cropper in their audits of banks. Norris explains in a separate piece that analyzes the PCAOB’s oversight reports of KPMG and PricewaterhouseCoopers: “[one] virtually identical criticism of the two firms could be a sign of the way all the firms have been auditing how banks value hard-to-measure financial assets.”

“In three of these audits,” the board wrote in its report on KPMG’s audits done in 2010, “for certain financial instruments the firm obtained multiple prices and used the price closest to the issuer’s recorded price in testing its fair value measurements, without evaluating the significance of differences between the other prices obtained and the issuer’s prices.”

With the banks being able to extract greater margins from opaque markets, the war over asset price transparency is currently being won by the might-makes-right team.

But a more simple solution that levels the playing field for investors big and small, and reduces the burden (and cost) of each auditor having constantly to reinvent the wheel, is to create a central platform for pricing.

Confidence will increase in the adequacy, verifiability, and consistency of financial statements. Regulators would have a field day and investors would be better able to spot when they’re being fooled. Of course the Banks wouldn't be too happy.

Here’s an analysis we put together of the material benefits afforded by a centralized (and perhaps standardized) pricing solution.

Update Dec. 2: According to a Bloomberg article by Jesse Hamilton that came out this morning (SEC’s Data Crunchers Find Red Flags Leading to Hedge-Fund Cases), the SEC through a prorietary tool, has been increasingly been taking action against hedge funds for misconduct including "fraudulent valuations and misrepresenting fund investors."

Hamilton brings in a relevant quote from Bruce Karpati, co-chief of the SEC's asset management enforcement unit:
“Hedge-fund managers depend on valuation and performance for both their compensation and marketing,” ... “These managers have either manipulated performance or engaged in other falsehoods in order to line their own pockets at the expense of investors.”

For a updated list of disputes around asset prices provided, click here.

Tuesday, August 23, 2011

Complexity is a Cash Cow (but not for you)

“Fortuna's wheel had turned on humanity, crushing its collarbone, smashing its skull, twisting its torso, puncturing its pelvis, sorrowing its soul. Having once been so high, humanity fell so low. What had once been dedicated to the soul was now dedicated to the sale.” – from John Kennedy Toole’s A Confederacy of Dunces

Frank Partnoy, in his recent Financial Times commentary, makes the bold point that while “[most] for-profit companies are run for the benefit of shareholders … banks have been run more for the benefit of employees.”

Partnoy doesn’t delve too deeply into the basis for his claim, but he may well be alluding to the fact that traders were being financially rewarded for executing trades that brought short-term profits at the expense of long-term pain.

We have all heard about the Abacus case, where the bank was accused of siding with one client at the expense of others. (Goldman settled with the SEC for $550mm). In other cases it is argued that banks actually positioned themselves in direct opposition to their clients. Needless to say it doesn’t augur well from a long-term, shareholder value perspective for a bank to be adverse to its clients. Either the bank will suffer or its client will suffer.

From a corporate governance perspective one might argue that senior management failed to the extent its traders were not being compensated based on the long-term quality of their decisions, but rather on their short-term profits. In such a scenario, the traders would not have been incentivized , or forced, to consider the long-term benefits strong client relationships. They would simply want to execute high margin, million dollar trades.

And hence the layering on of complexity, and the disappearance of transparency.


Complex, opaque, private trades afford broker-dealing banks numerous short-term money-making opportunities.

First up, the lack of asset transparency (inability to see through to the asset’s support) and trading transparency (inability, due to the private nature of certain markets, to follow the money or the trading levels) makes it easier for banks to get away with manufacturing prices to their advantage, or taking advantage of comparatively unsophisticated (trusting) clients.

Jim Grant (founder of Grant’s Interest Rate Observer) posited in a recent Bloomberg interview that the world we live in “is a world of fake prices and of manipulated prices.” For liquid, traded securities like municipal bonds or US Treasuries, it is understandably quite difficult to massage the numbers; but for lesser-traded, or illiquid, assets price discovery can be cumbersome if not impossible, making price manipulation all the more feasible.

In Michael Lewis’ The Big Short, Scion Capital’s Michael Burry warns that “[whatever] the banks’ net position was would determine the mark,” and that “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”

The lack of transparency, too, is entirely convenient to banks in the know: it creates numerous opportunities to profit at the expense of those with less information. We call this imbalance an "informational asymmetry." It may be very difficult to sell Apple stock at an above-market price to even the least sophisticated of investors: they can readily tell that the security ought to be valued lower. But when the security is complex and privately traded, and when the comparatively unsophisticated investors do not have the market know-how or savvy to model the deals, it can be much easier for a bank to "pull one over" on them. The Fed ponders the severity of this very advantage in its aptly titled report "Could Asymmetric Information Alone Have Caused the Collapse of Private-Label Securitization?"

Complexity also undermines the potential for investigative journalism (they cannot get access to the data or make a complex deal sound too interesting) and, more importantly, the ability for regulators to oversee the markets they regulate. The IMF in 2006 warned that “[while] structured credit products provide a wealth of market information, there remains a paucity of data available for public authorities to more quantitatively assess the degree of risk reduction among banks and to monitor where credit risk has gone.”

Investors would do well to acknowledge the incongruent incentives banks may have to add their complexity to their products. But as buyers, complex deals can be difficult – and expensive – to analyze, and cumbersome if not impossible to trade (out of) during times of heightened volatility.

Investors can push back when offered complex deals that don’t meet their interests – and they can strive to ensure that their rights to high quality information and transparent disclosures are upheld.

Complexity allows for high margin trades that elicit high profits, but sometimes on terms that are not commercially reasonable. And in times of high volatility, they tend to be accompanied by high bid-offer spreads. As always, it’s buyer beware.

Tuesday, May 10, 2011

Pricing Transparency

Professor Allan Meltzer argues, in yesterday’s WSJ article BlackRock's 'Geeky Guys' Business, that BlackRock Solutions’s pricing process “should all be open” and that “[they] may be doing things honestly and above board, but we won’t see that unless we see how they got the numbers.”

While legislators and supervisors scurry to plug the holes created by the absence of both balance sheet and asset transparency, the final piece of the puzzle – pricing transparency – remains largely unattended to.

It is this final element, the lack of pricing transparency, that concerns Prof. Meltzer. Right now, hedge funds, banks and insurance companies can all carry the same asset at a different price. In illiquid markets, the price differential between two price providers can be extraordinary, creating an opportunity for lesser-regulated financial institutions to profit handsomely from the regulatory arbitrage available, at the expense of their more heavily-regulated counterparts.

As with “ratings shopping” where market participants seek the highest ratings on their securities, investors are financially incentivized to seek out the highest value they can find for each security. Funds’ performance (and often their managers' bonuses) is directly determined from the valuations of their assets. Stronger performance, whether real or artificial, can even help a fund or company raise new capital.

Thus, there remains significant potential for derivatives mispricing. One could even argue that the potential for mispricing is heightened when the price provider offers additional advisory services to the client. Given the substantial fees and margins that may be earned on the advisory side, a conflicted price provider may be more open to accommodating a client’s price haggling to win or maintain it as a client.

Prof. Meltzer’s goal for pricing transparency would hone in on, perhaps eliminate, numerous possible sources for deliberate mispricing (see list of contested pricings here). While we fear it may be prove an insurmountable hurdle to require pricing providers to share transparency as to their methods, we feel strongly that an opportunity exists now for market regulators to ensure the consistency of prices used. (See Central Pricing Solution here.)

Absent complete pricing transparency, the usage of consistent prices would serve to increase investor confidence as to the adequacy of financial institutions’ balance sheets. A requirement for all constituents supervised by the same regulatory body to apply the same price can discourage price haggling, or price shopping.

Wednesday, April 13, 2011

Split Ratings

Given the high correlation between security prices and their ratings, we wanted to follow up on some of our prior pieces that contemplated the wide discrepancies between ratings opinions provided on certain securities (see for example here and here). Split ratings, of course, present trading opportunities.

Our analysis considered securities that were acted upon by a single rating agency between June and August of 2009. We then had a look at the average ratings split as of March 28 this year: one and a half years later. The outcome was quite astonishing.

While at inception the rating agencies seem typically to achieve the same rating, down the line they tend to substantially disagree with one another. (We have broken the differential down depending on how many rating agencies rated each security. If all three of Moody's, Fitch and S&P rated the security, we'll show both a max split and a minimum split. If only two raters rated the security as of March 28, 2011, the max split equals the min split.) The average max differential: 4.23 rating subcategories (or "notches"). The median differential - 3 notches. One rating subcategory would be the difference between a AAA and a AA+.

This table shows examples of the 748 structured finance securities considered in our database at each ratings split level, including one of the 20 securities on which there was a ratings differential of between 14 and 18 ratings subcategories.

For the purposes of this analysis, securities were only considered to the extent they had ratings outstanding from at least two of the Big Three credit rating agencies as of March 28, 2011.

Thursday, April 7, 2011

Contested Pricings List

The capacity for price manipulation or price inflation presents a major challenge for the market to overcome, especially in the illiquid markets where live trading data are seldom made available to the general public. Like "ratings shopping," investors may be incentivized towards seeking the highest price, or most accomodating price provider, for their securities.

We will continue to maintain this growing database of situations in which parties disagree as to the prices used, or pricing practices employed.

  1. Sept. 2014: SEC Finds Deficiencies at Hedge Funds: Shortcomings Include Valuation 'Flip Flopping'

  2. Sept. 2014: Pimco ETF Draws Probe by SEC: Regulators Are Probing Whether Returns Were Artificially Inflated

  3. Aug. 2014: FINRA Fines Citigroup Global Markets: "Citigroup priced more than 7,200 customer transactions inferior to the NBBO because the firm's proprietary BondsDirect order execution system (BondsDirect) used a faulty pricing logic"

  4. Feb. 2014: SEC Looking at How Alternative Funds Value Investments

  5. Feb. 2014: Danske Bank Faces Broader Probe of Bond Price Fixing in 2009: "The trades, conducted in February and March 2009, raised mortgage bond prices in a way that “harmed customers at Realkredit Danmark A/S,” Danske’s home-loan unit, the crime squad said."

  6. Jan. 2014: Federal Probe Targets Banks Over Bonds: Inquiry Looks for Deliberate Mispricing of Mortgage Bonds Key to Financial Crisis

  7. Aug. 2013: 2 more targeted in JPMorgan's London Whale case: "Prosecutors in the office of U.S. Attorney Preet Bharara in the Southern District said Martin-Artajo and Grout manipulated and inflated the value of position marks in the Synthetic Credit Portfolio, or SCP, which the government said had been very profitable for the bank's chief investment office."

  8. Dec. 2012: Deutsche hid up to $12bn losses, say staff

  9. Nov. 2012: KCAP fund, execs settle charges of overstating assets.

  10. May 2012: FINRA Fines Citigroup Global Markets $3.5 Million for Providing Inaccurate Performance Data Related to Subprime Securitizations: "Citigroup failed to supervise mortgage-backed securities pricing because it lacked procedures to verify the pricing of these securities and did not sufficiently document the steps taken to assess the reasonableness of traders' prices."

  11. May 2012: JPMorgan CIO Swaps Pricing Said To Differ From Bank

  12. May 2012: Ex-UBS Trader Sues After Firing for Mispricing Securities

  13. Feb. 2012: SEC Looking Into PE Firms’ Valuation of Assets

  14. Feb. 2012: Massachusetts Subpoenas Bank of America Over CLOs: examining whether Bank of America knowingly overvalued the assets in the portfolios in order to get the loans off its books

  15. Feb. 2012: Ex-Credit Suisse traders face US charges: Case relates to alleged CDO mispricing

  16. Jan. 2012: SEC Charges UBS Global Asset Management for Pricing Violations in Mutual Fund Portfolios)

  17. Nov. 2011: PwC and KPMG criticised over audits (of their clients' valuations of mortgage-related securities)

  18. Oct. 2011: Oversight board faults Deloitte audits

  19. July 2011: Polygon Faces Accusations It Used Tetragon For Cash

  20. April 2011: Report says Goldman duped clients on CDO prices

  21. April 2011: Wachovia cheated investors by inflating markups, SEC says

  22. March 2011: Buffett’s Berkshire Questioned on Accounting

  23. Feb. 2011: What Vikram Pandit Knew, and When He Knew It

  24. Feb. 2011: Mutual Funds' Muni-Debt Prices Are Questioned

  25. Oct. 2010: SEC Continues Crackdown on Overvaluations of Hedge Fund Assets

  26. Aug. 2010: Merrill's Risk Disclosure Dodges Are Unearthed

  27. May 2010: HK watchdog slaps fine on Merrill units

  28. April 2010: Legal Woes for Regions Financial

  29. Nov. 2009: Ambac Misstates Financials to Meet Minimums

  30. July 2009: Under Fire, NIR Group Switches Valuation Firms

  31. June 2009: Evergreen Pays Over $40 Million to Settle SEC Charges that it Overvalued Mortgage-Backed Investments

  32. April 2009: FHLB Executive Who Left Cites Securities Valuations

  33. Aug. 2008: "Large Number" of Banks Miss-Marked Assets, U.K. Regulator Says

  34. Aug. 2008: Financial Services Authority’s "Dear CEO: Valuation and Product Control" Letter

  35. July 2008: The Subprime Cleanup Intensifies: Did UBS Improperly Book Mortgage Prices? Several Probes Expand

  36. Feb. 2008: IN RE REGIONS MORGAN KEEGAN SECURITIES, DERIVATIVE and ERISA LITIGATION:"(g) The Fund's Board of Directors was not discharging its legal responsibilities with respect to “fair valuation” of the Fund's assets and had abdicated these responsibilities to the Fund's investment advisor, which had an inherent and undisclosed conflict of interest because its compensation was based on the amount at which which the Fund's assets were valued"

  37. Feb. 2008: AIG's bad accounting day

  38. Feb. 2008: OCC Supervisory Letter to Citi (identifies as one of two key concerns "CDO Valuation and Risk Management in the Capital Markets & Banking Group")

  39. Oct. 2007: Ex-RBC trader says colleagues mismarked bonds

  40. Oct. 2007: Pricing Tactics Of Hedge Funds Under Spotlight

  41. Aug. 2007: BNP Paribas halted withdrawals from three investment funds because it couldn't "fairly" value their holdings

  42. Aug. 2007: Goldman Disputes AIG Valuations and Office of Thrift Supervision Instructs AIG to Revisit Modeling Assumptions

  43. Jan. 2006: Deutsche suspends trader over £30 million 'cover-up’

  44. June 2002: An Analysis of Allied Capital:Questions of Valuation Technique

  45. Aug. 1994: Behind the Kidder Scandal: How Profit Was Created on Paper

Let us know if there are any we're missing.

Thursday, March 31, 2011

Central Pricing Solution

It continues to worry us that asset prices can be, or are, subject to conflicts of interests and inflationary pressures.

As an independent valuation consultancy we’re naturally disagreeable about market participants seeking valuations from biased counterparties like asset managers or even the broker dealers who sold them the bonds or are funding their holding of the bond. Scion Capital’s Michael Burry explained in The Big Short: “Whatever the banks’ net position was would determine the mark.”

But even aside from potentially conflicted external parties, we’re acutely aware of the inflationary pressures independent parties such as ourselves may face when evaluating a security. Similar to “ratings shopping” opportunistic market participants often seek out the provider willing to give the highest prices.

The incentive is clear: higher asset prices translate into stronger performance. Stronger performance may directly benefit an executive or employee (to the extent performance fees or bonuses are based on returns) or even indirectly improve a fund’s prospects (heightened ability to raise capital or negotiate decreased margin requirements on the back of strong performance).

While prices have been regularly contested problems are starting to crop up more and more regularly, with questions about mutual funds’ municipal bond pricings and Berkshire Hathaway’s pricing and writedown practices finding their way into the news in the last two months.

There’s no easy solution, but one we feel strongly about is the creation of a centralized analytical (read pricing) solution.

The cost of creating such a system could be shared among its users. The advantages are numerous. Here are a few:

  • If all holders were required to hold the same security at the same price, the result would be greater balance sheet consistency (across funds, companies)

  • Regulators, auditors and examiners would have an easier time analyzing their constituents’ books: they would be able to rely on a single, consistent model that is widely used. (The prevailing, seemingly inefficient alternative is to have each regulator/ auditor/examiner familiarize herself with the methodologies employed by each and every pricing provider used by each company scrutinized. This is no mean feat, especially across different asset classes, and so naturally a lot will slip through the cracks.)

  • Pricing consistency helps reduce portfolio-level variability and also helps the market overcome some of the uncertainties that come with informational asymmetries and modeling complexities in today’s market. Consistency and confidence together help promote market liquidity.

Wednesday, October 20, 2010

The Importance of Being Investment Grade

While references to credit ratings are being removed from statutes and federal regulations (effective July 2012) their position in our existing investment framework remains secure.

We have discussed previously how credit rating downgrades might negatively influence a security's price by decreasing investor demand (some funds and companies, for example, can only buy debt of a certain credit quality) and increasing funding costs (collateral/margin requirements), which may lead to the inevitable vicious cycle.

The deeply embedded nature of ratings in financial contracts is even more apparent when we look at the ramifications of a downgrade on H&R Block's corporate debt (CUSIP 093662AD6), which has been the recent focus of negative attention from the rating agencies. If the debt is downgraded by Moody's to Ba1 or below and/or by S&P to BB+ or below, the coupon on these notes will increase, and the debt will thereby become more expensive to HRB. In other words, if a downgrade is an indication that a company is struggling to meet its obligations, the downgrade in its enactment (by construction) might make said obligations more expensive, which precipitates further difficulty in meeting them. As such, the rating provided is integral to, and certainly not de-linked from, the performance of the security being rated.

These bonds are currently Baa or BBB, investment-grade bonds. However, as the table illustrates, if either rating agency alone downgrades the debt to the Ba1 or BB+ level, the coupon on the bond will increase by 25bps from 7.875% to 8.125%. If both rating agencies downgrade the debt to this level, the result will be a 50bps increase to 8.375%. The interest rate increase is capped at 2%, which will be effectuated if Moody's downgrades the bond to B1 or below and S&P downgrades it to B+ or below.

The (unfortunate) consequence: a downgrade immediately increases the coupon on the bond, which decreases the price. That's in addition to the decreased demand for the bond, the heightened illiquidity, and the increased funding costs for holding the bond. If downgraded, a devaluation of the bond is inevitable, irrespective of the market's opinion of the accuracy of the rating agencies' opinions.

Tuesday, October 5, 2010

Phantom Pricing

Mario Draghi, head of the Financial Stability Board, is making a splash about the loosely regulated “shadow banking system.” While estimates of the size of the system are tough to come by (the FRBNY report suggests $16 trillion) what makes this system a “shadow” system is not its size, but the location of the assets. Who owns what, where?

The provisions of off-balance-sheet accounting made it very difficult to know the exposures of your counterparties, one of the reasons Mr. Draghi felt the shadow banking system to be a key contributor to the crisis: if you don’t know what else your counterparty’s holding, you won’t lend to it in a time of crisis. The lending freeze, then, only serves to exacerbate the crisis for those parties in need of short-term liquidity. A minor disconnect in a small part of the market can therefore lead to panic, bank runs, and mass deleveraging. The scenario painted exaggerates what happened in our financial downturn, but the elements remain true.

The challenge becomes how best to cure this lack of transparency. Unfortunately there are at least three parts at play in this multidimensional version of Heisenberg’s uncertainty principle: we cannot measure the exposure because we cannot see it (questionable balance sheet transparency), we know not what it is (questionable asset transparency) and we cannot rely on the value being associated with it (questionable pricing transparency).

If we could cure the “balance sheet transparency” element, the difficulty would by definition be removed from the shadow banking system. Enhancing asset transparency practices is a regulatory initiative that has begun. The process toward improving pricing transparency, however, remains in its infancy.

Why the lack of transparency? The answer: a lack of transparency in the market creates a money-making opportunity for those parties in the know. The informational asymmetries in the market allow the better-informed market participants to take advantage of those who are guessing at certain characteristics. From The Big Short:

[Yale professor] Gary Gorton guessed that the piles were no more than 10 percent subprime. [Gene Park] asked a risk analyst in London, who guessed 20 percent. “None of them knew it was 95 percent,” says one trader. “And I’m sure that [AIG’s Joe Cassano] didn’t either.” In retrospect their ignorance seems incredible—but, then, an entire financial system was premised on their not knowing, and paying them for this talent.
Absent the ability to perform due diligence internally, market participants grew increasingly dependent on the soundness of advice being offered to them by their broker-dealers, a situation which has created forum for BD litigation. From Confidence Game:

Meanwhile, [MBIA’s lawsuit against Merrill Lynch alleged that] because MBIA “did not and could not perform a cost-effective loan-level valuation analysis of the ML-series CDOs, it relied on and trusted Merrill Lynch’s statements about the quality of the underlying loans.”
Pricing transparency is similarly powerful and problematic. In the deeply veiled world of broker-dealer intermediation, the buyer and seller seldom know each other. The bidder (for example a regional bank or a hedge fund trader) doesn’t know the offerer, nor the offer itself, nor the number of offerers out there, and vice versa.

In other words, neither party knows the bid-offer spread being made by the broker-dealer and they don’t know whether there are many bids or just a few. Buyers and sellers are guessing at the price and the liquidity.

The larger problem, of course, is that for leveraged funds your margin is being dictated by the seller’s price, and that price is not necessarily an independent, unbiased opinion. Back to The Big Short:

“Whatever the banks’ net position was would determine the mark,” [Scion Capital’s Michael Burry] said. “I don’t think they were looking to the market for their marks. I think they were looking to their needs.”
One solution, thus, is to centralize the pricing operations among one or more independent bodies — perhaps among existing regulatory bodies to the extent we can avoid conflicts of interests between their supervisory agenda and their pricing power. Else, why not create a new agency that creates various economies of scale in promoting pricing transparency and consistency in the name of, wait for it, consumer protection.

Monday, September 27, 2010

Credit Ratings Reversals

The debate continues over the usefulness of credit default swaps (CDS) spreads as alternatives to ratings.

Today, Moody’s Corporation announced that its Analytics division – separate from its ratings group – has improved the ability of its EDF (expected default frequency) model to estimate default probability as a result of the incorporation of CDS spreads to the platform.

Moody’s Analytics clearly agrees that CDS spreads provide useful predictive content. So did a fellow panelist of ours at a distressed debt conference on Friday.

Jerome Fons, EVP of Kroll Bond Rating Agency, included the following slide in his presentation (click here to download the presentation in its entirety).

Among other things, it shows CDS spreads to be better predictors of default probability (see the higher Accuracy Ratio).

The slide also displays the lower frequency with which credit ratings are reversed by rating analysts, versus the regularity with which CDS spreads can move from one bucket to another as per the market’s whims.

This feature, as displayed by Ratings Reversals and Rating Changes, reminds us of the human nature of rating agency analysts and in particular their psychological predisposition against reversing a prior rating action. The obvious upside is ratings stability – at the expense of volatility -- to the extent we care for it. Would we want our regulatory capital ratios to move on a daily or secondly basis, as a stock price may trade on the news, or on gossip?

For example, consider the case of Arlington CDO tranche A3. Moody’s and S&P both started off at Aa2/AA ratings, respectively, in the year 2000. In 2002, Moody’s downgraded it more aggressively than S&P, a situation which lasted until 2006, at which stage Moody’s upgraded the bond to A3, which was the then-current equivalent of S&P’s rating of A-. 2009 arrives and Moody’s drops to Caa3, before upgrading to B3 in early 2010 and then Ba3 last week. Moody’s is now just short of S&P’s current equivalent rating of BB+.

While certain market participants might benefit from more regular rating actions, others no doubt value ratings stability above all else. But either way, it seems entirely unlikely that rating stability and ratings accuracy go hand-in-hand.

We remain very interested in the topics of ratings alternatives and the comparison of ratings performance. Let us know if you have a similar interest in these topics.

For more on CDS spreads as alternatives to ratings, click here; to visit our submission to the Fed, OCC, OTS and FDIC on this topic, click here.

Tuesday, February 3, 2009

The Price is (not that) Right

The New York Times recently published an article on the risks associated with the poor valuation of Bad Bank assets.


Placing too low a value would force institutions selling and others holding similar investments to register crushing losses that could deplete their capital and make it harder for them to increase lending.

But inflated values would bail out the companies, their shareholders and executives at the expense of taxpayers, who would swallow the losses if the government could not recoup what it had paid.

The article is accompanied by a description of how the valuation of a specific toxic asset can range from 97 cents on the dollar (financial institution holding the bond) to 38 cents on the dollar (actual trading level of the bond). S&P, “the extra set of eyes,” valued it at 83 cents.

With valuations hitting nowhere close to home (actual trading levels), it’s hard to believe that the government won’t end up permanently losing hundreds of billions of dollars to the financial institutions through its Bad Bank.

We decided to dig a little deeper...

The following table contains actual valuations for a -- wait for it, regional bank's -- portfolio of TruPS CDOs (a proud member of the toxic family) obtained either through a trading desk (quite possibly the same one that originated and sold the bonds in the first place) or a rating agency. The current ratings range from A1 to Ba1 without a single bond falling south of the 30 cent line (optimistic, to say the least).

PF2 evaluated the first three bonds (TruPS CDO 1 Tranches C1 & D1; TruPS CDO 2) -- all of which came out in the single digits. In fact, we valued the TruPS CDO 1 Tranche D1 (the junior-most mezzanine bond) at only 87 bps, which reflects the tranche's continued deferral -- since March 2008 -- of its interest payments (and, besides, close to 10% of the portfolio's already a goner).

Regional bank writes down trups CDOs by 99%

Trups CDOs collateral has deteriorated sharply, according to PF2 Securities Evaluations

Wednesday, August 27, 2008

Side Pockets - Keeping Hedge Fund Capital in Their Pockets

In the light of increased regulation, we’re seeing a fair share of interest in side pockets. Without further ado, here’s the low-down:

Side pockets are essentially segregated sub-accounts used by some funds (think hedge funds) to allow them flexibilities in dealing with, and accounting for, illiquid and non-marketable instruments (think CDOs), and potentially other assets.

How, Why?
The fund’s offering and organizational documents should disclose pro forma the extent to which it may transfer fund investments to side pockets.

Side pockets provide a structural mechanism for transferring certain (typically illiquid or hard-to-value) investments into a separate class of the fund. The fund investors’ participation interests are separated in tandem with the assets: only those investors having ownership interests at the time the side pocket is created for a specific investment are exposed to the performance of that “side-pocketed” investment.

This accounting arrangement allows the fund to defer valuation of side-pocketed securities until a valuation or liquidation event occurs, such as the disposal of the security, the bankruptcy of the issuer, or the manager’s transfer of the side-pocketed security back into the fund’s main pool of (liquid) securities.


Importantly, an investor’s liquidity is limited while any investment to which she is exposed is side pocketed.
In other words, an investor cannot fully withdraw from the fund until all side-pocketed investments to which she is exposed are removed from the side pockets. She retains her proportionate share in these side-pocketed investments -- even after completely withdrawing from the fund’s primary investment portfolio -- and is subject to an unlimited lock-up period on this portion, during which she will generally not receive any distribution proceeds.

Management Fees, Accounting Repercussions…

Side pocket investments have typically been valued at cost (as opposed to being marked-to-market) for the period they remain in the side pocket, and so generally excluded from the fund’s NAV calculation for determining performance, fees, redemptions, etc. When side-pocketed assets are not marked-to-market, the fund’s financial statements will not be GAAP compliant; this ability to circumvent evaluating a side-pocketed asset at “fair value” -- and thus the avoidance of certain accounting standards -- may be a primary reason for placing it in a side pocket.

UPDATE - November 7, 2008: Public announcement that GLG Partners ringfenced illiquid investments from its European equities hedge fund