[DEBATE] : So what's it worth when there's no regular market?
Riaz K. Tayob
riazt at iafrica.com
Mon Sep 17 08:32:17 BST 2007
So what's it worth when there's no regular market?
Submitted by cpowell on 03:54PM ET Sunday, September 16, 2007. Section:
By Paul J. Davies, Jennifer Hughes, and Gillian Tett Financial Times,
London Thursday, September 13, 2007
When Synapse Investment Management, a London asset manager, revealed
last week that it was closing a $300 millio (L148 million, E216 million)
fund, its decision sent an ominous message for bankers and accountants
around the world.
That was because the death knell came not as a result of huge tangible
losses on the fund's investments; instead, the main trigger was that the
fund had become embroiled in a bitter, secretive fight with Barclays
Capital, its prime broker, about valuation issues -- how to price the
debt instruments the fund held.
"The fund was closed due to the severe illiquidity in the market, which
led to an inability to properly value the assets," says Mark Holman, one
of Synapse's founding partners, who notes that the fund held none of the
subprime assets that have been at the centre of recent market upheavals.
The tale highlights a much bigger battle about valuation that has
already brought down other funds and still rages behind the scenes in
numerous offices at banks, hedge funds, and accountancy firms on Wall
Street and in the City of London. One of the biggest problems spooking
the markets is the sheer uncertainty about just how large the losses on
many financial instruments might be -- and which institutions will be hit.
This uncertainty has in turn created a crisis in trust among banks
worried about the creditworthiness of their peers and therefore wary of
lending to each other -- which increases concerns about the possibility
of a bank failure. While central banks can inject liquidity, that will
cure only part of the problem. What is really needed is for banks to
trust one another -- and that requires transparency.
Many investors are therefore hoping that the coming weeks will produce
some welcome clarity. Big US banks will start reporting their
third-quarter results next week. Less publicly, a host of hedge funds
are also starting to tell investors how they performed during August,
the month of worst turmoil.
"The crucial question in the next few days and weeks is: How do you mark
the positions? I can only hope that we do not muddle through -- that we
mark them to market," Josef Ackermann, chief executive officer of
Deutsche Bank, said recently. Marking to market means recording the
value of assets at the prevailing market price.
"That gives the reassurance and the stability back to the system.
Because people will say, 'OK, we have seen that people have their
positions marked properly,' and . . . hopefully markets will recover and
some of these price levels [will] come back."
But while this call for more transparency is something investors and
policymakers alike would support, in practice it will be fiendishly hard
to deliver. One of the most pernicious challenges that face the
financial world today is that the industry does not have any common,
uncontested standard for measuring the value of many of the instruments
-- such as leveraged loans or securities linked to subprime mortgages --
that have been at the heart of this summer's storm.
Thus, the type of valuation battle that has erupted around the Synapse
fund and others could be replayed in the coming weeks, as banks and
hedge funds attempt to put the best possible gloss on their numbers but
investors, lenders, and shareholders keep wondering where the bodies
Take the case of leveraged loans, which -- like subprime consumer
mortgages -- are made to borrowers with low credit ratings, such as
companies owned by private equity groups. Traditionally, these were
booked at face value, because the banks intended to hold them until they
matured. But with these loans becoming more often sold in the market,
banks no longer intend to hold most of them to maturity, meaning that
traded prices are usually available. These are considered more relevant
for the investors who use financial statements to gauge the true
position of a bank.
A typical, difficult example is the L5 billion ($10.2 billion, E7.3
billion) worth of senior loans for the planned private equity purchase
of Alliance Boots, the UK pharmacies group, by Kohlberg Kravis Roberts,
the US buyout group, and Stefano Pessina, a Boots executive. Eight
European and US banks arranged this finance at the start of the summer
and expected to sell it quickly to capital market investors. But when
the credit turmoil struck, these planned sales fell through, leaving the
loans stuck on banks' books. Investors in so-called distressed debt are
now offering to buy these loans at 95 percent of face value -- but most
banks are reluctant to record a loss since they think the loans will
recover in value soon.
The worldwide volume of such leveraged loans that banks are stuck with
is estimated at between $350 billion and $380 billion.
While commercial banks with investment banking arms can legitimately
choose at the outset between holding these loans or classing them as for
sale, investment banks (known as broker-dealers in the US) have no such
leeway. The broker-dealers cannot escape marking to market, because
their whole business is about trading such loans and other securities.
Unsurprisingly, this accounting discrepancy infuriates some of the
broker-dealers. "We think all financial instruments should be marked at
fair value for consistency across the system and to simplify the
accounting for hedging," says a senior accounting officer at one of the
big US broker-dealers.
Such arguments elicit some sympathy from the regulatory world. Indeed,
regulators have quietly indicated that they will keep a close eye out
for any sign that commercial banks are trying to flatter their accounts
in the forthcoming results by failing to use "fair value" accounting
approaches when this would be appropriate. Fair value for financial
instruments means exit -- or sale -- price, which should in theory be
equivalent to market value but, for some complex products or in illiquid
markets, might differ drastically.
Even if all the banks use fair-value approaches, the nature of the
banking pipeline creates further scope for problems. It typically takes
a bank a month or more to arrange a leveraged loan and sell it on.
However, if a crisis strikes when banks are in the middle of arranging
deals -- as in the case of the finance to back the Boots acquisition --
the banks may vary in how they book these loans on their books. "These
things are not black and white," one senior banker admits.
However, the problems in using market prices become even more complex in
areas such as the complex bonds backed by mortgages. At present, the
leveraged loan markets are at least reasonably active -- which means
that bankers can find a price for an asset if they try, even if they do
not like the answer. But in the more esoteric corners of the credit
markets, which have been at the centre of the summerwoes, it is often
much harder to determine a price, because there is no market. In some
cases that is because these assets have never actually traded. But even
for those where trading has taken place before, activity has often dried
up in recent months.
Michel Prada, head of the AMF, France's bourse regulator, asks: "How in
the world can all these [accounting] rules be of any use if one is not
able to determine the price of a product?"
One way the industry seeks to address this problem is to value their
products using mathematical models instead. These typically work by
plugging a set of assumptions into mathematical models that deliver an
estimate of what a derivative should be worth. But the results of these
models can vary enormously from bank to bank, depending not only on what
the "inputs" might be but also on the actual models that are used.
Accountants at the banks say their job is to ensure their traders are
using sensible and verifiable inputs and check their results against a
real transaction. "There is huge oversight," says an accountant at a big
broker-dealer -- in the sense of supervision rather than neglect.
But in the case of bonds backed by mortgages, many of the inputs are
necessarily based on subjective assumptions about the future payment
behaviour of mortgagees. On top of this, with the market not
functioning, real transactions are hard to come by.
"The question here is to find, and constantly update, a valuation model
that could reflect or approach the economic reality, as consensually
defined by the market," says Mr Prada. "With products such as CDOs
[collateralised debt obligations], based on many different model
assumptions, the risk of such an approach is to become 'mark to myth,'
as Warren Buffett would call it."
Another option, which many investors now prefer, is to ask third-party
data providers to offer a price for assets. These are garnered by asking
brokers across the industry to supply anonymous estimates for asset
values and calculating an average. But while these services have grown
in popularity, they do not cover all asset classes. Some of the recently
troubled mortgage-linked securities, for example, are barely covered at
Moreover, these third-party prices can also be contested by brokers who
do not like the results. Markit Group, one such provider, is seeing
increased demand for its valuation services but is facing a sharp rise
in queries about the results, because differences between price quotes
have grown very wide.
As a result, some observers think that in the longer term much more
radical reforms are needed. In the next few weeks, regulators around the
world are expected to call for more transparency in structured finance.
They may push the industry, for example, to disclose better figures on
the performance of such securities and demand that banks become more
open about the price at which these instruments are trading, or being
quoted, even in private deals.
But even if these initiatives help to improve the credibility of the
financial profession in the medium term, they will not necessarily offer
investors much comfort right now. Nor will they address the fundamental
difficulty that faces the accounting world today: namely that fair-value
accounting based on market prices is easy to apply only when markets
For the moment, most senior accountants insist that such problems are
not enough to abandon the fair-value approach -- partly because most
other options are also flawed.
"Fair value in a credit crunch is more difficult, for sure, but what's
the alternative? We certainly don't want people to be cooking the books
as they used to by creating reserves and smoothing earnings," says Tom
Jones, vice chairman of the International Accounting Standards Board. "I
would make the case that in the long run, the damage of being able to
hide losses is far worse. We saw this in the [1980s] savings-and-loans
crisis in the US where accounting hid the scale of the problem.
"You need fair value to get to the truth: the facts are the facts," he
adds. "The idea of people selling compound instruments, then saying
they're too complex to value in a credit crunch -- that's not
acceptable. People [should] take the writedown now and, if markets come
around again, they can mark it up again."
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