When is a price not a price?

  • 26 Sep 2008
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The credit crisis has exposed a dirty secret of the structured finance market, even in Europe. Only a small fraction of investors were really in a position to value the assets they held with any sophistication beyond ringing up their dealer. Over the course of the crisis the industry has struggled to get to grips with the enormous challenge presented by the lack of readily available market prices. Chris Dammers assesses the progress.

Arguably more than any other issue, the current financial crisis prompted and then was propelled by a crisis of faith in how institutions price the assets they own.

For years, little attention had been paid to valuation. Years of falling spreads and abundant liquidity meant that investors and traders felt comfortable relying on quoted prices derived from recent trades. The move to fair value accounting forced some investors to think harder about their valuation models, but it was not until liquidity dried up completely in securitised markets that the inadequacies became impossible to ignore.

"Let’s not underestimate the incredible dislocation in the structured finance market in a very short period of time," says Niall Cameron, executive vice president and head of indices and equities at Markit. "Suddenly all the reference points that you need to do thorough valuations began disappearing rapidly. It was a very extreme market — extreme if you look at the stability of the market before then."

"The securitisation market was the most stable market," he says. "You had very clear types of instrument and rating bands. The spreads had extremely low volatility and, in fact, if you look at the previous five years, all that happened was spreads ground tighter every year. It was a stable, predictable, non-volatile market that, actually, underneath the covers was quite complex, both in terms of getting the data you need for valuations, the loan portfolios and the structure of the transactions. Then, when you started to lose the price reference points on individual transactions, it was very hard to nail down something that you could do a proper valuation with. It was almost an impossible task in that period, particularly as the valuation methodology for structured finance was not as sophisticated as it could have been."

As observable market prices disappeared and the performance of the underlying collateral in many asset classes deteriorated rapidly, market participants scrambled to find a way to value their holdings.

For many months it was a mess. On the one hand, accounting rules required them to use market inputs to place a fair value on most of their assets. On the other hand, many portfolio managers felt that the few observable prices available far overstated the likely losses on what were still cash-good assets.

In the earliest months of the crisis, there was a vigorous debate about whether fair value accounting was always appropriate in a such a market. After all, many institutions held assets which they had no intention of selling, but booked as "available for sale" to avoid tainting their entire portfolio if unforeseen events meant they wanted to or had to unload them.

Even regulators and politicians, who had been the driving force behind the introduction of fair value accounting, voiced concerns over its pro-cyclical effects, calling on standard setters to review their guidelines. The vicious circle of writedowns leading to liquidiations, leading to further writedowns, clearly contributed to the wildfire spread of the crisis from one market sector to the next.

Yet as it has become clear that the crisis is far from temporary and market value losses have become credit losses, those championing strict fair value accounting seem to have won the argument. Few expect significant changes to the fair value framework to emerge from the reviews underway.

In September, an expert advisory group convened by the International Accounting Standards Board produced a draft report on fair value in active markets strongly endorsing its use, while providing guidance on what constitutes evidence for fair value.

"Some think that, in periods of market turmoil, adverse market sentiment can create an apparently illogical view of risk and that fair value measurement should not consider the effect of this on model inputs, such as credit and liquidity premiums charged," said the report. "However, the objective of measuring fair value is to establish what the transaction price would have been on the measurement date in an arm’s length exchange and market sentiment is a factor in determining any transaction price."

The report stressed that model pricing, if used, must be calibrated to observable market information and emphasised that distressed trades are "rare" and evidence must be given before determining that they do not represent fair value. Specifically, it offers as examples a legal requirement to sell, the need to sell immediately without time to market the asset, or the existence of only one potential buyer.

While there are still some holdouts, the pendulum has swung back in fair value’s favour at most institutions as well. It is hard to argue for less transparency in your own books while refusing to transact with others on account of transparency.

In many cases, management initially resisted the aggressive markdowns indicated by synthetic indices and the few large scale cash trades undertaken, such as Citadel Investment Group’s $2.5bn purchase of E*Trade’s ABS portfolio. But as the housing crisis deepened, shareholders and regulators called for more transparency and auditors put pressure on institutions to justify their valuations, a culture shift began to occur that is still playing out today.

"I was speaking to a medium sized bank on this topic recently," says Mark Hale, chief investment officer at Prytania Investment Managers. "I remember them asking me some questions about how they might model the risk to be Basel II compliant. They’re a good example of how it was extremely difficult to get the management to commit the resources and take the process seriously. But now following a grilling by the regulator on a number of occasions, a grilling by the auditors, the non-execs starting to take their jobs seriously, and the understanding that something can go from par to 15 cents on the dollar very quickly, they now take it very seriously."

This change has taken many forms, but all involve devoting much more energy and resources to the process of valuation, and double checking the results. The exact route taken varies from institution to institution, but almost nobody is relying on a single quote from their dealer, as huge numbers of investors did before the crisis hit. Similarly, there is much more scrutiny of the prices supplied by banks’ trading desks — not surprisingly after the scandal surrounding a $2.65bn mismark by Credit Suisse traders earlier this year, which prompted a record fine from the Financial Services Authority.

"Traders own their valuations, or at least they should do," says David Clark, a consultant to the Institute of International Finance on valuation. "If they’re wrong, they’re going to get the sack. They need all the back up they can get. You need independent controls and governance, as much to protect the trader as to check on them."

The issue of controls and governance has been at the heart of many initiatives launched by regulators and industry bodies. The so-called Corrigan report on containing systemic risk, for example, published by the Counterparty Risk Management Policy Group, called for "serious and sustained investment" in risk management, with particular attention paid to the pricing of illiquid or complex trades.

"The Policy Group recommends that large integrated financial intermediaries ensure that they employ robust, consistent pricing policies and procedures, incorporating disciplined price verification for both proprietary and counterparty risk trades."

Similarly an IIF report in June recommended a "comprehensive governance framework" making use of independent data sources and controls. The IIF, however, highlighted one of the trickiest aspects of valuation governance. Traders and their management, on whom primary responsibility for valuation should lie, are closest to the market and hence likely to have the best picture of where an asset could be sold. Conversely, to have any credibility control functions must be independent from the trading desk. Yet the further the separation, the less in tune with market developments they will be.

The clearest and probably most sensible change in valuation since the crisis began has been the increased use of multiple, often independent pricing sources, rather than a single dealer quote or model value. This has been emphasised in many of the reports published, but is also being put into practice.

"Generally speaking, in the last six months there’s been very good progress in terms of market understanding of the issues," says Hale. "There’s obviously been a lot more focus on analysis of the data and timeliness and accuracy of reporting. There’s been a very encouraging and relatively widespread realisation that more work needs to be done — people need to subscribe to specialist software or data sources. From our side there’s been a positive trend because more people have asked for the help of specialist firms like ourselves."

The use of consensus pricing services, such as Markit’s European ABS pricing platform, which gather daily quotes from multiple dealers and "cleanse" them using a transparent methodology, has become particularly popular. The IASB draft says that in some markets, such as those for exotic derivatives, consensus pricing "might constitute the best available data".

"I think the current crisis may become known as the valuation crisis," says Markit’s Cameron. "This crisis will lead to a much higher standard of valuations in the business. People won’t just rely on getting a solitary mark from their broker. That’s history. People will need multiple valuations, they’ll need independent valuations, they’re going to need a lot more sophistication around valuation. There will need to be a blend of observable pricing and model pricing. This crisis will, when the dust settles, create a much more robust valuation situation in the market."

Some larger institutions have also augmented their own in-house valuation capabilities, often with the help of third parties, but the high initial costs make it impractical for those with small portfolios. Hale says that Prytania spent £5m setting up its valuation infrastructure. One small comfort is that the much higher asset spreads available since the crisis struck make such an investment more practical in the long term than when spreads were in the low double figures and shrinking weekly.

Furthermore, standardisation and increased availability of asset performance data — the subject of initiatives led by the Commercial Mortgage Securities Association, the European Securitisation Forum and the Securities Industry and Financial Markets Association — should help lower the barriers to entry.

"There’s been a huge shift," says Tony Clifford, a partner at Ernst & Young in London. "First of all, people using prices are much more canny about how they use them, which includes asking a few questions and also getting multiple inputs. Second, a number of people are trying to do their own valuations to a greater extent than in the past. There’s a slight shift away from reliance to bringing in some of this stuff in-house, but most of the end consumers are probably still relying on bank valuation."

Another change from the past will be greater consistency in pricing of asset classes within institutions. On many occasions, banks gave clients different prices than they used for their own proprietary holdings. Increased scrutiny and disclosure of prices and the methodologies used to derive them, however, has forced another culture shift. All the reports on best practice produced so far have stressed the need for consistent pricing across portfolios, unless differences are justified and documented in exceptional circumstances.

Failure to apply the same pricing across different books was among the failings identified by the Financial Services Authority when it fined Credit Suisse, putting other institutions on warning.

"There’s been a lot more rigour put around the process in some banks than perhaps hitherto," says Clifford. "The best banks have always been pretty good, but some of the banks I don’t think had quite the same controls around customer valuations in the past than they probably have now. I know of one example where a bank had less controls around its customer valuations than it did around the valuations of its own books and records, which clearly was not a particularly desirable situation to be in."

Even so, there is a long way to go before the industry can have any confidence that it won’t be caught out again by the next severe market dislocation.

"It’s not going to be done overnight," says Clark. "To achieve the sort of thing which Corrigan looked for — to be able to come up with a [firm-wide] valuation the next day — I don’t think it’s there. It’s sufficient to say there needs to be continued investment in that area."

Even with all the improvements in valuation, existing and envisioned, it will be impossible to obtain consistent, perfectly accurate pricing across multiple institutions, particularly in structured finance. The complexity of the underlying cashflows means that well reasoned valuations, even informed by recent trades, will inevitably vary depending on the assumptions one makes about the future. Even choosing an appropriate discount rate is no easy task and accounts for a surprisingly large amount of the variation in pricing on similar assets.

"[A] similar ABS is trading at a discount of 10 to its original issue price and nominal amount of 100," says the IASB report in an illustration. "If market participants estimate that expected losses on the similar security are six, then six of the discount relates to expected losses and four relates to the increased yield required in the current market. If market participants assume that there are no expected losses, then the entire 10 discount relates to the increased spread market participants currently require. Therefore, without visibility about market participants’ assumptions, these two elements that make up the discount (expected losses and spread) cannot be separated."

Consequently investors and regulators are putting increasing emphasis on disclosure about methodologies and assumptions, even while there is a growing acceptance that standardised valuation is unlikely and arguably not even desirable.

This area is one where substantial changes are expected in the guidance from standards setters. Already 80% of banks are complying with enhanced disclosure standards the European Commission will unveil October, according to French finance minister Christine Lagarde. There is still considerable variation among banks, however and the initial steps taken may even have been counterproductive.

Notably, in March the SEC sent a Dear CFO letter ostensibly clarifying the requirements for fair valuing ABS under SFAS 157, the US rule on fair value accounting. Because the letter reiterated the point that a distressed sale price does not have to be taken into account, many seemed to take the letter as a green light to increase the use of unobservable inputs.

"If anything there was probably more confusion and in some cases deliberate obfuscation," says Hale. "There was an element of that in the last quarterly accounts. I think there will be less this August and September, and even less this November and December."

One key step to increased disclosure will be IASB’s project on disclosure, covered by IFRS 7. IASB will publish proposed amendments later this year following discussions in September.

"The idea is that most banks have not been disclosing enough in most people’s view and they should disclose more and give more information about the inputs that are going into models and the potential sources of estimation uncertainty," says Clifford. "To give an example, at the moment under IFRS 7 you’re required to give a single figure for the effect of using reasonably possible alternative assumptions. The figure in Deutsche Bank’s accounts is Eu2bn, without giving any more information on how that was derived or what it really means. They’re playing around with different ideas. The version I last heard about is that at least that information should be given separately by each class of asset, which is one level more of granularity. The idea that everything should be one level deeper is a reasonable approximation of what it will probably say."
  • 26 Sep 2008

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