So what's it worth when there's no regular market?


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 might lie.

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 all.

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 function properly.

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."

* * *

Join GATA at these conferences:

The Silver Summit
Thursday-Friday, September 20-21, 2007
Coeur d'Alene, Idaho

New Orleans Investment Conference
Sunday-Thursday, October 21-25, 2007
New Orleans, Louisiana

* * *

Help Keep GATA Going

GATA is a civil rights and educational organization based in the United States and tax-exempt under the U.S. Internal Revenue Code. Its e-mail dispatches are free, and you can subscribe at

GATA is grateful for financial contributions, which are federally tax-deductible in the United States.