Wednesday, September 19, 2012

One Bond, One Price

The contemporaneous "scandals" recently covered in the media - the alleged manipulation of LIBOR and the possibility that JPMorgan used its VAR model to help disguise the riskiness of its portfolio - return us directly to the very shortcomings that led to, or exacerbated, our financial crisis. 

They provide ready examples of the frailty of our financial controls, and acute reminders of what can happen when financial institutions have the incentive, and capacity, to massage financial data and disclosures. 

It ought not to surprise anybody that, when trying to maximize their gain under a poorly-designed incentive structure, financial market professionals might choose to manipulate valuations or massage disclosures to their advantage. Would not most players maneuver to their benefit? 

The problem here, of course, is their capacity to massage important data on a large scale. Back in 1994, Kidder, Peabody's Joseph Jett was purportedly able to exploit an anomaly in Kidder's accounting system, booking substantial profits in the absence of any genuinely profitable trades. 

Almost twenty years after the "Kidder Scandal," our system remains open to abuse. 

The lack of transparency in our reporting, and the ability to finesse asset valuations, create an environment in which the value of a bank's assets quickly becomes whatever the bank wants it to be. Banks and funds need little incentive to inflate their asset prices: higher asset valuations typically lead to improved performance, which enables banks or funds to raise more capital at reduced rates. Imagine if mortgage borrowers could value their own houses and have their mortgage rates reduced based on their own inflated appraisals! 

It is time to realize that the current system does not work - it cannot. We can no longer rely on an institution to accurately evaluate its own assets, while being knowledgeable of the many and material conflicts it faces. We also cannot blindly trust the auditing firms to catch the cover-ups. Their success rate has been too low. 

One advantage of the ratings-based system - a system from which we're energetically moving away - is that it provided a single rating for each bond. It is true that banks may reserve different amounts of capital against each rated bond, but at least we knew that it was always one bond, one Moody's rating.  

Right now, however, there is virtually no pricing control - no consistent mechanism for the valuation of complex and illiquid transactions. One bond can have many prices, depending on who provides the price. We see regular examples of traders who mark their own portfolios, while earning bonuses and promotions based on their self-constructed performance. We often find that two similar banks, supervised by the same regulator, can hold the same security at materially different prices. JPMorgan itself was recently reported to have held the same bond in two different divisions at different prices. Banks can "shop" for opportunistic evaluations, just as they could actively seek the highest ratings, which precipitated a lowering of ratings standards. How does this all promote shareholder confidence, or cross-institutional comparability? 

Goldman Sachs, Wachovia, Bank of America, Citigroup and others have recently been accused of mispricing securities in one way or another. Traders at UBS, Deutsche Bank, Credit Suisse, RBS have been criticized for mismarking bonds. Hedge funds and asset managers have been accused of overvaluing their funds' positions and the audits of Deloitte, PwC and KPMG have all come under scrutiny for their failure to capture their clients' misrepresentations and securities mispricings. 

The list keeps growing. In last week’s case filing In re Lehman Brothers Holdings Inc., et al v. JPMorgan Chase Bank NA, the Lehman plaintiffs argue that the JPMorgan entities’ derivatives claims are inflated as a result of procedures including “the inconsistent valuation of trades to the JPMorgan Entities’ advantage.” 

While the problem of inconsistent, utility-maximizing pricing is overwhelming, the solution is simple. It only requires the political power for its implementation. All financial institutions should be forced to carry the same bond at the same price. Any digression from market pricings should be accompanied by appropriate disclosure that describes the reason for, and magnitude of, the deviation. Furthermore, any internally-marked positions should be open to public scrutiny especially for those institutions considered "Systemically Important Financial Institutions" (or SIFIs). What is there to hide, anyway? 

Supervisory authorities would have only to decide on the framework for deriving the ultimate price. There are several options available, not the least of which is to follow the precedent set by the National Association of Insurance Commissioners. The NAIC selected PIMCO and Blackrock Solutions, respectively, to help it determine risk-based capital requirements for insurers’ holdings of residential and commercial mortgage-backed securities. Rather than calculating capital reserves, one could implement an algorithm that produces a price. Another approach would be to create a central pricing repository which would accept a range of prices submitted by regulator-approved price providers. The final price could then be determined by applying an averaging process, for example, or by taking the median of the submissions. 

Pricing transparency, and a forum for the provision of feedback to the extent assets are being mispriced, would enhance investor confidence in the reliability of banks' balance sheets. Confidence and transparency, of course, lead to market liquidity. After the crisis of confidence we have had, and the associated liquidity freeze, wouldn't that be nice? 

Additional Resources 


Anonymous said...

" Another approach would be to create a central pricing repository which would accept a range of prices submitted by regulator-approved price providers. The final price could then be determined by applying an averaging process, for example, or by taking the median of the submissions. "

Sorry, isn't this just how LIBOR worked, or rather didn't ?

Really great analysis. Truly bum solution.

PF2 said...

@ Anonymous, thanks for your readership.

LIBOR (and many other calculation) follow a similar framework. It requires a number of assumptions on your part to conclude that ANY centralized (and visible) solution need suffer the same pitfalls befaced by the LIBOR-submission process.

LIBOR's shortcomings need not translate into a failure with the approach in in general. For one, there are many ways to overcome the challenges that face the LIBOR submission process.

One way is to require the submissions to be made by independent or disinterested parties - this obviously could not occur for LIBOR submissions and they required inside knowledge of borrowing rates. There are myriad other solutions.

But at the end of the day, even in your doomsday scenario, it's always easier to manipulate a single LIBOR submission than to manipulate LIBOR. The latter may require some form of collusion. (The argument therefore, is that even if the process were prone to the identical risks suffered by LIBOR, it's "gaming" would still be more difficult than status quo.)

Happy to chat further if you would like to share thoughts. Appreciate your constructive criticism.