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Friday, June 1, 2012

One Bond - Three Prices

The challenges of appropriately pricing illiquid assets have returned, with JPMorgan reportedly having valued the same trades at different prices in separate departments of the bank.  To be fair, the current pricing regime enables these types of discrepancies to occur, and it makes it difficult to catch them.

But this time, the problem was big enough to get some attention.  From Bloomberg's JPMorgan CIO Swaps Pricing Said To Differ From Bank:
The discrepancy between prices used by the chief investment office and JPMorgan’s credit-swaps dealer, the biggest in the U.S., may have obscured by hundreds of millions of dollars the magnitude of the loss before it was disclosed May 10, said one of the people, who asked not to be identified because they aren’t authorized to discuss the matter.
We've been writing about this problem for while - that in some cases 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.

The problem here is the same as with “ratings shopping,” where market participants seek the highest ratings on their securities.  Here, 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.

In yesterday's Financial Times, Michael Mauboussin and Alfred Rappaport added to the conversation on pricing transparency. A solution they put forward is to add more meaningful disclosure around the asset pricing, rather than reporting a single estimate. Their approach isn't novel, but it's worth consideration.  They suggest a three-pronged approach: 
This type of controversy vanishes when there are three estimates. Fire-sale prices are appropriate for the pessimistic estimate if it is likely that creditors or regulators will force the bank to sell assets to stay afloat. The optimistic scenario reflects the present value of holding the securities until market prices recover. The most-likely estimate lies in between. This disclosure acknowledges that there is no right answer, only a range of possibilities.
We're interested to hear what you think.

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For a list of problematic asset pricings, click here.
For our suggestion of one solution to the problem, click here.
For more on this, including Citi CEO's Vikram Pandit's proposal and that of Barclays' Group Finance Director Chris Lucas, click here.