The Art of (Illiquid) Securities Pricing

As you all know, the financial meltdown was caused by some part faulty-product (mortgages, RMBS, CDOs) and some part market-panic itself and its influence on certain other products (auction rate securities, SIVs) and market mechanics (pricing, rating).

Faulty products are not new: the world is awash with faulty products.  But we need buyers for them, and to encourage buyers we need forums (e.g. securitization) and mechanisms (e.g. ratings) that would induce buyers and give them comfort that the faulty products weren't, err, all that bad.

Well that's a long and old story.  But where we're going today is that many of the mechanics that went awry, and needn't have, have not been fixed.

Back in 2008, we had majestic moments of illiquidity, which spurred quotes like this one, from a conversation among AIG employees:

“we can’t mark any of our positions [to market price], and obviously that’s what saves us having this enormous mark to market. If we start buying the physical bonds back then any accountant is going to turn around and say, well, John, you know you traded at 90, you must be able to mark your bonds then.”

Since the crisis, the SEC has ramped up its investigations into pricing issues, and in 2013 set in motion three initiatives (the Financial Reporting and Audit Task Force; the Microcap Fraud Task Force; and the Center for Risk and Quantitative Analytics).  There has been a steady and growing stream of findings of asset valuation mismanagement.  Some hedge funds have been shut down. (A list of issues here.)

But there is much to be done, if the recent dispute between a Canadian pension fund and a US hedge fund is anything to go by.

We have written about that dispute in detail here and here, but a transcript was released as part of discovery in the matter that depicts just how tricky and error-prone our pricing systems are as soon as there is any level of illiquidity.  Before we get to the transcript, here's a brief picture of the issue at play, per the pension fund's (original) allegations.

• Pension fund requested a full redemption of its investment in Saba’s hedge fund 
• Prior to redemption, Saba marked down its valuation of one issuer’s corporate bonds (a relatively illiquid issuer), lowering the fund’s NAV and the amount to be returned to redeeming investors
• Saba altered its valuation methodology to mark down the bonds issued by The McClatchy Company (“MNI”): it applied a bids-wanted-in-competition (BWIC) approach instead of relying, as usual, on its external pricing sources 

• Saba had made sales of MNI bonds in March 2015 at prices from 58% to 60% (of par)
• 3/31/15 mark used for redemption, based on all-or-none $50 mm BWIC: 31% 
•  Saba later made sales of MNI bonds in April 2015 at prices from 53.75% to 55.75%
• After the redemption was completed, Saba resumed its prior valuation methodology for MNI bonds, marking them back up

With that background, here is a concise depiction (provided here by Bloomberg columnist Matt Levine) of the hedge fund's chats with its pricing providers in 2015, demonstrating just how much the pricing process is based on art, rather than science.

• Saba Capital's Weinstein: Z, where would you bid a few mm of the 29s with or without 5yr cds? ... 
• Trader: most likely below where you care. 50- 2mm 
• Weinstein: Yes, that is low I think. 
• Trader: where would u bid? 
• Weinstein: Who knows. See it quoted much higher. Actually you should change your 65/66 quote I guess. 
• Trader: im happy to reflect any market you would like me to make 
• Trader: i have no position 
• Trader: and quote it only 
• Trader: but thats the discount i would bid to go at risk 
• Weinstein: Yeah, the quote seems wrong I guess. 
• Trader: given how illiquid it is 
• Trader: sure do u have a two sided market? 
• Trader: or what is an appropriate quote? 
• Weinstein: I guess if you only care at 50 on 2mm then probably 65/ for any size is wrong. 

So we have reliance, for pricing purposes, on information produced by traders who are not really willing to meet their quotes, and whose quotes may differ depending on the size of the investment, and are therefore not well-tailored to depict the hedge fund's specific investment size. The quotes are just that, quotes.  Nothing more.

The concern, then, is that the next softening in the market will also be magnified by our pre-existing market's structural deficiencies: the issues of illiquidity, and our ability to cater appropriately for them in our pricing procedures, could again magnify the uncertainties at play and exacerbate the downturn.

Right now, the price is just not right for illiquid assets, and prices are not consistently applied across firms.  We are ill-advised to think that the prices presented are in any way reliable, given the clumsy (antiquated?) nature with which those prices are derived.

More on this topic soon.
~PF2