“It’s worth what I say it’s worth”: Part 1, neither more nor less
“It’s worth what I say it’s worth.”
The louder I shout it, the truer it must be!
That, more or less, is the defense offer by Bear Stearns as to the value of enormous pools of highly structured complex instruments on their books, a declaration so patently self-serving and self-interested that, with Bear now absorbed into JPMorgan Chase, those who depended financially on Bear are taking the opportunity to look at freeze frames of those crucial decisions:
Are you sure you had no better alternative right then?
As reported by The New York Times:
How much is your investment worth?
That might seem like a simple question on Wall Street, where the price of everything from Apple to zinc flickers across computer screens every day. But inside Bear Stearns, the answer was anything but clear last spring for investors who put their money into two giant, but ultimately doomed, hedge funds.
We thought it was safe when we boarded
In hindsight, all decisions are simple, all outcomes inescapable. Hindsight bias – post hoc, ergo propter hoc – is all too common in human affairs.
Two executives who oversaw the funds, Ralph R. Cioffi and Matthew M. Tannin, did not disclose that the funds were plunging in value until it was too late, the authorities say.
Why didn’t you tell me this before I got on?
On Thursday morning, the pair surrendered to federal agents and were charged with nine counts of securities, mail and wire fraud.
Cioffi and Tannin do their best to look innocent while being perp-walked
Let’s leave aside both the melodrama of perp-walking people who turned themselves in to be arraigned, and make no presumption one way or the other regarding Mr. Cioffi’s and Mr. Tannin’s culpability or innocence. Rather, let’s examine:
… one of the most vexing problems confronting Wall Street as the credit crisis plays out: How to value tricky investments linked to subprime mortgages and other risky debt.
Why is this hard? Several reasons:
‘What is value?’ asked jesting Pilate. Is a thing worth only what you could trade it for right this instant, or is there a ’shadow’ or ‘intrinsic’ value that acts as a lodestar around which the trading prices orbit?
“There’s almost a definitional issue of what you mean by value,” said Rick Antle, an accounting professor at the Yale School of Management. “You’re really kind of behind the eight ball.”
As Humpty Dumpty put it crisply in Through the Looking-Glass:
“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”
“The question is,” said
“The question is,” said Humpty Dumpty, “which is to be master — that’s all.”
There’s no consensus about what ‘value’ means, and as FAS 157 and its progeny work through the system, that problem with definition is wreaking havoc.
Lack of continuous trading. These assets are originated, placed, and then held. They do not trade continuously.
Financial companies flocked en masse in recent years to trading assets that are far harder to value than, say, shares of Microsoft.
Trading is important not just because it creates a continuous curve rather than a series of data points, but also because trading means more eyeballs on the assets, and therefore the wisdom of crowds can be brought to bear.
Wisdom in there somewhere
The level of losses industry-wide is sure to raise questions about how values were assigned in the first place. Banks generally look at prices in the market first. But when no market price is available, they turn to internal computer models. The practice is similar at hedge funds, though in some instances, banks give pricing out to hedge funds, allowing price levels to trickle through in nebulous asset classes like mortgage bonds.
(But remember, the observant herd sometimes stampedes …)
We lost confidence in the dormouse who got us into this
Uniqueness. Our best means of deciding something’s value is paired comparison: this is better than that, but worse than the other thing. When the number of dimensions of difference exceeds the number of objects in the trading universe, it becomes impossible to reach a definitive conclusion as to which is better – which is why everybody buys some assets sometime.
“Everybody falls in love somehow.”
Different computers models often use different data and produce different valuations. Investors have complained recently that Wachovia and Washington Mutual are modeling values with a housing price index that is more optimistic than the index used by their competitors.
Complexity. The more complex an asset is, the fewer people are actually capable of understanding it and thus having a meaningful opinion. (We can always get meaningless opinions, but they detract from rather than add to the wisdom involved.)
It’s really easy, just follow the directions
On Thursday, the chief financial officer of Citigroup said the company would use internal models to price mortgage bundles known as collateralized debt obligations rather than use the dismally low market prices as the only factor. On the other end of the spectrum, firms like Goldman Sachs say that market prices should be the driving factor in pricing.
Volatility. Assets that involve multiple layers of leverage, or have a derivative aspect from securitization, can go through wide fluctuations in notional value. They’re designed to do that, in fact – that’s where big wins come from. The volatility means that even if a holder would never actually trade the asset at its down price, it could display a down price at an awkward time – like, say, the day Bear went bust.
I WISH YOU HADN’T SNAPPED ME JUST NOW
All these factors play out in the Bear pools:
As the mortgage market slumped last spring, authorities say, Mr. Cioffi valued one of his funds as having lost 6.5% in April. But colleagues at Bear placed far lower values on investments in that fund. They said the fund had lost 18.97%.
BY itself, this is neither shocking nor necessarily criminal. Those who marched Messrs. Cioffi and Tinnan into their vehicles will have to show not only that they were wrong, but that they were consciously wrong, and did so with intent to defraud. Tough standard.
“If your securities were something kept in your wife’s refrigerator, what would they be?”
Still, it’s a data point: somebody thought Mr. Cioffi’s fund had dropped three times as much as he thought.
No, man, it’s all kewl
And the problem may be exacerbated by the way traders are compensated. Bank employees from lowly associates to chief executives are paid bonuses each year based on performance. But there is little recourse if their bets lose money the following year, so long as the employee is deemed to have made an innocent mistake.
Long ago, I pointed out, in Fannie Mae changes how it pays people, that compensation incentives skew executive behaviors. You’d think that would be obvious.
A bargain at any price!
Some banks are considering expanding the period in which traders are evaluated to longer than a year, said Chip MacDonald, a partner in the capital markets group at the law firm Jones Day.
The problem with using Mr. Cioffi’s valuation lies in human psychology. He bought ‘em, he’s likely to see them more favorably than others would (or than the market would). As against that, he’ll know the assets better than anybody else, and care about them more. He’s the most qualified, in short, but horribly biased.
“It’s a humongous problem for Wall Street,” said Michael Young, a lawyer with Willkie Farr & Gallagher. “These days these valuation obstacles are at the core of the write-downs.”
Humongous problems ahead?
As I’ve discussed in banking on value, there are plenty of sound reasons for using internal valuations rather than relying on trading prices for thinly-traded complex instruments. Yet who evaluates the evaluators?
Uniformity is our watchword!
[Continued tomorrow in Part 2]
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