Risk Without Reward

PwC Proposal on Fair Value Accounting

PwC has recently released an interesting discussion paper proposing changes to fair value accounting.  They do not propose eliminating fair value accounting - thankfully - but they do suggest that, for banks, only "credit related" losses be reflected in net income (this is, of course, the headline number that everyone focuses on for publicly traded entities.)  Other changes in current market value unrelated to the borrower's ability to repay a loan, such as write downs due to an illiquid or dysfunctional market, would be recorded in "other comprehensive income".  OCI is essentially a bucket for items that companies don't want to pass through their reported, "business" P&L.

Interesting reading, albeit more focused on banks rather than hedge funds.  However, the underlying theme is that only realized gains are "real", while unrealized gains are transitory and have less validity as measures of true business performance.  According to PwC:

"Removing liquidity and other transitory charges from the net income of institutions with a “buy and hold” business model may reduce distortion from excessive market pessimism in distressed markets and excessive market optimism in euphoric markets." 

The implication for hedge funds reverts back to a theme we have commented on frequently: that one of the flaws of the typical hedge fund structure is that investment managers can pay themselves on unrealized appreciation as well as realized P&L.  This remains a key issue that should be at the forefront of investor re-evaluation of the hedge fund model going forward.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

NAV Suspensions: Will FAS 157 Create Unintended Consequences?

We have now seen a growing number of funds suspend redemptions or propose restructurings, and expect that many more will follow over the coming weeks.

There are many implications here, but we wanted to focus on three issues related to accounting and valuation, particularly in light of FAS 157.

1) Is any sale a "fire sale"?

As part of the suspension process, there is a growing trend for funds to segregate securities into a liquidating portfolio.  As such, the proportion of the portfolio which needs to be liquidated to meet redemption requests is set aside and separated from the "ongoing" portfolio.  The securities will be sold and the proceeds - whatever they may be - will be paid to those investors who require short term liquidity and choose not to rescind their redemptions.  In other words, think fund of funds.

The question, though, is how those sales will impact the NAV calculation for securities held in the "ongoing" portfolio.

At first glance, it would seem obvious that if a hedge fund sells a security from the liquidating portfolio at a 25% discount, then that is the price which should be used for identical securities held in the ongoing portfolio.  After all, here we have tangible, specific evidence of a transaction and, at the moment at least, no-one is willing to pay more.

Not so fast.  We expect that many managers will argue that sales from the liquidating portfolios are involuntary - markets are so bad, that the managers,or so the argument will go, would not sell the securities by choice.  They are only doing so because they are forced to raise cash to meet redemptions and, therefore, all such sales must be fire sale, distressed or forced - take your pick as to the terminology.  

If you follow this argument through, then it would be possible for managers to ignore the prices from actual sales in the liquidating portfolio.  Securities held in the ongoing portfolio would be valued using other methods and could, of course, be recorded at higher prices than the actual sales.  

To this point, we were very interested to read an interview with a managing director from the valuation firm Duff and Phelps who commented that hedge funds "within the last couple of weeks" had increasingly returned to mark to model pricing.  The reason for adoption of mark to myth, sorry, mark to model methods is that "in illiquid markets the range of broker prices can be too wide to be very meaningful."  

There have, of course, been some recent "clarifications" as to the implications of mark to market accounting and FAS 157.  These include the FASB staff position 157-3 and the SEC guidance on fair value accounting (both available from Castle Hall's website).  Both provide new latitude to ignore "fire sales" when considering the prices to be used for identical or similar securities in a portfolio.

This is a huge issue that impacts, firstly, NAV calculations at November 30 and December 31 and then the audited financial statements as of year end.  We certainly agree that markets are tumultuous and the lack of market depth is unprecedented.  There is, therefore, definitely an argument that when markets are gripped by fear and transactions underestimate the "fair value" of a security, then those prices should be ignored or at least questioned. 

Mind you, this would be a stronger argument if people were more vocal to mark prices down at times when markets were unduly confident and prices clearly over-estimated fair value.  Everyone is, of course, very happy to mark assets up in a period of irrational exuberance (and get paid on those marks), but more than a little hesitant to mark them down in a period of irrational pessimism.

2) Investors have to make their own determination of fair value

Some time ago, we commented on a recent letter sent by the Department of Labor to an un-named US ERISA pension entity.  The emphasis of the letter was that it is the investor who is responsible for determining the fair value of all investments, including hedge funds.  As we said at the time:

According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan.  Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy.  In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value.  A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”

The audit profession makes exactly the same point: the financial statements are the responsibility of management, who must select appropriate accounting policies and then implement controls and procedures to ensure that the financial position and performance of the reporting entity is correctly stated within the parameters of materiality.

Against this background, let's pose a question.  If I am a hedge fund investor - a fund of funds or an institution with positions in numerous, single strategy hedge funds - what happens if I have 5 underlying funds who adopt some variant of the restructuring discussed above?  Each underlying manager will make their own determination as to how they should cut their NAV, potentially making their own, different assumptions about what prices they should ignore as being "distressed" or "fire sale".

What happens, though, if those underlying managers do not make consistent decisions?  How do I, as an investor, ensure that the valuations I have used are consistent and comparable if I have underlying managers who have adopted differing valuation techniques in these markets?  

Equally, what happens if I, as the investing entity, disagree with the underlying manager's accounting policy - perhaps I believe that at least some of the actual, realized transactions actually are representative of fair value and should not simply be ignored.  This means that the underlying manager's accounting policy flows through to become the investor's problem.

On this point, investors should also remember that the auditors of underlying hedge funds are not responsible for those funds' accounting policies: those, too, are set by the management of the underlying fund.  As such, different funds holding the same security, audited by the same audit firm, may well hold that same security at different prices, yet still receive unqualified audit opinions.  The auditors are not, to be clear, imposing any form of pricing standardization or consistency: the auditors do not have a central master pricing file that they force all hedge funds to use.

There is clearly a huge challenge for the auditors across all these points, and we very much appreciate that the auditors will have an enormously difficult time trying to work through these tortuous valuation issues.  Equally, though, we have to highlight a conflict: auditors serve both to audit underlying hedge funds and then also to audit the accounts for investors who allocate to those hedge funds.  

As the audit firms work through these issues, therefore, we have to hope that they will have a mind to both constituencies.  The challenge is one of chronology: the underlying hedge funds usually complete their audits before the end investor (after all, the end investors need the financial statements from the underlying funds before they can finish their own audits.)

What would be completely unacceptable for investors is to find that the auditors first complete the underlying hedge funds' accounts and work hard with each manager, client by client, to "justify" each fund's individual accounting treatment.  It would be ironic indeed if those same auditors then turn round to investors and make an audit issue of the lack of accounting consistency and comparability across a portfolio of those underlying funds.

This is a time for the accounting profession to step up to the plate.  When auditing a hedge fund, the client is not the hedge fund manager.  The client is the fund, which is owned by the investors.  If there was ever a time for the auditors to remember who they are preparing financial statements for, this is it.

3) If a hedge fund has suspended redemptions, is it restricted from sale?

And last but not least.  Pretty much exactly a year ago, in November 2007, we wrote a post with the dramatic title "will FAS 157 destroy the hedge fund industry."

The argument was that hedge funds are restricted from sale as they offer infrequent redemption opportunities.  If I invest in a fund with a five year lock up, therefore, should I still carry it at par as I cannot exit from that fund for 60 months?

The industry has side-stepped this one (albeit more for reasons of practicality than technical rigor). The issue is still out there, though, for funds which suddenly suspend redemptions indefinitely.  If I am an investor in one of these hedge funds, must I make some allowance for the lack of liquidity and restriction as to sale which has suddenly been imposed?  Is it still appropriate to carry these funds at the reported NAV, or should I take some form of discount?

We await audit guidance on this point as well.

Again, these tumultuous times create unprecedented issues for everyone involved in the hedge fund industry.  These issues also do not have any easy answer.  At times like these, we also have to applaud the efforts of many managers to "do the right thing", even when it is not clear - today at least - what the "right thing" actually is.  

It is a fair point, however, to state that the decisions made now by the managers will flow through to the investors post year end.  We certainly do hope that the lawyers and accountants giving advice to the managers this weekend do stop to think about the impact their advice will have on the investors next year.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence  

Performance Smoothing

An article in the FT this week commented that "hedge fund investors seek shelter from meltdown."  The discussion touched on the Bear Stearns' funds, raising the broader question of whether investors do - or can - properly adjust hedge fund returns for illiquidity.  In other words, is that nice, smooth "carry trade" return with very low volatility and an exceptionally high Sharpe ratio hiding a risk of significant loss if markets become illiquid? 

One of the other sources quoted by the FT was a study by Riskdata: 

"Olivier le Marois, chief executive of Paris-based Riskdata, a provider of software solutions that helps asset managers and hedge funds control risk, says that given the potential illiquidity of Bear Stearns’ assets, the funds’ steady returns could have raised a red flag. The reason: in a Riskdata study of 3,216 hedge funds and funds of hedge funds, he found that nearly one-third of funds trading illiquid securities may be smoothing their returns, which could mislead investors about actual underlying turbulence."

Riskdata's website has a number of interesting resources, including a more detailed article (see link) called "return smoothing practices: a potential threat to alternative asset growth."

This is very interesting reading, and concludes that procedures should be put in place to "ban" performance smoothing.  To achieve this, the firm makes four recommendations:

"First, thorough due diligence should be made on the valuation process, whether it is performed with in house calculations, vendors software or third parties quotes. Not only should valuations be fair and based on appropriate input data, but all available quotes should be considered without discretionary selection. This point is especially important, due to possible conflicts of interest between managers and brokers about fair valuation when dealing with illiquid securities. 

 

Second, a notable progress in the direction of investors mastering their investments is to give them a quantitative means to detect return smoothing practices. The Bias Ratio – along with Riskdata risk profiling techniques – offers one effective way to alert on possible return smoothing. By itself, quantitative analysis is not sufficient and ought to be supplemented by effective control of managers’ practice. But conversely, quantitative techniques are a necessary add to due diligence and monitoring of investments, as only them can provide an unbiased alert system of managers unfair behaviour. 

 

Third, a complete alarm system should be put in place, which includes not only regular contact with managers, but also a systematic and regular quantitative analysis of their returns, in order to detect biases – like the Bias Ratio – and style drift, as well as to identify sources of risk and potentially hurting scenarios. 

 

Finally, each fund should not only be analysed by itself, but also in the context of a portfolio. For this purpose, the individual risk of one single fund should not hide the risk of diversification – or rather lack of – at the global portfolio level. In other words, this means identifying market scenarios under which investments become correlated and diversification vanishes." 

These remain very sensible and necessary recommendations, and ever more timely as the industry moves towards a new cycle of launching distressed funds trading harder to value securities.

What are some of the lessons to be learned?

1) Investors should always remember the paramount principle of valuation: absent an actual sale, prices used in a NAV calculation are only estimates.  Estimates are, of course, open to manipulation.

2) Best practice universally calls for the valuation process to be segregated from front office investment professionals.  Allowing the front office to price securities creates a clear conflict of interest and an obvious potential for performance smoothing.

3) Investors should take heed of Riskdata's recommendation that all available quotes are included in the pricing process.

4) Very careful due diligence is always required to evaluate valuation procedures adopted by the manager as well as the administrator.  In Castle Hall's experience across the industry, we continue to see enormous variation in valuation procedures.  Investors need to understand, in detail, the valuation process adopted by each fund: investors should not assume that large funds always have good valuation procedures and, as we have commented frequently, should definitely not assume that the administrator is actually pricing the portfolio independently.  Investors must also be conscious that funds which adopt different valuation procedures may not produce directly comparable NAVs.

As always, caveat emptor.

www.castlehallalternatives.com

Hedge fund operational due diligence

The FSA and Valuation

Nakedshorts has just published an excellent post on the FSA's response to the recent pricing problems uncovered at a variety of investment banks based in London.

According to a Bloomberg article referenced by Nakedshorts, a "large number" of UK banks have mismarked securities.  Ouch, to say the least.

The blog also includes a link to the FSA's "dear CEO" letter regarding valuation.  Some highlights:

- "Firms should proactively review their processes and controls to ensure that they are commensurate with the challenges and issues posed by the increased market illiquidity and valuation uncertainty."

- "In the current market environment, characterised by illiquidity, constrained profitability and management stretch, firms are more susceptible to mis-marking frauds perpetuated by trading staff.  In the current environment, we are more concerned that weaknesses in processes and controls are more likely to be exploited and exposed."

- "Product Control Staff (i.e. the back office) were unable to adequately challenge the front-office staff, through lack of skills or seniority.  Against this background Product Control seemed to be acting too much as a business facilitation function and not enough as a control function."

Once more, we make the same comment as in prior posts.  If this is the environment in an investment bank, what is it like in a hedge fund, free of these "bureaucratic controls"?  

When thinking of hedge funds, investors must be ever conscious of the clear conflicts of interest and potential for valuation manipulation when portfolio managers mark their own books.  Just because the investment banks do it, doesn't mean that it's a good idea.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Credit Suisse: More on Mispricing

Some time ago, we commented on Credit Suisse's London office, where a group of CDO traders managed to "deliberately misprice" their portfolios to the tune of nearly $3 billion.

The regulatory process has made some progress: according to the FT, the UK's FSA is close to agreeing a GBP5 million settlement (we wonder how that compares to the bonuses the traders in question hoped to earn based on their fictional prices.)

The FT describes the mispricing event as follows:

"Credit Suisse’s losses occurred in trading books dealing in residential mortgage-backed securities and collateralised debt obligations. They emerged within days of the bank hailing a resilient set of annual results which it argued demonstrated the strengths both of its risk management and risk culture. The mismarkings came to light in an ad hoc review, and there had been no specific indicators that there was any cause for concern."

As always, we remind investors that if this could happen in an investment bank, it could certainly happen in a hedge fund.  How many hedge funds, for example, have a process of "ad hoc" reviews of their pricing?

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence.

ERISA vs. the Hedge Fund Industry

According to Pensions and Investment, the Boston office of the US Department of Labor (the “DOL”) recently issued a letter to an (unidentified) US Pension Plan subject to ERISA (the Employee Retirement Income Security Act) stating that the plan was in violation of ERISA regulations.  The DOL is responsible for monitoring - and sanctioning - ERISA plans and, in their letter, threatened legal action if the plan in question did not remedy the noted violations.

The problem?

When valuing hedge funds and other alternative assets for purposes of the Plan’s annual filing, the pension investor had apparently relied upon valuations provided by the underlying funds’ general partners and, in some cases, on audited financial statements for those funds.

This is, of course, standard practice for many hedge fund investors.  It appears, however, that this approach could create a major roadblock for ERISA plans.

According to the DOL, “it is incumbent on the Plan Administrator to establish a process to evaluate the fair market value of any hard to value assets held by the Plan.  Such a process would include a complete understanding of the underlying investments and the fund’s investment strategy.  In addition, the Plan Administrator must have a thorough knowledge of the general partner’s valuation methodology to ensure that it comports with the fund’s written valuation provisions and reflects fair market value.  A process which merely uses the general partner’s established value for all funds without additional analysis may not insure that the alternative investments are valued at fair market value.”

In other words, the entity which has to value all assets – and especially hard to value assets – is the pension investor subject to ERISA.  There is no way of dodging this poison chalice - the ERISA investor cannot simply rely on the hedge fund’s own valuation.

This is an enormously challenging obligation, particularly in the context of the severe fiduciary standards set by ERISA.  Indeed, the DOL position raises a broad question - is it even possible for ERISA plans (or indeed any hedge fund investor) to meet this duty of care?

We have three observations.

Firstly, very few hedge funds provide position level transparency.  However, it is stating the obvious to say that, without position level transparency, it is impossible for an ERISA investor (or any other investor for that matter) to have a “complete” understanding of the underlying investments and the fund’s investment strategy.  Moreover, even if managers do provide position information, how can investors ensure that it is timely and accurate?  The best solution to the transparency issue is a managed account – as such, would one outcome of the DOL’s position, if enforced, be for ERISA plans to only invest through managed account structures?

Secondly, the DOL states that ERISA plans must have a “thorough knowledge of the general partner’s valuation methodology”.  However, in practice, most hedge fund offering documents have deliberately vague and unspecific clauses as to valuation and calculation of the net asset value, especially in relation to hard to value instruments. To add salt to the wound, every prospectus we have ever read includes a final caveat along the lines of “notwithstanding the above policies, the general partner (or the Board of directors in “consultation” with the investment manager for an offshore fund) may elect any “alternative method” of fair valuation. “ There is hence very limited specificity as to valuation procedures in virtually all hedge fund offering materials, and certainly insufficient information to provide a “thorough knowledge” of the valuation methodology which will be applied.

If the prospectus gives an inadequate description of the valuation process, investors need to turn to supplementary information from the hedge fund manager.  At this point, however, things get worse - many hedge fund managers have not developed any internal, written valuation policy at all.  For those funds which do have a valuation document, there is no standardization, and many valuation policies remain uncomfortably vague and unspecific (although, in fairness, we congratulate the minority of managers who have some stepped up and do furnish investors with comprehensive valuation information.)

The worst case is when a manager does have a valuation document, but will not provide it to the investor.  Ironically, the worst culprits in this situation are some of the industry’s largest and most well known hedge fund managers.  The issue is liability: hedge fund lawyers now appear to advise managers that the more information provided to investors, the more the potential liability.  (As an aside, we recently spoke with the CFO of a large hedge fund: he noted that the sight of the Bear Stearns hedge fund managers being led away in 'cuffs had resulted in urgent calls from the firm's lawyers, advising the manager to reduce the amount of information it provided to investors.)

The third area of concern is the ongoing assumption by many investors, including many ERISA plans, that third party administrators assume responsibility for valuing hedge fund portfolios.  As such, the administrator, it is perceived, can provide the necessary independence in the valuation process.

Not so fast.  As we have noted before, much of today’s administration industry is now emphatic that they perform only the services of a “calculation agent” not a “valuation agent”.  This is a relatively mute point when dealing with exchange traded securities, but it is an enormous issue when looking at a hedge fund which trades hard to value instruments (it goes without saying that we need help to value exotic CDOs, not IBM stock).

As a “calculation agent”, many administrators have amended their legal contracts to retain the right to “consult with” the manager and, indeed, accept prices from the hedge fund manager without further verification.  Again, we hate to make an “emperor has no clothes” comment, but this is obviously nonsense: taking prices from the manager is like a police officer issuing speeding tickets on the basis of asking drivers how fast they were going.

These issues, in our mind, share a common theme.  In recent years, with an ever-accelerating pace, we have watched the legal pendulum which defines how investors and hedge fund managers transact drift ever further in favor of the manager at the expense of the investor.  It is trite, but uncomfortably accurate, to say that, in today’s hedge fund industry, no-one wants to be responsible for anything.  Everyone is instead seeking to be indemnified to the point of invulnerability.

And this is the disconnect between the hedge fund industry and DOL.  ERISA establishes onerous standards of fiduciary responsibility, deliberately designed to make those responsible for ERISA plans accountable, responsible and liable for their actions.  Today’s hedge funds, however, are increasingly structured to ensure the lowest possible degree of accountability and liability on the part of pretty much everyone involved.

Against this background, we will watch with great interest ongoing developments as the DOL monitors ERISA plans with material hedge fund portfolios.  The question, of course, is whether investing in opaque, uncommunicative hedge funds (even when they are some of the largest in the world) is too close to pushing a square peg in a round hole for investors who do operate within a strict fiduciary framework.

www.castlehallalternatives.com

Hedge Fund Operational Due Diligence

Toronto Dominion....this is getting very predictable

We've commented more than a couple of times (here, here and here, for example) on the folly of putting portfolio managers and traders in charge of pricing their own books - and in recent months Credit Suisse, Morgan Stanley and Merrill Lynch have all learnt this lesson the expensive way.

Add Canada's Toronto Dominion Bank to the list.

According to a Bloomberg article, one of TD's London traders has just left the bank (i.e. been fired) as a result of "incorrectly priced credit derivatives, costing the bank around C$96 million ($94.3 million) in pre-tax earnings."  The culprit is described as a "senior male trader".

Thinking about this, a number of comments come to mind.

Firstly, all the recent mispricing episodes seem to have occurred in London.  This is despite the view that the FSA's gentlemanly guidance provides a more tightly controlled regulatory environment than SEC rule making.  Whatever that means about the quality of the FSA's guidance, more generally we are of the view that if these problems can happen in London, they can certainly happen in NYC.

Secondly, these episodes - so far, at least - are not the work of disgruntled traders at the bottom of the totem pole, envious of their high flying peers (that's the Paris syndrome, of course.)  These are senior traders, who have tenure, high compensation - and the knowledge and authority to find ways around control systems, at least for some period of time.

Thirdly, and very disappointingly for TD, this is not the first time their London trading team has landed the bank in hot water.  Barely six months ago, in November 2007, the FSA fined TD GBP490,000 for "systems and control failings."

According to the FSA news release at the time, 

"Mr. [Simon] Brignall was employed as a senior fixed income trader at the firm.  On 9 March [2007], he resigned and revealed to TD Bank that he had been attributing false values to his trading positions for a period of almost two years.  He had done this in order to hide significant losses on his trading book.  He had also entered into a number of fictitious trades during the two weeks leading up to his resignation.

TD Bank did not identify, through its own systems and controls, either the extent of the mispricing of the trades or the fictitious trades.  The FSA identified three main system and control failings in relation to Mr. Brignall's trading book.

These were:

- the absence of a system of independent price verification;

- a lack of effective trading supervision; and

- a failure to implement effective trade break escalation procedures.

The most important of these was the failure to have in place a system of independent price verification in relation to Mr. Brignall's trading book.  This meant that there was no independent third party check on the valuations that Mr. Brignall had attributed to his own trading positions.  The FSA regards this as a fundamental control."

The only good news for TD at the time was that, as a result of the FSA's "executive settlement procedures", they qualified for a 30% discount on their fine (we're not kidding.)

It's clearly a major ouch for TD that they have just let exactly the same thing happen again.  More generally, this is (yet another!) example of why traders, compensated based on performance, should not be able to price their own books.

Given the frequency of these mispricing episodes, however, it also raises another question.  Obviously, if a multitude of investment banks can lose many millions of dollars when they let their traders mark their own positions, the same could happen in a hedge fund which also puts the PM's in charge of marking their own book.  So far, though, we have pretty few examples of deliberate mismarking (Lipper, Beacon Hill etc.) and not many of recent vintage, despite the valuation challenges of recent months.

Why is this?  Is this because hedge funds have better controls, or because when the portfolio managers own their own hedge fund, there is no-one to blow the whistle on mispricing events?

That's something to think about.

www.castlehallalternatives.com

There's another one - the traders are still pricing their own portfolios

Bloomberg reports today that Morgan Stanley London has suspended a credit trader and made a $120 million "negative adjustment"related to "erroneous values of his positions."

This comes, of course, after Merrill London identified a $20 million loss due to deliberate mismarking by a trader on the equity derivatives desk (see our earlier post.)

We shouldn't pick on Merill and Morgan, mind you: their misfortunes fall into insignificance compared to Credit Suisse's stunning $2.65 billion write down related to a trading group that mispriced CDO's (also, see our earlier post.)  Lehman has also had some difficulties, let alone the Bank of Montreal which had a near $500 million loss due to two natural gas traders providing bogus prices to their head office.

We continue to believe that pay structures dominated by incentive compensation (be it a hedge fund's "20%" in 2 and 20, or the "eat what you kill" model of prop desk compensation) create an unavoidable conflict of interest (incidentally, hedge funds which have 2 and 20 and then pay their staff on individual P&L is probably the most toxic combination of all).

As such, best pratice must always be for the security pricing process to be owned by the back office, independent of the traders.  Yes, we may give up some market color and "accuracy" if we put the back office in charge, but we gain independence.  We have yet to find the investor who is not prepared to accept a few basis points of difference between front and back office marks across the aggregate book in return for removing the risk of a 5,000 basis point loss in the event of a hedge fund pricing fraud.

Clearly, if a global, regulated institution like CS, Morgan, Merrill and Lehman can have a pricing problem, then so can a hedge fund.  So how can investors respond?

The recent best practice papers from the President's Working Group, the hedge fund working group, AIMA etc. have all emphasized the need for segregation of duties, although with varying degrees of "weasel words" which let the PM's get involved on the hard to price positions.  It's time to get rid of these exceptions and make sure that the hedge fund industry adopts a clear and consistent back office pricing regime. 

In other words, it's time to walk the walk, not just talk the talk.

www.castlehallalternatives.com

And the traders are still marking their own books....

We recently commented at length on the issues which arise when traders and portfolio managers are put in charge of pricing their own portfolios.  In particular, we highlighted that the the institutional world has already given us plenty of examples of what could happen in a hedge fund if the PM's are in charge - notably Credit Suisse's multibillion dollar loss related to CDO valuations.

As an addendum to our comments, we were unsurprised to see the same thing happening again: this time it's Merrill Lynch.  According to Bloomberg, the bank is "probing one of its trading desks in London and has suspended a trader after discovering he may have overstated the value of some of the bank's equity derivatives."  The damage?  Just about 10 million pounds, or $20 million.

Interested readers may also want to check Greg Newton's post on the same topic at NakedShorts.  As Greg says, how many times does this has to happen before someone...

This time it’s Credit Suisse - why do we keep letting traders mark their own books?

Credit Suisse announced last week that the bank will take a $2.65 billion - yes, that’s billion - write down related to debt securities which were, in Bloomberg’s words, “deliberately mispriced by traders”. Bloomberg’s coverage continues: “An internal review found that the pricing errors, first announced last month, were made intentionally ‘by a small number’ of traders, who have since been fired or suspended....The Swiss bank hasn't disclosed the names of the traders responsible for the incorrect pricing of residential mortgage- backed bonds and collateralized debt obligations. Credit Suisse said it reassigned trading responsibility for the CDO business and took measures to improve controls to prevent and detect misconduct, which were ``not effective'' previously.” Sound familiar? It should. A few days earlier, another Bloomberg article noted that Lehman had suspended two London-based equity traders after internal controls identified ``issues'' on share valuations.” CS and Lehman are not the only institution with valuation problems - earlier in February, AIG announced multi billion dollar write downs on a portfolio of credit default swaps: Bloomberg stated “AIG's difficulty in valuing its derivatives portfolio earned it a rebuke from its auditor, which earlier this month cited "material weakness" in the company's internal controls.” While it’s not clear who was marking these instruments, we’d hazard a guess that front office investment professionals / risk takers who had a hand in developing the models underlying AIG’s initial marks. These events merit close attention, because they highlight that in today’s investment banks, it is the front office traders who mark securities, subject to checks by mid / back office accountants and product controllers. Many hedge funds take the same approach, with marks for hard to value positions generated by the portfolio managers subject to checking by the fund’s back office and perhaps some form of verification by a fund administrator. Indeed, hedge funds often point to the “best practice” example of investment banks as justification for their own front office pricing approach. The argument behind putting the front office in charge is simple: some instruments are so complicated, that only the traders who bought (or sold) them in the first place stand any change of valuing them correctly. Perhaps it is only the traders that have the contacts with other brokers and market markets who can give quotes and levels, or perhaps some derivative and structured products are so complex that the back office is (considered) incapable of understanding how valuations change. Valuation is not a black and white story, and there is certainly merit to these arguments. Faced with three broker quotes, it probably is the case that the portfolio manager could know that one broker is short of inventory and will bid up, while another counterparty would laugh if the fund tried to trade at the level given on their price quote. (The complete lack of accountability Wall Street enjoys when providing these prices, notwithstanding the fact that the banks know that their hedge fund clients need those quotes to cut their monthly NAV’s is, of course, a topic for another day.) These arguments roll together to form the view that the only way to price complicated hedge fund portfolios with “accuracy” is to put the front office in charge. Sorry - we disagree. For two reasons. Firstly, how much is any security actually worth? As we have said before, a security is worth what someone else will pay for it, at the time you want to sell it. The rest of the time, pricing is just an estimate. Let’s emphasize that point again: when pricing a hard to value security, we are not identifying an actual trade, but rather trying to figure out who can come up with the best estimate of what the position would be worth if it was sold. This is not a mathematical science where one price is right, and another wrong. If a price is not tested in an actual transaction, there is absolutely no way to prove that the PM’s mark is more “accurate” than a price generated by the back office, be that the back office of a hedge fund or an institution. It is a flimsy argument at best for a PM to assume that his or her price of a distressed bond (based, say, on a single quote from Goldman with perhaps a subjective adjustment to make it more "conservative") is more accurate than a price generated by the back office, using, for example, the average of three broker quotes received from different dealers. Secondly, putting the front office in charge ignores what is the bigger problem - the human dynamics of power and authority. Risk takers are compensated - handsomely - based on performance. It is pretty unrealistic to assume that the back office has an equal seat at the table when challenging marks (after all, the trader usually has a pretty good story as to why his or her mark is right.) Let’s take an example: what happens if a back office professional making, say, $100k challenges the marks of a front office trader who stands to make a bonus of $10 million based on his or her trading P&L? We don’t think you need to be an advanced student of workplace psychology to understand the dynamics of that conversation. Front office professionals are compensated based on their performance, and putting the front office in charge of valuation puts, to a significant degree, the front office in charge of their own compensation. Given this conflict, investors will consistently prefer to trade some front office “accuracy” for more back office “independence”, and a reduced risk of deliberate price manipulation. The Credit Suisse and Lehman examples illustrate exactly this problem. The lesson for hedge fund investors? Just because institutions do something, it doesn’t mean that it’s a good idea.