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.