Mark to Model or Mark to
Myth?
Why valuations of credit instruments based
on Mark to Model might be a really good
idea
Asset managers and Custodians have a
real problem valuing illiquid assets in their portfolios even
though many of these assets are perfectly sound and the asset
manager has no intention of selling them. Assets should be valued
at mark to market prices as required by the Basle rules. However
mark to market prices should not be used in isolation in my view,
but rather compared to model prices to test their validity. Models
should be improved to take into account the greater amount of
market data available.
No less a person than Warren Buffet decried the traders of Wall
Street for "Marking to Myth" their assets as they sold untold
trillions of them to the ill-informed. The traders were using
models to price these assets but miraculously the models always
seemed to offer high valuations. This has given the process of
Marking to Model a bad rap. What Warren Buffet was really
criticising was the bubble in valuations caused by the systematic
under-pricing of risk. In the same way that analysts during the Dot
Com bubble extrapolated forecast profits into the multi-billions
for companies that had not yet $1 of revenue and then sold
over-priced junk stock to unwary investors, so too did Wall
Street's finest with credit instruments.
The credit crunch is now 19 months old and the fundamental reason
why we had one in the first place is due to the mis-pricing of risk
and therefore of assets. With cheap and plentiful supplies of
money, competition drove down the prices at which banks would do
deals and drove up the prices that investors were willing to pay. A
lethal combination of faulty models and bonus-driven salesmen did
the rest. When at last people started calling into question the
values of these accumulated assets (not just ones based on falling
property prices but also on optimistic future profits and
continuing economic fair weather) the giant game of financial
musical chairs began as everyone searched desperately for any
remaining buyers in the market to off-load their
"investments".
With the new Basle rules about marking to market this has had a
domino effect on a prodigious scale. Assets that otherwise would
have been held to term have had to be dumped as prices have been
marked down to the most recent market prices. As corporations and
banks have been unable to get any credit, the lack of liquidity has
turned to potential (and actual) insolvency and that in turn has
triggered a mass of downgrades of credit ratings. This once again
has caused many investors to sell off downgraded assets as their
investment mandates forbid them to hold any bonds with less than AA
ratings.
It stands to reason that on the way up prices that were marked to
market were affected by over supply of buyers and on the way down
the mark to market prices are affected by a massive under supply of
buyers. However, just because there are no buyers for your asset
doesn't mean that the asset is worthless if (and this is a BIG if)
you are not a forced seller. The core issue is whether you need to
sell your asset to raise cash. If you are not in a rush, over time
the market price will recover. Many fixed income assets are bought
and held to term (with no leverage). Provided the issuer does not
default on interest or capital, the asset has the value of its cash
flows and principle. So if you have such assets and a long term
investment horizon and no liquidity issues, how should you value
these assets? What happens if you are put into the perverse
position where you have to mark the value of your assets down to a
level where your terms of reference force you to sell them? Mark to
market is good for transparency, but where there is no liquidity
does this approach still work?
Look at value another way, if you wanted to sell your house that
you bought for £1.0 million 18 months ago, you would probably go to
an agent and get them to estimate what the going rate was for
similar houses. Let's say they gave a range of £650K to £750K you
would then "model" your house price on this and put it on the
market for £790K hoping to get £750K. If someone offers you £50K
for the house you would be unlikely to sell it to them, however
their offer would represent the only "market" price for the
specific asset: your house. For better or worse, you would stay put
and wait for better market conditions and in the meantime you would
probably make a mental note that your house was probably worth
£650K despite it only being a model valuation rather than £50K (the
last real offer).
In other words there is a problem with mark to market when there is
no liquidity. By definition a liquid market is where consenting
parties agree on a price at which they will deal with each other
freely. It is not surprising that rather graphic terms are used for
buyers in the current illiquid markets such as sharks, rapists,
bottom feeders and vultures as they are only interested in buying
from the truly desperate. In the housing market the forced sellers
are the people who have defaulted on their mortgages, are divorcing
or have inherited a property and want to get cash quickly. These
are the asset sales that at the margin define the market price.
Until this overhang of supply works its way through the system
there will be no motivation for buyers to pay more.
I am not arguing that one should ignore the market but rather that
blind faith in it does not make sense and that the law of
unintended consequences can play havoc as a result. Rules that
enforce one approach can have perverse results. An example is with
Index Funds. When a new stock enters an Index, they all buy it,
propelling the price of the stock higher. When a stock exits the
index, they all dump it, causing the price to fall further. What is
needed is a circuit breaker or alternative way of thinking to
validate the orthodox approach. Indeed the accountants that set the
rules for the International Accounting Standards Board are also
concerned about "Fair Value" over a market price. To them Fair
Value is the amount at which an asset could be exchanged in a
current arm's length transaction between willing parties where each
acted knowledgeably, prudently and without compulsion. If that
cannot be obtained from quoted prices, then they look to proxies
and finally to model prices.
When Warren Buffet buys an asset, he uses his own model for
determining whether the asset is good value or not. Sometimes he
will pay more than others for a given asset. He works out the price
he will pay and then he sticks to it. This is a good example of
making the market come to the model price. Buffet's model is based
on a fundamental approach to valuations that stays consistent
irrespective of "Mr Market" (as he likes to call it) and he
maintains the discipline of sticking to his model for valuation
even if he has to wait several years to buy.
The problem faced by asset managers and the custodians of their
assets is what approach to take vis-à-vis valuing so many illiquid
assets where there are seldom any trades? There are some 4 million
or so bonds in issue not counting CDOs, CDSs and other derivative
assets and 95% have no regular market made in them. Even where a
broker price can be obtained these are often skewed and reflect the
trading book of the broker. It makes sense then for custodians and
asset mangers to use multiple sources to gauge more accurate
valuations of their assets including model prices. Market prices in
any case are based on the models used by the investment banks so it
is good to have an alternative model to validate them.
However, not all model prices are equal and custodians and asset
managers should look for more sophisticated models. For example,
historically, credit ratings provided the only means of gauging the
risk of default, but now the CDS market for a given issuer is a
much more up-to-the-minute guide on the likelihood of default.
Further one can build up the price of an asset by looking at the
various spreads over LIBOR including the sector spread by using
highly liquid indices like iBoxx and iTraxx. Thus the price of an
asset can be modelled from LIBOR, its credit spread, its CDS spread
and its sector spread and whatever other factor based on its term
sheet. Such a price will be very robust and a sound basis to
challenge the "market" price from an investment bank.
In summary, a valuation is not the same as a transaction and at
times of stress dogged application of rules can cause more harm
than good. There is no harm in challenging "market" prices if they
seem skewed and the best way to do that is to have alternative
opinions in the form of independent model prices. New methods and
new data are available to help improve models and these should be
used. In the end all prices start off from a model.
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