The credit crisis is putting pressure on investors -- even those who do not have to mark assets to market every quarter -- to cope with valuing complex securities when they cannot rely on market prices.
Since the bottom has fallen out of the market for structured credit, Washington Square Investment Management Ltd, for example, has seen wide variations in the few quotes available from banks, and mostly one-sided quotes at that -- bids at extremely low levels aimed at forced sellers, but no offers.
We had a real problem of coming up with a sensible way of informing our investors about net asset values (NAV), said Claudio Albanese, a board member on the pricing committee of Washington Square.
We could see a cross-section of prices for assets that were about identical in terms of exposure and correlation but were trading at vastly different levels, he said.
The asset manager is not required, as a buy-and-hold investor, to mark investments to market prices and has not been forced to sell assets, which means its valuations have not had to reflect the extreme volatility in the market since June.
Even so, Washington Square wants to give a NAV figure to its investors every month that reflects underlying shifts in the market and in the firm's rate of return, Albanese said.
Its solution has been to use a mathematical model and then recalibrate that model every month to reflect changing conditions, with the final objective of converging to market quotes in six months or so, when volatility has subsided and market liquidity is restored, he said.
Many investors who are not required to mark to market have focused on valuations because of the growing concern of senior management over exactly what their firms are exposed to, bankers said at a conference in Brussels this week.
Every time there is a crisis, people realize that valuation needs to be more accurate, said David Gershon, chief executive of pricing service SuperDerivatives. People are becoming impatient about not knowing where they are.
Washington Square manages Carador, a 50 million euro ($74.2 million) listed fund of equity tranche holdings in collateralized debt obligations (CDOs), which have been shunned by the market and are particularly difficult to price.
CDOs are portfolios of credits divided into tranches, with the riskiest equity tranche exposed to the first few percent of default losses from anything in the portfolio and the top tranches exposed to loss only after the rest have gone under.
To come up with a CDO valuation, the investor must value all the underlying assets and then assess the value of his tranche relative to the other tranches, known as correlation risk.
European investors in synthetic CDOs, which are portfolios of credit default swaps, or bets companies will not default on their debt, may have an even greater need for pricing models.
Under International Financial Reporting Standards (IFRS), unlike U.S. GAAP accounting, even buy-and-hold investors in such derivative-based products must mark them to market.
Institutions with hundreds of millions of euros invested in CDOs of whatever type may find it worth spending a million or two to get a pricing model of their own when they see bid/offer spreads of, say, 16 to 95 -- or no prices at all.
Another option is to turn to independent pricing providers, such as Markit and SuperDerivatives, which get bank and broker quotes and feed them into sophisticated models.
IN SEARCH OF THE PERFECT MODEL
Lots of people are building models, said Jeff Gooch, Markit executive vice president for valuations. You can argue the merits of different models, but however good your model, the hard part is getting access to inputs and then testing them.
Auditors say that before allowing these independent numbers, they look in detail at the price inputs that went into them.
It's all useful evidence, said John Hitchins, UK banking leader at PricewaterhouseCoopers. None of them are the definitive word.
Washington Square's Albanese said the development of investor services in this area is sorely needed.
The reality is so complex that the important issue is consistency. That is where research is going, Albanese said. It make take a couple of years, he predicted, for the rocket scientists to come up with the model that all can agree on.
But even in a situation where you have the ideal engineering solution, you still need inputs into those models. If there are no market prices, that means each of 10 different banks will input its own assumptions, still ending up with 10 different figures, he said.
(Editing by Quentin Bryar)