Fair value lessons from ‘London whale’; Regulators determined to safeguard investors’ interests as valuation models vary

November 15, 2013 11:24 am

Comment: Fair value lessons from ‘London whale’

By Mark Hepsworth

Regulators determined to safeguard investors’ interests as valuation models vary

The US justice department’s civil and criminal charges against two traders at JPMorgan in connection with the so-called “London whale” trading losses have kept the methods employed by banks and investors for valuing complex securities in the spotlight. Valuing a bond or a derivative can be challenging for a variety of reasons. Foremost among them is that a large portion of these instruments do not trade frequently, if at all, in over-the-counter markets.This can lead to a lack of discernible “market colour” on which to base a valuation. There is also no uniform method to determine a valuation when market quotations are not readily available or reliable. This generally makes determining a price a complex and nuanced task.

As a result, two companies can come to different conclusions about the value of the same OTC instrument – and there are millions of these assets that need to be valued each trading day.

Consequently, this can create opportunities for price manipulation if a trader or portfolio manager is seeking to boost returns. That is why regulators continue to re-examine and modify their rules, and increase enforcement activity.

But no single industry-wide accepted valuation approach exists. Investors employ a variety of techniques to determine a price for OTC instruments. This includes quotes from brokers or counterparties, prices from third parties or by using model-based valuations. But valuation models can vary widely – from the simplistic approach of calculating the mean or average of contributed prices to more sophisticated methods, using analytical software or models that incorporate multiple market inputs.

Yet regulators are determined to ensure that investor interests are safeguarded and that financial institutions have the right level of risk management in place. Central to this is ensuring financial institutions apply the appropriate due diligence and continuously review their valuation methods.

In the US, the Securities Exchange Commission is moving aggressively to enforce that a mutual fund’s directors and trustees closely oversee their valuation processes.

In June, it settled a case it brought against certain Morgan Keegan fund directors, in which the agency claimed the directors violated their oversight responsibilities for asset pricing. The International Organization of Securities Commission also weighed in on instrument pricing earlier this year, detailing key principles to be used to develop and implement procedures to value their assets, including complex and hard-to-value assets.

However companies must provide additional quantitative and qualitative disclosures in their financial reports to help identify the types of inputs used to determine fair values. Furthermore, these reports are audited by third party companies who are applying a growing level of scrutiny.

Against this backdrop, it is critical for investment companies to have controls in place and to document and demonstrate how they arrived at a particular valuation.

Regardless of whether a company uses broker quotes, internal models or a third party pricing vendor, the resulting valuation needs to reflect a potential exit price in an orderly market, and is not vulnerable to manipulation to deliver a more favourable outcome.

For example, there are concerns surrounding the risk of companies basing the value of a security on a single broker quote, because there is often a lack of transparency into the inputs and methods used to produce that quote, which may also lack independence.

Implicit in this is identifying and eliminating conflicts of interests. An overreliance on the perspective of a trader is fraught with conflict, which can skew results and lead the valuation group to accept prices that may not represent the market. A model-based valuation may use bids and offers as important inputs, but it still requires controls to be in place in order to prevent manipulation.

Regardless of the valuation technique used, companies are increasingly recognising that incorporating multiple input sources and independent inputs to value complex, less liquid securities can produce a higher quality valuation.

There is little doubt that regulators are determined to bring new levels of transparency to previously opaque markets. These changes in market structure can help improve transparency, but they do not solve the issue that many of these instruments will still trade sporadically (if at all) while others will remain over-the-counter. As a result, the valuation of this asset class will probably remain an operational challenge.

The London whale is just the latest case that reinforces why regulators around the world are moving in terms of rulemaking, monitoring and enforcement to ensure higher quality valuations and remove conflicts of interest.

Mark Hepsworth is president for Pricing and Reference Data at Interactive Data Corporation