Mark to Model or Mark to Myth?

Date: September 21, 2009

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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