This is starting to get interesting. Readers may recall that a fair number of hedge funds have restricted or barred redemptions (a classic example of “possession is 9/10 of the law” since it is contrary to the redemption policies in their investment agreements).
The justification goes something like this: We the fund hold liquid and illiquid investments. For us to cash you out, we’d have to sell the liquid stuff and leave all the other investors with illiquid holdings. That leads to an unbalanced portfolio and is unfair to them. So you have to wait until we can sell in an orderly fashion (which will take a bloody long time).
Paulson shreds this notion in his latest letter to shareholders (from Paul Kedrosky via John Hempton):
As a firm, we have not imposed any gates or other restrictions on clients withdrawing their assets. While we recognize the difficulties of the current environment, we think it’s a manager responsibility to raise liquidity to meet the needs of their investors. There is plenty of liquidity in the markets. Even in opaque areas of the markets such as in bank debt, mortgage backed securities and other distressed securities, we see hundreds of millions of dollars trading every day. We are especially surprised that many managers have restricted client withdrawas when: 1) the total redemptions are manageable (15-25% of AUM); 2) the managers have the cash; and 3) one of the stated reasons for restricting withdrawals is so the manager can continue to invest in new opportunities.
Hempton connects the dots:
I read this as John Paulson saying that there are funds which have easy enough to mark to market assets and where the assets are sufficiently liquid are refusing to give money back. Theft or fraud. Or maybe both. Moreover the liquidity according to Paulson is sufficient that funds almost never should have stop withdrawals – even in opaque areas of the market.
Now it is possible that Paulson is being unfair (maybe some of these firms do have really drecky dreck, or exotica like funky CDO tranches) but he clearly is pointing to particular players, so at least some of the redemption-avoiders are behaving badly.
This is already plenty juicy, but I wonder if there is an even bigger implication: are banks also trying to claim that markets for poor credit quality paper is less liquid than it is and using that as an excuse to mark the instrument more favorably?
Let’s go back a few steps. Readers may recall that the Financial Accounting Standards Board clarified its rules re fair value accounting in FAS 157. It provided for a three level hierarchy for valuing financial firm assets:
Level 1 is where a market price exists
Level 2 is where there is not an active trading market in the instrument but the price can be derived from other similar instruments that do trade (think corporate bonds)
Level 3 (fondly known as “mark to make believe”) is where the price cannot be derived from market inputs, so the firm gets to use “unobservable inputs.”
Now where this gets really interesting that firms were directed to value an asset at the lowest possible level of the hierarchy. When the credit market continued to decay this year, industry lobbies like the American Bankers Association pressed for relief, arguing that firms shouldn’t be required to mark prices based on “distressed” prices. The
fantasy view was that asset prices had overshot and firms would be showing equity losses that would later be reversed.
The industry got what it wanted. From an October press release:
The Mortgage Bankers Association (MBA) hailed yesterday’s announcement by the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB) permitting the use of discounted cash flow fair value measurements under FAS 157 when no active market for a security exists.i
So if a firm contends that the market for an instrument isn’t “active”, they can use more creative measures for valuing it.
Paulson says hedge funds have been claiming that certain types of securities are not being traded much when in fact they are. Could banks be making the same false claim? Year end financials are audited, but how would an accounting firm be able to verify a client’s claim that a particular security didn’t trade very much and therefore had to be valued on a Level 2 or 3 basis?
Informed reader input encouraged.
Update 11:20 PM. The New York Times provides some confirmation:
The wild variations on the value of many bad bank assets can be seen by looking at one mortgage-backed bond recently analyzed by a division of Standard & Poor’s, the credit rating agency.
The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.
97 versus 38? Even worse than I imagined was possible…..