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…..
The change to FAS 157 (and related changes in Europe) only serve to continue to undermine the credibility of the Anglo-Saxon financial system.
Pushing it closer and closer to the edge when credibility collapses altogether.
Uh, would it be THAT hard to have some sort of aggregated (at the individual firm level) reporting of what is being traded, with anonymity as the cloak? All of this could then be pulled together to decide what is being traded sufficiently or not, based on the volume of trade vs the known outstanding issued. Id think someone would want to twist some arms at this point, and just say, look, you auditors need to send all your anonymous info to a clearing house, and let’s figure out what the frak is going on.
This stinks to high heaven.
This is starting to get a bit absurd… and leave it JP to pull the conversation into the open. And he’s absolutely right!
In the MBS/ABS/CMBS universe, I wouldn’t describe the current situation as “illiquid”. Tons of stuff is put out for bid every day and most of it trades. Of course the prices suck, but in the structured credit world we’re kind of at the point where given 24 hours a seller can get multiple bids and find a clearing price. People who own similar securities don’t like the clearing price… much like fat people don’t like what the scale says when they step on it. Unfortunately for them, that doesn’t do anything to change the story…
And as for your thoughts on maybe some HFs own “drecky dreck” or “CDO tranches”, that is likely true. But here’s the thing… there’s no clearing price and no trading because the things are truly and utterly worthless. Stuff gets offered out all the time — say, a CCC-rated subprime bond — @ $8-00. It doesn’t trade. Not because no one would show a bid, but rather because there is no possible way in the world that the bond is worth any more than $0-16, no matter how optimistic you are.
Good for JP that he’s willing to call the losers out. Not that anyone will listen. The “Powers that Be” who you’d otherwise expect would investigate these sorts of claims are doing their absolute best to perpetuate the myth.
This story isn’t going to end well…
What’s great is that all the kvetching about marking to market started a long, long time ago (I can remember it at least as far back as last July, but I’d guess some of it existed as far back as the fall of 2007). The story was the same: “It would destroy our balance sheets to be forced to mark these assets at ‘distressed’ prices that don’t line up with their intrinsic value, so let us choose our marks instead.” Of course, whatever the “distressed” marks of November 2007 were then, the marks on those same assets are MUCH lower now. What makes anyone think they’re better at telling a “distressed” price from a market price now as opposed to then?
Somehow valuing a pool of piggyback seconds at $.38 seems a bit optimistic to me…these were no money down purchase loans…How many counties in California and other bubble states have not lost 30% since these loans were made?
maybe paulson is unhappy he can’t buy some stuff at fire sale prices and he blames redemption restrictions for the lack of enough supply.
I admire the detailed analysis provided here both in this article and overall by Yves. But from where I sit the financial world has been living in denial and generally everyone else supports this denial. Maybe because no one wants to really contemplate the reality. Nonetheless the reality is that the banking system is insolvent and has been for at least 12-18 months now. You’ve had the Fed and the Treasury complicit in attempting to hide this fact, probably even from themselves.
Accept the reality, let the self induced fog lift and you will get a remarkably stark and different view that makes the answers to most of the questions raised quite obvious.
“97 versus 38? Even worse than I imagined was possible….. ” If they could find a way to make it 97 versus 1 they would make it happen. The reality is that the inmates are in charge of the asylum. Inmates are not capable of putting the asylum back in order. We may wish and pray they can but that does not change the reality. Please stop the denial!
God cursed America. The land you used to love.
He stood beside Her, and He guided her
Through the night with the Light of His love.
From the mountains to the oceans
To the prairies bright with grain.
God cursed America, your home sweet home.
WHY did God curse America?
The main thrust of the argument seems to be that by denoting assets as illiquid you can claim a greater value for them than would otherwise be true. Banks with the aid of hedge funds thus pretend certain assets cannot be sold so that they can preserve capital by classing assets as level 3 or illiquid.
What does interest me is that accounting rules in the US and the rest of the world are different and specifically in this area. There is a argument that this is a US problem only which not knowing the specifics of the differences in the accounting rules I am unable to assess. Portfolio securities valuations,Probability Weighted Cash Flows,taking into account your Own Credit Risk(ratings) and Discounting Cash Flows being of particular concern.
“What does interest me is that accounting rules in the US and the rest of the world are different and specifically in this area.”
That used to be the case, but IASB changed its rules to harmonise with FAS 157 a couple of months ago. In fact, IASB is arguably more lenient than FASB in that it has stated explicitly that the current market conditions justify reclassification from “available for sale securities” to “loans and receivables”.
Maybe they’re all Made-offs
When these “securities” were made they had never traded. Somebody put a price on them. Why can it be done before they ever sell but after the initial sale it is impossible. It does not make sense. Maybe their needs to be an agency called the “illiquid security evaluation committee.” The question that goes begging is that if there is such a huge gap in what the market will offer and what the holder says it is worth, then why hasn’t some financial genius stepped in and made some product called the “improper value swap” (IVS since i coined it) and sold it on the market?
And remember only a few mathmatical geniuses can understand these securities….How are they supposed to regulate..Bankers are geniuses for creating them..Rip everyone off before anyone figures it all out..Then get more money in a Bailout!! AWESOME PLAN!!
a classic example of “possession is 9/10 of the law” since it is contrary to the redemption policies in their investment agreements
This is not entirely correct. At least some of the funds receiving press for “gating” have explicit provisions in their investment agreements stating that in the event that there are large-scale redemptions, the manager can (or even must) limit such redemptions to a specific pre-determined percentage. This, in theory, prevents a bank-run type of event.
All I say is…wow.
While I agree with Paulson that HF managers (of which I am one) have a duty to provide for adequate liquidity in normal circumstances most do have the legal right, at some cost to their reputations, to delay or ration redemptions if these would reasonably result in investors being treated unfairly. Continuing to collect fees on frozen funds is however beyond the pale in my view.
I would also point out that there are two reasons why it is in Paulson’s interest to push this story as loudly as he can. One, forcing these HF’s to liquidate their assets to meet redemptions will depress prices, which Paulson is no doubt set to benefit from being net short. Two, Paulson’s funds have done very well shorting throughout the last 18 months, and could be expected to be major beneficiaries of any fund reallocations, that is provided his prospective clients are able to get their money from their current managers.
Poulson just wants more investor cash for his own fund so he can go after the next target after Iceland and collect on all those CDS contracts he’s got. He’s hot and everyone wants to redeem elsewhere and go with him. Self-service once again…