CMRA Commentary

CMRA Articles and Commentary

Are your pricing policies and procedures for less liquid instruments adequate? – the SEC is looking

The unrelated position mismarking incidents that quickly precipitated the closures of both Visium Asset Management and Marinus Capital have been recent focal points for market participants, but regulatory scrutiny of valuation choices for less liquid instruments is certainly not new. Askin, Piper Capital Management, and other market participants have also faced high profile regulatory/legal consequences when valuation issues exceeded regulatory tolerances (see the walk down memory lane below). However, even market participants who have had the good fortune of avoiding Wall Street Journal headlines likely still face challenges on a daily basis when marking less liquid and hard-to-value positions.

Capital Market Risk Advisors (CMRA) recommends:

  1. Updating written policies and procedures to reflect new transaction types, new data sources, and new “lessons learned” from others’ stumbles. It is all too easy to make policies a one-time exercise rather than monitoring and updating them as circumstances change.
  2. Ensuring that written policies and procedures reflect your firm's actual practices rather than being aspirational. It is far better to "say what you do and do what you say" rather than memorializing an aggressive policy that you hope to one day achieve but that is not currently implemented. 
  3. Implementing a pricing process that results in a documented set of challenges and revisions, with any adjustments to pricing source inputs/outputs being thoroughly memorialized in writing. We note that if the pricing policies and process never result in a challenge or change, they will be easy to criticize. There should also be a Pricing Committee and a clearly defined escalation process for valuation issues.
  4. Back-testing of actual new transactions vs. “marks,” and rigorously validating both third-party and proprietary valuation models for accuracy and reliability. Don't forget spreadsheets!
  5. Maintaining a database of broker quotes, pricing service data, screenshots, etc. for less liquid instruments and a regular review of:
    1. Volume trends,
    2. Discrepancies between pricing sources, and
    3. Bid/offer spreads

A trip down memory lane of selected regulatory valuation issues

  • Marinus Capital, a credit hedge fund, closed after uncovering the apparent mismarking of certain interest rate derivatives as a result of irregularities in the discount rate selected for valuation purposes (LIBOR vs. OIS)[1]
  • Traders at Visium Asset Management mismarked certain distressed bonds and loans using “U-turned” quotes from friendly dealers where they provided those dealers with inflated prices with the understanding that they would be quoted back to them without going through any independent verification process[2]
  • Askin transitioned from using dealer quotes to relying on more optimistic internal pricing methods to value its collateralized mortgage obligations in February 1994, just as a Federal Reserve interest rate hike roiled the bond markets – resulting in SEC charges that were later settled[3]
  • Another investment fund, Piper Capital Management, also faced problems pricing Agency CMOs in 1994 and was sanctioned by the SEC for relying upon stale prices and artificially smoothing decreases in NAV[4]
  • A large fixed income investment manager used round lot pricing service pricing to value smaller odd lot positions, resulting in an SEC order requiring it to retain an independent compliance consultant and pay nearly $20 million to settle charges[5]
  • A group of open-ended investment funds that valued complex and illiquid Toll Road Bonds using a third-party analytical tool that did not properly account for the bonds’ cashflows and marked them at prices that were significantly higher than market purchases of those same bonds[6]
  • Morgan Keegan and its Board of Directors being accused of the fraudulent valuation of subprime mortgage-backed securities based on arbitrary “price adjustments” to fair value[7]
  • A managed futures fund that failed to account for the pricing of its own market transactions when valuing a set of bespoke over-the-counter options[8]
  • A number of mutual funds fielding SEC queries into their valuation practices for private investments in tech “unicorns”[9]

CMRA has provided risk advisory (including for hard-to-value assets) and litigation support solutions for over 25 years. We are a group of senior professionals, each with decades of direct market experience that includes trading, managing risk, working with regulators and serving on boards. We specialize in derivatives, asset-backed securities, mortgage products (Agency and private label MBS, CMOs, and whole loans), structured finance and other complex financial products and strategies.