Valuing illiquid assets is a delicate and dangerous business. Mark them too low, and your portfolio managers and investors start getting pissy. Mark them too high, and your regulators and investors start getting litigious. But mark them you must, even if they haven’t traded in years, and since securities are only worth what people will pay for them, that means making up a price that someone might conceivably pay for them—and making it up just right, or else, see above.
But what if there was someone who could do your overly-generous valuations for you? Someone who’s willing to do just aboutanything to win your lucrative, lucrative business. Someone who’s already passing you inside dirt and with whom you are feasting on the corpses of your competitors and who’s maybe one of 90-odd employees you outsourced to a bank but who’s still doing the same stuff for you as when you were paying her directly? What if you could outsource overvaluation? Turns out maybe you can.
The regulator is reviewing at least a dozen banks and brokerage firms to determine whether they provided inflated prices on debt securities that funds used to pump up the value of their investments, said the people who asked not to be named because the inquiries aren’t public.
JPMorgan Chase & Co. and Citigroup Inc. are among the banks being looked at, said one of the people who added that the SEC is also scrutinizing other large firms and several smaller ones.
It allegedly goes something like this. Hedge funds set up valuation committees to figure out what their illiquid stuff is worth. The portfolio managers who buy that stuff aren’t allowed to sit on them for the same reason their banks have Chinese walls. Now, the valuation committee throws a dart at a board and says, “This is how much this stuff is worth,” but their wrist was a little wonky that day and so the dart wound up in one of the big white spaces with a single-digit number on top, and now the portfolio manager is throwing a hissy fit. So he goes and calls his friendly local prime broker and says, “Listen to this bullshit. What do you think this crap is worth?” And the prime broker says a high number, because he knows that’s what the portfolio manager who’s putting his kids through college wants to hear, and then the portfolio manager angrily storms the next valuation committee meeting and says, “Look what this totally objective and not-at-all conflicted THIRD PARTY says this is worth, you numerically-illiterate has-been paper-pushers.” And the numerically-illiterate has-been paper-pushers shrug and say, “Sure, whatever.” And then when the SEC calls they and the portfolio manager can say, “But look! We got an impartial third-party valuation on this worthless crap, and that said it was worth as much as a first-day Amazon.com share.” Which is all great and good until the SEC starts wondering if that impartiality has as many holes as those rather-porous Chinese walls.
The investigations, which won’t necessarily lead to any allegations of wrongdoing, focus on valuations of mortgage securities and other thinly traded bonds where swings of just a few cents can have a big impact on hedge fund returns, the people said….
The SEC’s suspicion that brokers sometimes provide sham prices isn’t just theoretical. In June 2016, the agency accused two portfolio managers at Visium Asset Management of soliciting phony quotes from friendly brokers over an 18-month period to justify inflated valuations on distressed debt holdings.