Warts on a Balance Sheet: Asset Valuation Remains Troubled

At the heart of the financial crisis was an inability on the part of banks to set a value for their assets.

That heart is still malfunctioning. Asset pricing – and we are talking about CDS, CDOs, other derivatives, etc. – practices continue to wander in the wilderness.

I was convinced that banks are very, very far from able to price assets accurately after attending a panel discussion sponsored by the Risk Management Association’s New York chapter this week. The situation is not good.

The key point – the one that showed the warts on the apple – was delivered by Daniel Sullivan, the deputy manager of the Market Risk Management Department at the Federal Reserve Bank of New York. Sullivan “is responsible for the oversight of all the examinations of Market Risk Management including the valuation practices at banking institutions in the second district,” according to his bio, and at one point during the discussion he was asked a pretty fluffy question: what are some best practices in asset valuation today? He offered several answers, but the one that stuck out was this: “Culture is one; assets need to be modeled independently,” he said. “Control units look at valuation practice to make sure they are independent and not influenced by the front office.”

Culture?!? So let me get this straight, a “best practice” in asset valuation is making sure that the C-suite does not “influence” the results?!? Presumably – and remember, this is coming from the person who is responsible for the oversight of all the valuation examinations in the New York Fed’s district, arguably the nation’s most important – senior bank executives are still “influencing” asset valuations, which are themselves continuing to be subject to bank “culture.” This, to me, is shocking. We are talking about the price of assets. That Sullivan could not express a hard and fast methodology as a best practice means that there is none, that the Federal Reserve has allowed asset valuation to remain an artistic endeavor for bankers and traders.

Let’s take this a step further. If asset valuation remains an art, then the artists cum bankers can “paint” as they wish. If market participants “feel” that assets should plummet in value again, then plummet they will. If market participants collectively choose to buttress an asset’s price (as they are today), then buttressed it will be. Forget formulas, forget fair value, forget mark-to-market. Have we learned nothing in the last 12 months?

“At the Fed, we would like to see more data in valuation,” Sullivan said.

Uh, yeah.

To be sure, some of the other practices spelled out by this panel reveal additional ugly truths about asset valuation. For example, Roger Curylo, senior vice president, credit risk, at Fidelity Investments, said it was not the case that all asset valuations are done with “multi-source pricing,” meaning that multiple price quotes are used to formula a valuation. Rather, some banks still opt for “single-source pricing.” If that was not disturbing enough, Curylo went on to say that, as for a “best practice,” it was not enough to use multi-source pricing, “but how do you pick [the sources]? You don’t want to cherry pick.” Cherry picking for asset valuation – ugh.

The regulators deserve some of the blame for this mess. Another of the panelists (the best one, in my opinion), Barbara Matthews, principal at BCM Strategies, a Washington, D.C., consultancy, explained bluntly how the international regulatory bodies have gone back and forth on suggested valuation practices that effectively banks have no idea what to do now. Think about this. Not every bank around the world uses fair-value accounting. Does the Basel Committee favor it? Not really. But don’t tell that to the American regulators, because they’ve throw it at the US banks.

“Policy is all over the map,” Matthews said. “Many assets will have different accounting rules within two years.”

That, in and of itself, is problematic for those banks trying to nail down a consistent valuation methodology.

So what to do? Are the regulators really MIA? The New York Fed’s Sullivan offered a glimpse at how the regulator is handling the situation. It is true that the Fed cannot articulate a definitive methodology, but Sullivan hinted that it doesn’t have to. What the Fed has increasingly told banks is, “You believe [a specific asset] is worth this much? Then sell it,” Sullivan said.

How much “selling” is going on is another discussion entirely.