Respect for the valuation bogie man

The FT has a rather alarmist article about ABS valuation. Unsurprisingly to anyone who has been in the market, but a surprise apparently to a regulator was the fact that for some ABS

There was little confidence about how to value the holdings

The wrong conclusion is drawn from this

To an extent, the valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. [...]

But unless circumstances arise that force a market trade, valuations often remain at the investment managers’ discretion. While managers say they strive to assign honest values, these are often difficult for an outside accountant to verify, since the techniques used are invariably highly complex.

The market infrastructure isn't the problem and neither is the complexity of the techniques used. It is simple old fashioned invisibility of the model inputs. Let's take a German middle market corporate with no issued bonds and privately held equity. What is the fair value spread for a loan? Well, there are things you can do based on discounted cashflows and models of corporate structure and so on, but they are approximate. If you came to try to sell that loan, you might get a different price from your model. It is the same with IPOs (which is why there is a pricing range which is often revised before the company comes to market).

There may well be problems with CDO models - the right choice of copula is unclear in some situations for instance. And market infrastructure is not perfect, particularly on the legal side. But fixing these issues won't give a market price to something that does not trade. It might however help if commentators who are perfectly comfortable with utterly subjective loan loss provisions in the banking book accepted that when the same kind of assets are subject to fair value the determination of those fair values can be problematic. That doesn't mean the assets are bad, just that market participants need to understand and manage valuation risk.

The place this really gets delicate is when actions depend on estimates of fair value, for instance in a SIV where the definition of solvency might depend on the ratio of the FV of assets to the notional of liabilities. Writing that kind of clause is asking for trouble if there is any doubt that the FV of the assets is easily determined.