Valuation Issues

The key metric in being able to evaluate an investment is knowing what it is worth. With a publicly traded investment such as a share of common stock, there is ongoing price disclosure generated by prices offered, and the prices accepted by a multitude of buyers. Reoccuring episodes of irrationality and over exuberance suggest that this may not be the perfect method of determining the true value of a given security. However, since what a willing buyer will pay a willing seller is the final arbitor of current value, the transparency of price disclosure by the market forces of the multitude at least has the merit of establishing a more level playing field as a starting point. Indeed, some financial theorists argue that markets are efficient to the extent that current prices determined by market forces are an accurate representation of true value. Be that as it may, an entirely different issue arises when investments are illiquid. Alternatively, if the value is determined by reference to a valuation model, this may contain self-serving, or otherwise erroneous assumptions.

For example, one of the problems, recently creating turmoil in the global financial markets, has been the valuation of Collateralized Mortage Obligations(CMO). When subprime mortgages are bundled together and packaged with other mortgages, assumptions need to be made about such things as the default rates of these mortgages. With a minimal history of these mortgages, there is also minimal information about default rates. Nonetheless, this had not stopped trillions of dollars of these securities from being created, and consequently being valued by, at best, an arbitrary method, and at worst a self-serving procedure of malfeasance. Consequently, when these valuations were challenged by the real market conditions of defaulting mortgage holders, these valuations became glaringly inadequate.

The latest example, after a litany of tens of billion of dollars of losses being claimed by the likes of Bear Stearns, Citigroup, Merrill Lynch, Deustche Bank, and having the Central Banks of the world pump $500 billon into the global banking system to try to avert a global financial catastrophe, is Ellington Capital Management, a $5.2 billion debt-focused hedge fund which recently announced it had restricted withdrawals from its fund because of the difficulty of valuing the securities in its portfolio. Along the same line, a Wall Street Journal article(Pricing Tactics Of Hedge Funds Under Spotlight, October 6, 2007) cites academic research findings which show that hedge fund managers sometimes "cherry pick" valuations to give a more positive appearance.

The bottom line is that these shenanigans, under the guise of free market capitalism, are anything but champions of free market capitalism. At core, these tactics erode the strength of a vital and strong economic system by distorting the efficient allocation of capital based upon fundamentally sound information.