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In Bear Stearns Case, Question of an Asset’s Value

6/20/2008

New York Times

How much is your investment worth?

That might seem like a simple question on Wall Street, where the price of everything from Apple to zinc flickers across computer screens every day. But inside Bear Stearns, the answer was anything but clear last spring for investors who put their money into two giant, but ultimately doomed, hedge funds.

Two executives who oversaw the funds, Ralph R. Cioffi and Matthew M. Tannin, did not disclose that the funds were plunging in value until it was too late, the authorities say. On Thursday morning, the pair surrendered to federal agents and were charged with nine counts of securities, mail and wire fraud.

Whatever the outcome, the case spotlights one of the most vexing problems confronting Wall Street as the credit crisis plays out: How to value tricky investments linked to subprime mortgages and other risky debt.

As the mortgage market slumped last spring, authorities say, Mr. Cioffi valued one of his funds as having lost 6.5 percent in April. But colleagues at Bear placed far lower values on investments in that fund. They said the fund had lost 18.97 percent.

All across Wall Street, similar battles are playing out inside banks, albeit without the legal drama. Many banks are struggling to value the assets they hold, raising doubt among many investors about those companies’ financial health.

“It’s a humongous problem for Wall Street,” said Michael Young, a lawyer with Willkie Farr & Gallagher. “These days these valuation obstacles are at the core of the write-downs.”

Mr. Cioffi and Mr. Tannin are the first Wall Street executives to face criminal charges linked to the credit mess. But many other bank executives are grappling with far bigger financial worries. Worldwide, banks have written down the value of assets by $380 billion, as high-flying markets have crashed back to earth. Some banks suggest that the write-downs have been conservative and that some assets may be written back up in the future. Others say the bill will keep mounting.

Bankers like to say that valuing complex investments is part art and part science, but four large firms have said recently that some employees have not been honest.

In February, Credit Suisse found a group of employees who had bumped up the value of mortgage assets by $2.65 billion during the fourth quarter last year and through the start of this year. The employees were fired.

In March, Lehman suspended two traders on its equity derivatives desk for overpricing bets in the market by tens of millions of dollars. In May, Merrill Lynch disclosed a similar incident that cost it about $18 million.

Morgan Stanley was the latest to find misconduct. On Wednesday, the investment bank said it had lost $120 million this year because of a rogue trader. The trader, Matt Piper, is British and has worked for Morgan Stanley in London for four years. He was suspended while Morgan Stanley continued investigating his trades in credit-index options.

“In this sort of environment of stressed markets, one would expect to see people trying to behave improperly,” said Colm Kelleher, Morgan Stanley’s chief financial officer, on a conference call. “We’re very angry about it.”

The level of losses industrywide is sure to raise questions about how values were assigned in the first place. Banks generally look at prices in the market first. But when no market price is available, they turn to internal computer models. The practice is similar at hedge funds, though in some instances, banks give pricing out to hedge funds, allowing price levels to trickle through in nebulous asset classes like mortgage bonds.

Now, bank executives are increasingly scrutinizing their employees and trying to catch them if they are too optimistic – or downright dishonest – about valuations.

But it is not simply a question of catching rogue traders. Marking the book, as the industry calls the pricing process, has become one of the more controversial topics among finance executives, even in instances where no fraud has been alleged. On Thursday, the chief financial officer of Citigroup said the company would use internal models to price mortgage bundles known as collateralized debt obligations rather than use the dismally low market prices as the only factor. On the other end of the spectrum, firms like Goldman Sachs say that market prices should be the driving factor in pricing.

Different computers models often use different data and produce different valuations. Investors have complained recently that Wachovia and Washington Mutual are modeling values with a housing price index that is more optimistic than the index used by their competitors.

“There’s almost a definitional issue of what you mean by value,” said Rick Antle, an accounting professor at the Yale School of Management. “You’re really kind of behind the eight ball.”

Away from Wall Street, plaintiffs’ lawyers are circling. Suits over losses in funds like Charles Schwab’s YieldPlus Select assert that managers were irresponsible in not knowing how risky the mortgage assets would turn out.

A spokesman for Charles Schwab said the company does not comment on pending legal cases.

“I don’t know if I could tie it to some kind of widespread conspiracy. Certainly the fact that the write-downs have been so massive would mean that somebody was optimistic,” said Ryan Bakhtiari, a lawyer who has filed an arbitration on behalf of investors against Schwab. “It was true from the beginning to the end of the food chain: everybody made inflated money.”

Banks are sometimes forced into write-downs because of selling in the market. Lehman Brothers, for instance, said that the collapse of the hedge fund Peleton Partners in February forced Lehman to write down the mortgage assets it owned similar to ones held by Peleton. Some banks say the write-downs caused by fire sales may be overkill.

“There is a bit of this atmosphere that says, ‘Let’s just mark it down, no one is going to question it if we mark it down,’ ” said Christopher Hayward, the finance director at Merrill Lynch, at a recent industry conference.

Not all banks are eager to take their hits. In the fall, for example, a large city in the Southeast asked Bank of America to write down the C.D.O.’s the city held, said Mr. Bakhtiari, who represents the city but was not authorized to identify it.

Bank of America refused to mark down the C.D.O.’s, Mr. Bakhtiari said, because it did not want to create a mark-down domino effect in its other holdings. A spokesman for Bank of America declined to comment Thursday.

Investors are increasingly complaining that banks have become too opaque about the assets they own and the trades that make – or lose – them money. Financial companies flocked en masse in recent years to trading assets that are far harder to value than, say, shares of Microsoft.

And the problem may be exacerbated by the way traders are compensated. Bank employees from lowly associates to chief executives are paid bonuses each year based on performance. But there is little recourse if their bets lose money the following year, so long as the employee is deemed to have made an innocent mistake.

Some banks are considering expanding the period in which traders are evaluated to longer than a year, said Chip MacDonald, a partner in the capital markets group at the law firm Jones Day.


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