What's A Security Worth?Jeffrey M. Laderman
On most any day, an individual investor--or a money manager, for that matter--can check the price of IBM, a futures contract en the Standard & Poor's 500, or a 30-year U.S. Treasury bond by calling a broker or punching a couple of keys on a PC.
But what about the price of an interest-only collateralized mortgage obligation (CMO)? Or a bond whose interest payments are tied to the price of copper? Or a municipal bond whose yield floats in the opposite direction of interest rates? That's not so simple. As the markets have become more inventive and have devised complex and often esoteric financial instruments, pricing those securities has become one of the toughest jobs on Wall Street.
But it's also one of the most critical, one that can make the difference between profit and loss for a securities firm such as Kidder, Peabody & Co., which has a $10 billion inventory of mortgage securities, and even for nonfinancial companies such as Procter & Gamble Co., which invested in complex securities.
COMPUTER ENHANCED. How securities are priced is crucial for mutual fund investors, too, since funds must price their portfolio at the end of every business day. That's especially challenging for bond funds that invest in some of the unusual, less-liquid securities. Mutual fund maven A. Michael Lipper says when the auditors come in to review funds' semi-annual reports, they're on alert for how the funds are pricing their derivative instruments. "It's uncommon, but it isn't unheard-of for auditors to make funds write down securities," says Lipper.
What's a security really worth? When there are lots of buyers and sellers, the answer is simple. It's the price at which the security changes hands. But what about when markets are under stress and trading almost dries up? Under those conditions, is the market the best gauge of a security's value?
The Piper Jaffray Institutional Government Income Fund is a case in point. Its portfolio is chock-full of such exotic mortgage securities as interest-only and principal-only CMOs. Using the market as a pricer, the fund is down a numbing 26.4% so far this year. But have its long-term shareholders really taken that bad a hit? No, says Edward J. Kohler, president of Piper Capital Management Inc. He contends that Piper's computer models--which use such variables as interest rates and prepayment schedules--value the fund's portfolio way above its current market price. If the fund were priced by its models, says Kohler, its losses would be only about half of what they are. If he's right, the fund should rack up some hefty gains when the market becomes more normal. In fact, the fund has closed its doors to new investors to preserve those expected profits for existing shareholders.
But in fact, like most mutual funds, the Piper fund prices its portfolio by what's going on in the market, not by what its computers spew out. And now, says Kohler, mortgage-backed securities are a "dysfunctional market." William C. Powers, a managing director at Pacific Investment Management Co., agrees. The difference in prices from dealer to dealer, he says, "are as wide as I've seen in my 11 years in this market," indicating a highly illiquid situation.
Indeed, some investors wonder if the third-party services that gather market prices--such as Interactive Data Corp. or Kenny S&P Evaluation Services, a unit of McGraw-Hill Inc., publisher of BUSINESS WEEK--are up to the job of valuing complex, illiquid securities. "The absolute truth is they can't price these things," says George Hall, president of Clinton Group Inc., who runs a $700 million mortgage hedge fund. "I know, because they've asked for our help." Hall prices his own portfolio.
Executives at the pricing services say they've got a good handle on the hard-to-price securities. They gather bid prices from dealers and put that information into their own computer models to determine a fair price. "Our evaluators are specialists. They come from trading desks, and they know how to make a price judgment," says James Perry, a vice-president at Interactive Data.
"ALMOST GENERIC." The mortgage market may be illiquid right now, but illiquidity in itself does not mean you can't put a reasonable value on a security. Take corporate and municipal bonds. There's no "tape" or commonly shared record of prices in either of those markets, and only a tiny fraction of all bonds trade mn any day. But pricing services value them by comparing them with those that do trade. Muni bonds of a certain credit quality, maturity, and coupon tend to be priced similarly. "Munis are almost generic," says Francis H. Trainer Jr., director of fixed-income at Sanford C. Bernstein & Co. "All A-rated general-obligation bonds of medium-size city and maturity will be priced pretty much alike."
Corporate bonds, too, are segmented like munis and are usually priced at some spread, or level, above the yield of a Treasury bond of the same maturity. That spread can vary depending on the state of the markets and the state of the economy. Even customized instruments, such as a bond whose interest payments are tied to the price of a commodity, pose no great difficulty to the pricing services. The evaluators look at the price of the underlying commodity and how the interest is calculated.
The pricing services don't have the last word, either. Money managers can challenge the pricing of a particular security and often provide information that may prompt the pricing service to make a revision. Pension fund managers, who may report only monthly or quarterly to investors, can wait for the market or the services to catch up with a mispriced security. Mutual funds, too, can change the price a service has set for a security--if they can make a good case for it. And in fact, in cases where even a pricing service can't help, the funds do it themselves.
As the markets have created more innovative and unique securities, they've given investors a wide range of opportunities. But what has been sacrificed is the ability to get a price that everyone will agree on. That indeed may be the price of financial innovation.
HOW DIFFERENT SECURITIES ARE PRICED
PUBLICLY TRADED STOCKS Last sale in market where stock trades
U.S. TREASURY BONDS Last sale in the huge over-the-counter market
CORPORATE BONDS By comparison with similar bonds and with U.S. Treasuries
MUNICIPAL BONDS Matching up with similar bonds that have recently traded
By comparison with similar securities, spreads over U.S. Treasuries, changes in prepayment rates, dealer quotes, and computer models
PRIVATE EQUITY At cost, adjusted up or down when investment manager can document the reason for making the change