Sloppy subprime valuations on Wall Street?…

July 25, 2008

On Wednesday the SEC released its second-ever “ComplianceAlert.” (Gee, what ever happened to spaces between words?) The alert, addressed to SEC-regulated firms (e.g. broker-dealers and investment advisers), used a low-key tone but raised serious issues. For example, SEC examiners found some large broker-dealers to be surprisingly sloppy about verifying the values their trading desks assign to subprime mortgage-related products.

It’s disturbing to learn that at some Wall Street firms, the process for independently verifying traders’ pricing was “of questionable merit.” Problems included “the use of outdated information in determining valuations, reliance on non-independent contributing sources for valuation determination, the failure to fully address variances, and the usage of overly manual procedures.” Insufficient and/or inexperienced staff was also a factor at some shops.

At certain unnamed broker-dealers, subprime securities held as collateral for financing transactions were “solely priced by proprietary traders and/or outside pricing services,” with zero oversight by the personnel who were supposedly overseeing these valuations. It’s rather troubling that, at a moment when dealers are presumably on high alert about the financial health of their counterparties, any firm holding subprime-related collateral would be anything but anal-retentive about how it’s valued.

The SEC alert only addressed broker-dealers’ internal valuations. But companies outside Wall Street often turn to experts for valuations of illiquid securities held on their books, and who would those experts be? Oh, yeah, big Wall Street broker-dealers. So if some of the folks on Wall Street have flawed processes for valuing subprime mortgage-backed securities, other companies may unwittingly be going along for the ride.

If, this far along in the subprime crisis, the compliance departments at some broker-dealers still aren’t on top of their processes for valuing subprime paper, how much confidence should we have that these guys are correctly valuing other kinds of illiquid securities?

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