Business and financial regulation in the United States builds upon two worthy traditions - self-regulation and self-disclosure. By design, these traditions preempt and represent lightweight alternatives to more heavy-handed and prescriptive direct regulation by government agencies. When the SEC deputizes private organizations such as the NYSE to police its members, it is adhering to the time-honored tradition of deputizing private citizens to maintain public order. When the SEC requires electronic disclosure, it respects the dependence upon, and responsiveness of, financial markets to the flow of information - to the idea that, indeed, markets are little more than the flow of information.
However, when industries themselves call for more self-regulation and more self-disclosure, it is always an act of desperation, not merely because they want to avoid direct government oversight, but because they are acknowledging that they can no longer survive without some measure of public accountability and public trust. They are acknowledging that the open markets to which they pay fealty now threaten to consume them.
In that spirit of desperation, today we are privileged to experience the much-anticipated release to the President's Working Group on Financial Markets of two private sector reports on hedge fund best practices - one from the hedge fund industry and one from institutional hedge fund investors (primarily pension funds, endowments, and foundations). These reports represent responses to the meltdown in the financial services industry that has led to the evaporation of more than $245 billion in asset write-downs and credit losses since the beginning of 2007, and to market instability that the hedge fund industry no longer trusts it can manage.
What strikes me in reading these reports, and observing the conversation about the recent financial crisis from a distance, is the centrality of the problem of valuation. Both reports combine reference to valuation with other key aspects of hedge fund management and investment - disclosure, risk management, taxation, accounting, liquidity, trading, and compliance. But there is a palpable sense that the other practices and conditions are secondary - that all would be well if we only knew how to value structured securities and derivatives.
The bottom line is that we don't. The credit rating agencies don't. The banks don't. The hedge funds don't. Institutional investors don't. And in the absence of robust valuation data, methods, and models, there is no floor to the risk that financial institutions face when they toy with structured securities and derivatives.
Both reports carve out special sections for the discussion of valuation challenges. The institutional hedge fund investors' report - which starts by affirming that "valuation is ultimately at the core of any investment" - is more discursive on this subject than the hedge fund industry report. This may be indicative of general differences in stylistic approaches to the subject matter. Or it may suggest an entirely different perspective on the depth of the issue, with anxiety about valuation reflecting investor concerns more than the concerns of asset managers.
While both reports focus on the need for better valuation methods, valuation policies, valuation committees, and valuation governance, neither really grapples with the core reality - which is that huge dollar volumes of assets simply cannot be valued. There is insufficient liquidity and inadequate data, and in their absence, values depend upon someone simply assigning a value that has no relation to anything except the interest in making a market out of vapor. Until the hedge fund industry, and government regulators and policymakers, acknowledge this deep emptiness at the heart of the financial industry, all the reports in the world will amount to nothing more than a rearrangement of the deck chairs on the Titanic.
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