But the temptation to avoid an asset write-down is a strong one, because once an asset write-down is reported, the value of plan holdings drop, exposing plan fiduciaries to consequences they would rather avoid. Chief among these adverse consequences is that an asset write-down requires marking the assets to market. This decreases collateral value used for leveraged trades. So if collateral decreases, the fund may be required to sell assets to maintain required leverage limits. Decreased collateral value also impacts any discounted cash flow analysis the fund may undertake.
This is precisely what happened in Sept. 2022 in the UK in the LDI market. the budget proposed by then prime-minister Liz Truss caused the UK bond (gilt) yields to explode higher. This, in turn, caused collateral value in leveraged LDI trades to become less valuable and collapse, jeopardizing the entire LDI market. No small thing.
But while the temptation to avoid asset write-down (to avoid collateral value decrease) is high–that strategy only works in transitory markets, where a value bounce-back is foreseeable. However, in today’s market, no reliable indicators suggest that market stability is anywhere on the horizon. Rather, failures are looming almost daily.
THE FAILURE OF LEHMAN BROTHERS
Lehman Brothers is the infamous poster child for an asset manager choosing a head-in-the-sand approach re: asset values that were dropping across the board.
By mid-2007, the quality and value of Lehman’s asset holdings were under scrutiny. So its management team evaluated ways to reduce its dangerously high leverage. But Lehman found itself with a dilemma. It did not want to raise capital on public markets, lest it send a signal of weakness to the market.
But reducing leverage through asset sales was equally problematic: it could not sell assets without doing an asset write-down to fair market value, because, of course, no one would buy those assets at anything other than fair value. And recognition of those asset losses would undermine the collateral value of the firm’s remaining assets that it used for repo market financing.
Lehman kept the valuation ruse as long as possible without doing an asset write-down. But as everyone now knows, its massive leverage in low-quality CDO and MBS bonds ultimately exposed Lehman for the fraud it was–and the rest is history.
This problem likely exists on a massive scale in asset management today. No one wants to do an asset write-down and expose the low quality of its assets. So, reports regularly rely on “net asset value” (which is no statement of fair value at all) rather than report actual fair value.
Doing this in the context of a pension investment is a violation of fiduciary duty.