Maybe Merrill isn't Enron after all.
According to the WSJ, as a result of the forthcoming big subprime writedown at Citi, "analysts are beginning to see Merrill's big hit as less of an anomaly than originally thought." The WSJ explains that the industry-standard valuations were based on credit ratings, and that the write-downs result from revisions of the ratings. The ratings were off because they didn't reflect the rise in defaults.
So why didn't the firms re-price on their own to reflect the rise in defaults as soon as they learned of that rise? Could it be the risk of liability for departing from industry standards? But that won't prevent the litigators and regulators from leveling fraud charges for failing to flag subprime risks and Sunday-morning quarterbacking the governance that led to the failure.
The better solution would be to fix the valuation model. For example, a commentor to my yesterday's post says:
The current method of rating only attempts to recognize apparent value. That evaluation could be appended with what can be termed the “TNSTAAFL”, (there’s no such thing as a free lunch), standard. Any asset producing 10%, (?%) or more over prime would receive a 1+ rating with a .1 increase for each additional 1%. As an investor, one could thus take into account the greater risk generally incumbent with higher returns and balance against both the historical rating and faith in the integrity/competence of management. Management, for their part, will have put the burden of responsibility onto the informed investor in the same manner as requirements for insider trading adds transparency to transactions.
Also, we should recognize that the basic problem here is that the market for the relevant securities dried up, forcing non-market valuations (i.e., guesses). As I've suggested, this could be addressed by prediction markets and insider trading.
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