Deer Park Road Mgmt. Pays $5 Million over Valuation Issues

I bet it’s fun to run a hedge fund in Steamboat Springs, Colorado. In my mind’s eye, my life as a hedge fund manager there has me skiing in the morning, thinking up interesting and profitable trades on the Storm Peak Express, and then heading back down the mountain to click them into existence in the afternoons. Tappity tap tap tap. My office is filled with Bloomberg terminals. It’s all very easy, but engaging and exhilarating, too.

It’s probably not really like that. In real life, you have weird aches and pains, and snow gets in your boots. You worry about your kids. Are those trades coming together like you need them to? Sometimes you have to pay a $5 million penalty to the SEC. It puts a damper on things.

That’s what happened to Deer Park Road Management in June. Deer Park actually is in Steamboat Springs. You can find it on Bangtail Way there, which is almost too much. Anyway, Deer Park has made itself into a prominent player in the residential mortgage-backed securities space, growing its assets under management from several hundred million dollars to more than $1.5 billion between 2012 and 2015. Today it manages over $2.5 billion. But it ran into issues in valuing some of the securities in its portfolio. Why does that matter? Well, to hear the SEC tell it:

Valuation of client assets is a critically important area for investment advisers. Failure to properly value assets can impact key areas of fund operations and also potentially lead to over or under payment of withdrawal proceeds, incorrect calculation of fees and inaccurate performance reporting, among other things.

Deer Park’s problem, the SEC says, was that from 2012 to 2015 its compliance policies and procedures failed to address sufficiently how to conform the firm’s valuations with GAAP. Also, given its use of valuation models and pricing vendors, and the potential conflict of interest arising from traders’ ability to determine the fair value assessment of a portion of the positions they manage, its policies weren’t reasonably designed for its business practices.

The Valuation Policy

The valuation policy for the portfolio in Deer Park’s flagship STS Partners’ fund had two components. First, it provided that assets must be valued in accordance with GAAP. Second, it contained a pricing source protocol that prescribed sources to be used to value its securities.

As to the first component, the valuation policy said Deer Park would value securities at “fair value” in accordance with Statement of Financial Accounting Standards No. 157 and then with Accounting Standards Codification 820. ASC 820 defines “fair value” as “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” Sort of what you would think, right? ASC 820-10-35-36 provides that the methods used to measure fair value should “maximize the use of relevant observable inputs and minimize the use of unobservable inputs.” ASC 820-10-35-24C provides that, when market participants use models to assist in determining fair value those models must be calibrated to relevant observable market data.

The SEC says the valuation policy lacked procedures regarding how it should ensure consistency with the requirements of ASC 820 for the positions Deer Park valued. For example, though Deer Park relied heavily on valuation models, its valuation policy did not mention the calibration requirement in ASC 820,2 and Deer Park gave no training on calibration. The policy also didn’t mention any valuation methodologies, and lacked procedures to promote consistency in valuation and to reduce the potential conflict of interest arising from the role of traders valuing securities they managed. Deer Park’s Risk Management Committee was supposed to ride herd on the pricing source protocol but also was allegedly deficient. For the period at issue, that committee consisted of a former geochemist, a former tax accountant, and a lawyer, none of whom had experience in bond valuation and two of whom were related to a mysterious “Portfolio Manager A”.

Alleged Pricing Shenanigans

According to the SEC, the looseness in Deer Park’s valuation policy led to some skewed valuations by its traders. Here are a few:

• In March 2015, Deer Park sold a part of its position in the RMBS bond SASC 2006-WF1 M6 to a dealer for $56. Several days later, that dealer sought to buy more of the bond from Deer Park. It bid $57.50 and on March 25 increased its bid to $59, but Deer Park wouldn’t sell even at that higher price. For the month-end valuation, Pricing Vendor A raised its price for the bond to $54.94 while Deer Park traders valued the bond at $50. This end result a final March valuation of $50.94.

• “[T]he Deer Park traders . . . conveyed inaccurate information concerning the price at which Deer Park bought or sold a bond. For example, in July 2014, Deer Park bought an additional piece of the bond MSAC 2007-HE7 M2 at $29.25, yet listed a price of $21 in a column with the heading ‘add-on’ in a spreadsheet provided to Pricing Vendor A.”

• “Deer Park in June 2013 received a message from a broker that the cover price of [CMLTI 2005-OPT3 M5] at an auction was $35.13, but valued the bond using an internal valuation of $12.09.”

The SEC charged Deer Park with violating Section 206(4) of the Advisers Act and Rule 206(4)-7, and its Chief Investment Officer Scott Burg with causing Deer Park’s violations.

Two Points

One thing I don’t quite get about the SEC’s allegations on the valuation policy is its treatment of ASC 820. The policy did explicitly say that Deer Park would value securities at “fair value” in accordance with ASC 820. As a policy matter, that seems sound. But the order explicitly says, “[A]lthough Deer Park relied heavily on valuation models to value the securities in the STS portfolio, Deer Park’s valuation policy did not mention the calibration requirement in ASC 820.” How specific did Deer Park have to be? I guess pretty specific! Other fund advisers should take note and be aware that if the weeds of a particular GAAP pronouncement address a situation you face, it is worth digging into those and addressing them in your written policies and procedures. That said, without the diversions from the valuation policy described later in the order, I wonder if this matter would ever have seen the light of day.

Separately, how did this see the light of day? For all of the disparities between the market-based pricing and the values allegedly engineered by Deer Park’s traders, the order doesn’t discuss a lot of harm to counterparties. It sounds like it could be a whistleblower, or maybe it arose from a routine exam.