The Securities and Exchange Commission is updating rules governing the way mutual funds value their holdings, a reflection of how fund firms have struggled to determine the value of mortgage-backed investments amid the subprime-lending crisis.
Regulators are reacting to an explosion in derivatives and mortgage-backed bonds that don't always trade on exchanges, Douglas Scheidt, an associate director in the SEC's investment management division, said yesterday. The guidelines, to be proposed this quarter, will set out steps to value assets when trading prices aren't available.
"Funds seem to be relying on stale pricing on several occasions," Scheidt said. "They were continuing to value the securities at prior levels" even though "facts would suggest that the price would have gone down."
Baltimore-based Legg Mason Inc. recently arranged about $1.5 billion in financing to shore up two foreign money market funds against losses on debts related to mortgage-related securities known as structured investment vehicles. Bank of America Corp. and SunTrust Banks Inc. have taken similar actions to prevent investor losses. Legg Mason, which is scheduled to report earnings Wednesday, has said it will take a $90 million charge to reflect those moves.
Federal Reserve Chairman Ben S. Bernanke said last week that the lack of prices for such securities helped erode investor confidence, contributing to billions of dollars of losses.
The new rules, which will be binding for companies registered under the Investment Company Act, mark the agency's "first comprehensive" revision in four decades, Scheidt said.
The effort, which may also prove useful to hedge-fund managers, will lay out the degree to which mutual funds can rely on price quotes from brokers and professional services. The guidelines will also address the responsibilities of funds' boards of directors to make sure assets are correctly valued, Scheidt said.
"The subprime crisis has helped motivate the SEC to take another look at valuation," said Elizabeth Knoblock, a former SEC attorney who is a partner at Mayer Brown in Washington. Over the past few years, "the SEC staff was fairly laissez faire" unless they caught an investment adviser "inflating assets to charge more fees."
Mutual funds determine the net value of their portfolios each day. That sets prices at which investors can sell shares back to the fund and new investors can buy in. Fund managers base calculations on trading prices "readily available" from exchanges, according to SEC rules.
When prices don't exist because an exchange is closed or an asset is infrequently traded, funds base valuations on prices for which they can reasonably expect to sell. In such cases, fund managers rely on quotes from brokers and pricing services.
Inaccurate asset prices may prompt mutual fund managers to overestimate a fund's net value and overpay when shareholders sell back their stakes. That can shortchange long-term investors.
When demand for subprime-backed debt dried up last year, more than 80 percent of investment managers had difficulty obtaining prices for mortgage-related investments, according to a survey in September by Greenwich Associates, a financial services consultant in Greenwich, Conn.
Brokers stopped providing quotes out of concern that they might have to honor the prices and buy back securities that had plummeted in value, said Timothy Sangston, a managing director at Greenwich Associates.
SEC Commissioner Paul Atkins said in November that the market tumult showed the need for updated "valuation" guidance vetted by the agency's commissioners.