Spokesmen for the SEC, JPMorgan and Citigroup declined to comment.
Related News: Hedge Funds Facing U.S. Criminal Probe Over Bond Valuations
The probes show the SEC isn’t letting up in its multi-year push to try to uncover illicit conduct in one of Wall Street’s most opaque markets. Bonds tied to home loans and other debt aren’t bought and sold on exchanges, and the securities can go months without trading. That lack of transparency prompts investors to value bonds by relying on estimates from brokers and other third parties, a system the SEC believes is ripe for abuse.
Hedge fund firms typically task internal committees with valuing thinly traded bonds, a process that prevents conflicted portfolio managers from assigning favorable prices to their own investments.
Still, portfolio managers can push back if they feel prices don’t reflect the current market. In such instances, they sometimes tap brokers at banks for additional, higher estimates.
The portfolio manager might argue that the higher valuation is more accurate because it comes from an actual market participant. If the hedge fund’s valuation committee accepts the broker quote in pricing a bond, it might make the difference between a good month or a bad one for money managers depending on the size of the position in their portfolio.
Portfolio managers at hedge funds have significant clout with brokers because they are sought-after customers. Hedge funds engage in frequent buying and selling, they amplify their bets with borrowed money and they are big buyers of derivatives. Banks receive millions in fees from such services.
The SEC’s suspicion that brokers sometimes provide sham prices isn’t just theoretical. In June 2016, the agency accused two portfolio managers at Visium Asset Management of soliciting phony quotes from friendly brokers over an 18-month period to justify inflated valuations on distressed debt holdings.
Due to the scheme, Christopher Plaford and Stefan Lumiere were able to post a 0.68 percent gain in 2011 for the credit hedge fund they ran at Visium, instead of a roughly 4 percent loss, the SEC said. Plaford has pleaded guilty to related criminal charges brought by federal prosecutors, while a judge sentenced Lumiere to 18 months in prison in June for his role in inflating some of the firm’s bond investments.
The SEC is also looking at Keri Findley, a former partner at Dan Loeb’s Third Point hedge fund firm, people familiar with the matter have said. The regulator is probingwhether Findley, who left Third Point in February, caused mortgage bonds in her portfolio to be undervalued, the people said.
While it’s unclear how she might have benefited from her investments being worth less, it’s possible that undervaluing a position for much of the year could make it easier for a portfolio manager to then mark up the investment to match market prices at year-end when firms calculate fees and bonuses.
A spokesman for Findley has declined to comment. Third Point has said it has a rigorous process for pricing securities and that it is cooperating with the SEC.
Technological advancements have assisted the regulator. In recent years, it has been using computer algorithms to spot bond trades that occur at prices that are suspicious because they don’t reflect recent transactions. SEC officials say the algorithms have helped them to identify billions of dollars of problematic trades.