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An Independent Fiduciary Can Be Your Best Friend (and Security Blanket)

No one has the right answer.  This weekend’s news papers and financial blogs are filled with every prediction imaginable (from economic disaster to boons) and financial advice to fit each prediction.

With the markets swinging 500 points in opposite directions, this is not the time to embark on market predictions and changes in investment strategies.

Steep, drastic price plunges are not fun.  Like the free-fall drop on a roller-coaster when your stomach does its own loop-de-loop, these prices plunges elicit a real and physical reaction.  Panic is scary.  A racing heart beat, cold sweats and sleepless nights are subjects of cliches.  But, when you are experiencing it yourself, it ain’t a cliche.  It is very real.

From the deepest wells of our very being, panic surges forward.  The visceral emotional response becomes its own reality.  Emotion as reality.  That is never a good place to be. And certainly, not a time to be making decisions.

Prudence on the other hand, provides the required antidote to panic.  In the perennial push and pull between heart and mind, prudence provides the counter-weight to panic. Defined as “care, caution and good judgment, as well as wisdom in looking ahead” (see, www.dictionary.com), prudence requires the mind to prevail over the heart.

The key to extracting oneself from the distorted reality of pure emotions, one needs a trigger, or a technique to break the panic spiral.  Within the world of managing and overseeing retirement assets, care, caution and good judgment can be supplied by an Independent Fiduciary who can review and assess your portfolios against the plan’s Investment Policy Statement (IPS).  Call her.  She is paid to be prudent.

Hopefully drafted with the assistance of professionals and during a period of lessened volatility and other external pressures, an IPS reflects the prudent judgment of plan fiduciaries.  The IPS, in effect, is the road map for wisdom in looking ahead.  An Independent Fiduciary should always have the IPS in hand.

Have the investment performance of each of the plans’s asset classes evaluated.  Determine if any portfolios need to be re-balanced in order to reflect the allocation among assets classes envisioned by the IPS.  Instruct your Independent Fiduciary to make certain recommendations and then implement them.

Taking specific prescribed actions can deflate the power and energy of panic.  The key is to make sure that these actions had been well thought through before the specter of panic arises on the horizon.  An Independent Fiduciary can help allay the fear and the imprudent actions which a volatile market environment can inspire.

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Is Anyone Paying Attention?

The debt-ceiling crisis has been momentarily addressed and the financial markets are continuing to tremble.  In my past few blogs, I’ve raised topics which Plan Sponsors should address with their various plan fiduciaries.   It’s all about being prudent.  Today, the focus is on Securities Lending.

In the 2008-2009 financial crisis, Securities Lending programs froze.  Collateral pools experienced huge liquidity issues and loans could not be unwound.  Pension plan portfolios suffered significant loses.

The last time around the culprits were mortgaged-backed securities and all the various related derivatives.  This time, it could be sovereign debt.  Today, the NYT reports Large Banks in Europe Struggle with Weak Bonds.  The main thrust of the article is that sovereign prices for certain European countries are weakening dramatically thereby affecting the capitalization of some large European banks.

However, tucked deep in the article are references to repo transactions and the posting of collateral.  Sovereign debt is often used in these trascations.   This is where Securities Lending (the “reverse” side of a repo transaction) comes into play, and where Plan Sponsors should be focusing their questions.

Plan Sponsors should examine two separate, but very closely related, potential risk related to European debt and the European banks:

Short-Term Bank Paper Held by Collateral Pools — Remember Lehman Bros?  It’s paper was held by many investors, including pension funds.  As the paper became worthless, securities lending collateral pools lost values.  Plan Sponsors are on the hook for the investment losses related to collateral pools.  Many plan sponsors were not happy.

Collateral Posted by Broker/Dealers — When broker/dealers borrow securities to facilitate short sales by their clients, the broker/dealer must post collateral.  Often, Sovereign Debt offered as collateral qualifies for better terms than other forms of collateral.  Therefore, there is a huge incentive for broker/dealers to offer Sovereign Debt for these purposes.  However, to the extent that debt from any of the troubled European countries was used as collateral, and as prices continue to deteriorate, the broker/dealers will have to post more collateral as the value of this debt deteriorates.  Watch the capitalizations of the broker/dealers.

Don’t dismiss the role of broker/dealers in the stability of our financial system.  As Lehman as entered in bankruptcy, all the others teetered on the edge of the abyss.

Few areas are more technical, “nichey”, or esoteric than Securities Lending.  If Plan Sponsors want to partake of the benefits of Securities Lending, then they must really understand the risk.  They must dive into the details which I outlined above.

If these questions are too “geeky” for Plan Sponsors to develop in-house expertise, then they should delegate oversight to true experts.  Ignoring complicated issues can never be prudent.

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Does Anyone Really Know?

Everyone takes money market funds for granted.  Don’t know where to invest idle cash?   Stick it in a money market fund, right?  Our entire financial system treats money market funds as safe and secure investments.

And, they are safe.  Until they are not.

Today’s NYT, Hopeful, but Wary at Money Markets, prudently identifies the fault lines and risks associated with money market funds.   Fortunately, Edward Wyatt’s reporting is not a Chicken Little,  the-sky-is falling rendition of risks inherent in the financial markets.  [The press and blogosphere are filled with too many of these.]  Instead, Wyatt effectively outlines and explains the risks inherent in money market funds in the context of extreme volatility in treasury securities.

Money market funds exist solely by virtue of a vastly complicated regulatory structure.  Anyone interested in the risks associated with money market funds must be familiar both with the regulations as well as with the investment securities.  One without the other is simply half-the-story.

And, as the Wyatt’s article points out, money market funds are not free from risk.  During the financial crisis of ’08-’09 one of the largest money-market funds, Reserve Primary Money Market Fund, “broke the buck”.  That is, investors lost money.

Plan Sponsors often are not familiar with all of the intricacies surrounding money market funds.  As fiduciaries, however, they should understand the general parameters of the risks.  And, more importantly they should make sure that the experts they have hired are in fact experts on every intricacy and beyond.  The hired experts, however, do not take the plan fiduciaries off the hook.  Everyone needs to be doing their job.

Wyatt, quoting an executive from Fidelity Investments, reports that Fidelity, which manages $440 billion in money market assets, has had “a contingency team focused on this since the end of May.”  Fidelity recognizes that “we have to be prepared to respond to the unthinkable”.

In light of the Reserve Primary Fund’s experiences just a few short years ago, the previously unthinkable is not so unthinkable.

If Fidelity is engaged in contingency planning, prudent dictates that all plan fiduciaries should be engaged in similar contingency planning.  In the financial world, the unthinkable can happen.  Plan sponsors must plan accordingly.

http://nyti.ms/qufP8p

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