Harrison Fiduciary

In 2009 mortage-backed securities, and other related instruments, wreaked havoc on Securities Lending programs.   Many institutions froze assets in their securities lending programs because of illiquid securities held in the collateral pools.

Flash foward two years later and the specific details may have changed, but the principles remain the same.   Rather than mortgaged-backed securities, its now sovereign debt and the short-term paper of European Banks.

Remember, securities lending is a trading/investment program which attempts to capture the spread between the yield on the cost of the “loan” and the yield on the investment of the collateral pool.  By definition, collateral pools are managed to capture higher yields.  This can create, and has created, significant investment risk.

One would hope that Plan Sponsors learned their lessons in 2009.   But, in the event they that resumed business as usual, here are a few simple steps to engage in proper fiduciary oversight.

1.  Request a face to face meeting with the portfolio manager of the collateral pool.

Many different skills sets and functions contribute to the operation of a securities lending program.  However, no one is more important than the portfolio manager.  You need to understand how the collateral is managed.   Don’t have your questions deflected to a client service professional or anyone else.

Any resistance to allowing you to talk with the portfolio manager should result in you conducting a search for a new securities lending manager, ASAP.  It’s that simple.  You are the client.

2.  Review the portfolio against the investment policy statement and investment guidelines.

The first step is simply assessing the holdings of the portfolio and determining whether the portfolio is being managed consistent with the investment guidelines.  Ask the portfolio manager to walk you through the composition of the portfolio and explain the investment rationale concerning any holdings in the portfolio which you may not understand.

With each explanation, ask yourself a simply question:  “does this sounds prudent?”

3.  Request a face to face meeting with the head of compliance.

After the portfolio manager, the senior compliance person responsible for oversight of the securities lending program is the next most important person you need to meet.  Again, any resistance to this meeting should clearly question the long-term nature of your relationship with the securities lending provider.

Ideally, this meeting should be solely between your staff and the compliance professional.  Neither the portfolio manager nor anyone with business line operational experience for the securities lending program should attend this meeting.  You want to be sure that the compliance professional operates with autonomy and independence.

This meeting should cover three distinct topics:  1) the reporting structure of the compliance group, including a description of the flow of information and communication in the event that a significant problem is uncovered; 2) a detailed description of each of the processes and procedures designed to monitor the securities lending program; and, 3) a review of any compliance violations and the corrective actions taken in response to the violation.

As the meeting approaches its conclusion, you should ask the compliance officer to describe their own internal processes for reviewing and updating the compliance department.  Ask about any weaknesses or where they might be directing added resources.   No organization is perfect and no organization is exempt from the obligation to learn from experiences.   An honest response to these questions will engender significant trust btween you and the securities lending manager.

The success of any securities lending program is dependent upon generating high investment yields in the collateral pool.   This “yield chasing” can produce some significant unintended consequences.  As investors continue to “chase yield”, it is the plan fiduciary’s job to make sure these activities are prudent.

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Asking the Right Questions — a Fiduciary Responsibility

Sovereign debt (Greek and others) continues to plague financial markets.  My last few posts have tried to illustrate that these are not abstract issues, but can have real impact on money market funds, securities lending and stable value programs.  Fiduciaries must understand these implications.

Today the NYTimes reports that many money market funds have been paring back their exposure to european bank debt.  Wary Investors Shun European Banks.  As explained in the article,  European Banks rely heavily on short term funding provided by U.S. money market funds.   And, let’s not forget that most US investors turn to money markets as safe investments.

Not surprising, there is a wide spectrum of investment views on european sovereign and bank debt.  The Times points out these different views and, these differing views make markets. Again, no surprises here.

When asked about money market funds’ exposure to european debt, Deborah Cunningham, a senior portfolio manager at Federated Investments commented, “We’re always rethinking it and assessing it, but we’ve not come up with a different answer,” she said. “We don’t feel there’s any jeopardy with regard to repayment.”

Similarly, a spokesman from Fidelity Invetments, Adam Banker explained, “We’re very comfortable with our money market funds’ European bank holdings, including French bank holdings.”

Both Federated and Fidelity are huge players in the 401(k) retirement arena.   The article reports that they manage $114 billion and $428 billion, respectively in money market funds (note, the article was explicit about the Federated money market assets under management, where as the Fidelity number was not specifically identified as money market assests. However, Fidelity reports that it currently manages $1.5 trillion of assets, so it is reasonable to assume that $428 billion is held by money market funds).

The real point is that Federated and Fidelity collectively manage more than $500 billion in money money market funds.  Thousands of plan participants are relying upon their judgment with respect to the safety and security of the participants retirement assets.

The volatility of financial markets these days is historically very high.  In large part due to questions raised by European Debt.

Fidelity and Federated must do better than “we’re very comfortable”  or “we don’t feel there’s any jeopardy … “.  Those are nice quotes for a NYT article.  But for fiduciaries these quotes should constitute red flags.  If we have learned nothing else from the financial crisis, bland statements issued by corporate spokespeople have the potential to hide serious issues.  According to the Times article, Federated has about 13 to 17 percent of assets … invested in French bank debt”.   That is not insubstantial.  It begs further explanation.

For any Plan Sponsor whose retirement plans offer Fidelity or Federated money market funds, pick up the phone today.  Just ask a few basic questions.  Remember, other smart investment professionals are not comfortable.  They in fact see potential jeopardy ahead. Fidelity and Federated must explain their positions.  Here’s a few questions for starters:

• Why are you comfortable?
• Why isn’t there any jeopardy?
• How did you analyze your investment positions to reach this conclusion?
• What assumptions did you make?
• What are the weakest points in your analysis.

As if often the case …. a few open ended questions can spark a very enlightening discussion.

Plan fiduciaries have an obligation to ask these questions and assess the reasonableness of the responses.

Rarely would I turn to Ronald Regan for wisdom, but here goes,  “Trust, but verify.”

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