Harrison Fiduciary

Harrison Fiduciary Group — Our Pledge

As anticipated, the SEC issued it’s report, Study on Investment Advisers and Broker-Dealers, and recommends a new Unified Fiduciary Standard for broker/dealers and investment advisors.  Uniformity can be applauded, as well as a higher standard applicable to broker/dealers ….but, let’s not kid ourselves, as I discussed in my prior Post, it is a diluted fiduciary standard allowing for the payment of commissions, the sale of proprietary products and other accommodations to Wall Street.

At Harrison Fiduciary Group we will always rise above the morals of the market place and we pledge as follows:

1. We will not receive commission income;
2. No conflicts will be tolerated;
3. We will not promote proprietary products; and
4. All actions that we take, and decisions which we make, will be solely in the interests of participants and beneficiaries.

Regulators and Congress may be compromised by political interests, but at HFG we are not subject to these pressures.  Instead, we are guided by our core corporate values which shall remain undiluted.  Our responsibility is to put the interests of plan participants ahead of our own.

Our flat fee schedule goes to the heart of our business model, and reflects our core fiduciary values.  For each assignment we will be paid a flat fee and not a basis point fee on the size of assets under management.  The “basis point” model has become endemic to the pension industrial complex.  Many service providers attempt to hitch their revenue streams to the ever growing pool of pension assets –investment managers, custodians, record-keepers and consultants.  We aim to break this link.

As a fiduciary we will be paid a fee in exchange for our fiduciary services.  This fee will reflect the fiduciary risk we assume, the complexity of an engagement and the amount of resources which will need to be devoted to the engagement.

Overseeing and managing the hard earned retirement assets of plan participants is a position of trust.  At Harrison Fiduciary Group we will earn and safeguard that trust zealously.

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Honest Talk about Fiduciaries

Next week, January 21, 2011, the SEC is due to deliver its report to Congress, as required by the Dodd-Frank Act, on the standards of conduct applicable to registered advisors and broker/dealers.  There is little doubt that this report will recommend a uniform standard — ostensibly, a fiduciary duty.  My greatest concern is that they will in fact adopt a unified standard and that they will trumpet fiduciary principles, but in reality it will amount to nothing more than a diluted version of fiduciary principles.

The lobbying by Wall Street has been intense.  Once the recommendations are made, the lobbying will get even more intense.  Wall Street’s business model is at stake.  This guarantees a watered down result.

In fact, the directives given by Congress to the SEC effectively preordained a diluted notion of fiduciary duty.  On the one hand Congress raises the prospect of a unified fiduciary standard, but on the other, also makes provisions for brokers to continue to sell propriety products provided there is sufficient disclosure of compesantion arrangements and conflicts of interest.   This is disappointing.

Simply put: commissions and disclosure are not consistent with fiduciary principles.

Fiduciaries are subject to a duty of loyalty.  This duty requires that a fiduciary put  client interests first, not engage in acts of self-dealing nor involving conflicts of interest.  Earning commission income from the sale of proprietary products clearly raises the potential of acts of self-dealing and conflicts of interest.  A fiduciary’s actions should never be clouded by acts of self-dealing.

Congress believes that disclosure will serve as the bulwark against acts of self-dealing.  In other words, if a broker discloses potential commissions, as well as how the commissions might impact his compensation, then the broker is “off the hook” from a fiduciary perspective.

Here, Congress is simply mistaken.  While disclosure is the corner stone of the securities laws, it does not hold the same weight as far as traditional fiduciary principles.   Under the securities laws, whether it is corporations or mutual funds, the underlying theory is that material facts need to be disclosed and investors can then exercise their own judgment based upon the facts.

For a fiduciary, however, the prohibition is fairly straight forward.  No acts of self-dealing.  A fiduciary cannot use its fiduciary discretion to engage in acts of self-dealing.   And, a fiduciary cannot disclose the potential self-dealing and obtain the client’s consent.

I focus on commissions and disclosure because it serves as a perfect example of how fiduciary principles will be watered down.  For those of us who believe that fiduciaries have a critical role to play in our financial system, this is a disappointment.  The marketing machine of Wall Street has the potential to dilute our commitment to longstanding principles.

At Harrison Fiduciary Group, we categorically reject efforts to masquerade self-dealing and conflicts of interest.  Our business model is structured on a fee for service basis.  Our fiduciary judgment will not be clouded by the potential to earn additional compensation.

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See No Evil, Hear No Evil, Speak No Evil

The Massachusetts Supreme Judicial Court handed trustee banks a disappointing decision on Friday; Massachusetts Ruling on Foreclosures Is A Warning to Banks.  Gretchen Morgenson of the NYTimes has been a prescient observer of, and commentator on, the subprime frenzy, subsequent collapse and its aftermath.  In today’s paper, she reports on the  court’s ruling that U.S. Bancorp and Wells Fargo did not have proper title to mortgages when they instituted foreclosure proceedings.

Yes, everywhere along the way in the securitization process, people and institutions were sloppy.  Why pay attention to detail when there was so much money to be made?

However, there is a critically important sub-text here, which has far greater impact on our financial well being than simply paying attention to details.  The real issue is that the role of serving as a trustee has been dumbed down over time so that trustees claim, “not my job”  when it comes to assuming responsibilities for their actions.

The securitization process is a lengthy one with many parties participating.  However, at the end of the day, there is a trustee of a trust, and the trust holds certain assets.  In this case, notes and mortgages.

Scrape away all of the financial engineering and mumbo jumbo.  At a very minimum, a trustee must know what assets it holds and is responsible for the management and disposition of the assets.  This is not a new concept based upon fancy algorithms or computer models.  To the contrary, it is a basic principle of trust law dating back to the development of the common law in England.

And yet, in defending it’s actions, a spokeswoman for Wells Fargo, Vickee J. Adams states, “As trustee of a securitized pool of loans, Wells Fargo expects the entities who services these loans to abide by all applicable state laws, including those laws that govern foreclosure sales.”

There you go ….it’s the other guy’s fault!   Great legal defense.

Unfortunately, as a fiduciary, it is not that simple.  Yes, trustees are often authorized to hire service providers.  And, yes, trustees can make reasonable assumptions about the service providers.  But, trustees have an obligation to conduct due diligence on the service providers they hire and they have an obligation to monitor these service providers as they perform their duties.  They simply cannot hire someone and then walk away from this responsibility.

Serving as a Trustee requires the exercise of judgment and discretion.  The privilege of holding assets in trust, on behalf of another party, carries with it the obligation to act prudently. There is no way to get around this.

The problem is that the role of the institutional trustee has been dumbed down over the past decades.  The large trust banks sell their trust services as if they are simply record-keeping services.  Both the banks and their customers discount the obligations and responsibilities of serving as a Trustee.

In fact, with the blessing of ERISA, a whole new role has developed known as the “directed trustee”.  These are trustee’s whose roles are so limited  that they simply follow the directions of other fiduciaries.  It is this directed trustee role which has greatly diluted the concept of the discretionary trustee.

And so, we have ended up with a network of institutions who at one time proudly served as fiduciaries and exercised discretion on behalf of their clients, but now do everything to limit their roles.  Therefore it is now easy to point the finger of blame at someone else.

Our financial system is deeply in need of responsible individuals and institutions ready to assume fiduciary roles and discharge those responsibilities prudently.

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Golden Boy Steven Rattner Crossed the Line

He had it all: Brown, Partner at Lazard, started his own firm, Quadrangle Group, appointed Car Czar by President Obama, reported net worth of between $188 million and $608 million, and he regularly rubbed elbows with the likes of Bill and Hillary Clinton, Robert Rubin and Michael Bloomberg.

Wasn’t that enough?   What more did he want?  Another vacation house, a bigger bank account, more accolades?

On December 31st, when most of Wall Street either was sun worshipping in St. Barts, or dining on sushi at Nobu in Aspen, the NYTimes reported, New York Closes Pension Inquiry: Gets $10 Million.  So ends the drama surrounding Mr. Rattner, the Quadrangle Group, the SEC and Andrew Cuomo, the former Attorney General, and now Governor, of New York.   On probably one of the slowest news cycle days of the year, Mr. Rattner’s transgressions are practically swept under the rug.   Who is even paying attention?

I purposely characterized Mr. Rattner’s actions as transgressions rather than “alleged transgressions.”  No doubt Mr. Rattner vigorously denies any culpability.  However, from the perspective of a fiduciary, simply being involved in activities giving rise to ambiguous behavior is transgression enough.

For fiduciaries, there can be no ambiguity:  No conflicts of interest.  No acts of self-dealing. No questionable payments. No movie deals.

Mr. Rattner, and thousands of hedge fund, private equity, venture capital and investment managers, hold and manage assets that belong to other people — retirees who accumulate benefits over decades of employment.  They work “on behalf” of other people.  They are fiduciaries.

The investment stewards of pension funds must demand that all investment managers abide by fiduciary standards.  They must rebuff attempts by ERISA lawyers working on behalf of their investment management clients to eschew fiduciary responsibility .

Over a century ago, Justice Benjamin Cardozo eloquently wrote;

A trustee is held to something stricter than the morals of the market place. Not honesty alone, but the punctilio of an honor the most sensitive, is then the standard of behavior… the level of conduct for fiduciaries [has] been kept at a level higher than that trodden by the crowd. (Meinhard v. Salmon)

Though the language is flowery, and some criticize it for being to0 vague, and therefore impractical,  the principle and spirit abides; fiduciaries are held to a higher standard.

Notwithstanding his education, prior business successes and stellar reputation, Mr. Rattner failed to conduct himself “at a level higher than that trodden by the crowd.”  That is a disappointment.  Let’s not gloss over this behavioral misstep.  Upon reflection, it may present a critical insight to the future of our financial system.

After the crisis of ’08-’09, academics, businessmen and legislators endlessly debate the pros and cons of the various proposals to shore up our financial institutions and markets.  However, the simplest, least costly and most effective remedy lies in a change of behavior.  We need leaders in the financial community to abide by principles “stricter than the morals of the marketplace.”

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Tight Liquidity Can Create Volaitility

All is good in the financial markets, right?   The stock market continues to climb; and, Frank Norris in the New York Times suggests that the thrid year of a presidential term is a good one for the stock market. On top of that, no doubt, Wall Street and Corporate America will be thrilled that a compromise appears to have been worked out on the Bush Tax cuts.  And yet, I have a quesy feeling that a perfect storm is brewing with respect to stable value funds.

You may ask, what would a recovering stock market have to do with stable value funds? Experience shows that the two move hand in hand with one another —- except, in opposite directions. This phenomena is attributable one-part to investor phsychology and two-parts to the arcane mechanics of stable value programs.

Coming out of the financial crisis of ’08-’09, many plan participants sought safety in stable value programs.  First, the programs were typically marketed as safe (and possibly even as risk free); and second, with money market rates excessively low, stable value programs offered a slightly higher return.

Bingo — higher returns, lower risks and huge waves of money shift into stable value funds.

While yields remain at historically low levels, the robust returns generated by equity funds will likely attract attention from plan participants.  So far, plan participants have been reluctant to embrace the equity markets, but at some point, and we don’t know when, the equilibrium will tip and vast amounts of retirement assets will likely flow back into equity funds.  Plan fiduciaries must anticipate that a significant portion of these assets will come from withdrawals from stable value programs.

Prudence requires that plan sponsors plan for this contingency. If plan participants “head for the exit all at the same time” to cash out of stable value programs, plan fiduciaries will have to sell assets into a falling market.  We’ve seen this movie before.

Plan fiduciaries must instruct investment managers of stable value products to evaluate and monitor their liquidity needs.  Liquidity guidelines must be re-assessed for the market conditions.

Similarly, plan fiduciairies must also review the demographics of their participant base.  Understanding previous flows in and out of various investment options, can also provide important data for assessing liquidity needs.

Of course, rising equity equities markets are generally a good thing (assuming it is not a bubble brewing).  However, there can be unintended consequences.  The stable value world is a small niche within the global capital markets.   However, it is a niche with $700 billion of retirement assets.  It is also a niche in which many investors have been promised “safe” “stable” returns.  These promises can set the stage for a calamity.

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Simple & Risk Free?  Hardly.

Plan participants have flocked to Stable Value programs to the tune of $700+ billion. As the name implies,  and most investors believe, these programs are touted as safe investment options for plan participants.  Maybe yes, maybe no.

Offering investment yields greater than money market funds, without the volatility of bond funds, Stable Value programs are hybrid investment and insurance products.  An investment manager manages the underlying cash portfolio, and an insurance company or bank then guarantees (or wraps) the book value of the program.  In essence, the value of the fund is not suppose to go below $1/share.

Hybrid products, however,  offer complexity, and complexity presents risks.

In the current low interest rate environment, unique risks confront plan fiduciaries.

To date, stable value plans have generated a higher investment return than money market funds because they can invest in securities with longer durations, paying higher interest rates.  When interest rates turn higher, however, this benefit becomes a drag.  Money market funds are more nimble and can take advantage of the higher rates in a rising rate environment.

Since most Stable Value funds are “marketed” as higher return investment options, plan participants will be very surprised to learn that their Stable Value options may be paying returns less than money market funds.  Employees must be educated on the true risks and mechanics of Stable Value Funds.  Failure to educate employees properly can bring sizable fiduciary risks on the plan sponsor.

With interest rates so low, Fiduciaries must not only monitor an upturn in rates, but they must also track withdrawals from Stable Value programs.   If interest rates do not increase, participants undoubtedly will begin switching into investment options generating higher returns.  Whether this makes investment sense is irrelevant.

The wrap contracts (which guarantee the value of the stable value program) often contain covenants that require the Program to maintain a minimum number of participants or assets in the Program.  Falling below this threshold constitutes a breach of the wrap agreement, and would allow an insurance company to walk away from the guarantee.   This is a total disaster from the perspective of the plan fiduciaries.

The very name “Stable Value” lulls everyone — participants and fiduciaries, alike – into a false sense of security.   These are highly technical and complicated investment options that should be monitored, evaluated and negotiated by Stable Value experts.

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Credit-Related Strategies Warrant Heightened Scrutiny

It’s called the Great Liquidation.  As reported in today’s NYT, The Haggling for Troubled Assets Begins, “hundreds of billions of dollars of bad investments …are going up for sale”.  Fiduciaries must ensure that these bad investments do not end up in retirement plans.

Notwithstanding TARP, QE1 and QE2, financial institutions still hold impaired or “bad” assets.  This simply means that the assets are still held by institutions at values that are likely far in excess of their fair market value.

And so, the Great Liquidation begins.  The term — coined by Fortress Investment Group — refers to the prediction that “you’re going to see in the next five years, more financial asset liquidations than you’ve seen in the sum total of the past 100 hundred years.”  An exaggeration?  Ok, let’s assume it’s simply more than in the pat 50 years – that’s still a lot of assets being put up for sale.

If this appears daunting, don’t worry.   Fortress already has $12.7 billion of assets devoted to credit-related private equity and hedge funds.  No doubt the entire spectrum of the Wall Street herd — investment banks, commercial banks, hedge funds and private equity firms — will be bulking up in this area, if they haven’t already.

Just imagine a 2% management fee and 20% of profits on “hundreds of billions of dollars”.  Now that’s a nice bonus pool!

Before the Great Liquidation Orgy (my term) begins, however, Wall Street is going to need to raise money to indulge in this financial bacchanalia.  Certainly there will be private investors, wealthy individuals, sovereign wealth funds.  But the $16 trillion pool of pension assets is the granddaddy of all funding sources.

I can just see the entire pension investment consulting industry working itself into a frenzy cranking out their graphic laden presentations recommending Credit Related investment strategies and firms.  The graphs and the statistics, no doubt will be very impressive – worthy of PhDs.  But Beware.  “Its déjà vu all over again”.

Think back to the early 90’s.   Who had heard of hedge funds?   Private equity firms were still referred to as LBO firms.  In terms of financial markets and products it was a different era.  As the new century dawned, however, investment strategies and products exploded in complexity.  Simultaneously, in order to remain relevant, the pension consultants began touting these new products.

In time, consultants were recommending significant shifts in allocations to “Alternative Investment Classes”.  It was not surprising to see allocation recommendations of 8%, 10%, 15% or more to alternative asset classes.  In fact, in the summer of 2008, I had lunch with the Chief Investment Officer of a university endowment who said that they had allocated 45% of the endowment to hedge funds.

We all know the outcome of this story.  In the end, the investment returns of many plans were negatively affected by these allocations.  No one knows yet, if in the long run the plans were better off or worse for these significant allocations to Alternative Asset Classes.

We do know one thing, however.   Consultants merely make recommendations.  Plan fiduciaries hold the real power in making allocations to asset classes and to specific managers.

Without a doubt fortunes will be made in the course of the Great Liquidation.  The question is whether retirement plans need to venture into this arena.  Fiduciaries must invest assets prudently.   When a new asset class emerges, such as credit-related investments, how is a manager evaluated?  What’s the track record?  How is risk measured?  How are projected returns evaluated against the risks that are assumed?  What about due diligence on investments?

The list goes on and on.

The Media is going to feature the newly minted credit-related billionaires.  Investment returns may likely be huge.  The allure of jumping into these investments will be strong.  The consultants will be putting on a hard press.

Plan fiduciaries must be very wary.  For those who do decide to play in this game, make sure you do your homework.  Remember, you are investing other people’s hard earned retirement dollars.  Keep the financial debacle of 2007-2009 at the forefront of your mind.  And, tread carefully.

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Not In-House Lawyers

Any lawyer who has worked in-house in a financial services firm, no doubt, is not surprised about the mortgage documentation mess.  Articles abound in the newspapers:  Gretchen Morgenson, One Mess That Can’t be Papered Over; Joe Nocera, Big Problems for Banks: Due Process; and a NYTimes editorial, More on the Mortgage Mess.

As I have experienced, and many, many friends and colleagues have confirmed, few issues command less respect than properly documenting a transaction, a process or a meeting.  Everyone on Wall Street, and throughout the financial services industry views themselves as a deal-maker, a trader, a big-picture gal or guy.  Documentation is clearly beneath them.  (Yes, this condition crosses gender lines).

I will never forget in the early 90’s when equity swaps and other over –the –counter trades were gaining in popularity.  We were wrestling with the documentation process … executing confirms as well as master agreements.  Admittedly, it is a tedious process.

The Wall Street model had junior associates who worked directly on the trading desks who were responsible for completing first drafts of trading documents.  Deals were only kicked up to the legal department in the event that negotiations broke down over issues like indemnification or other liability limiting provisions.

Not so in our organization.  Notwithstanding my otherwise well-honed skills of persuasion, no one on the trading desk wanted anything to do with documentation.  Any piece of paper with more than 2 paragraphs of written English clearly was a “legal document” and belonged with “Legal”.

I tried to explain that understanding the legal documentation between two parties provided a junior person with valuable training.  Certainly someone who aspired to be an equity or fixed income trader would gain insight into their roles if they understood the contractual nature of the obligations they were creating.

I might as well have been from Mars.   Everyone just wanted to “do deals”.  Very few people were interested in “dotting the ‘I’s’ or crossing the ‘T’s’”.  In the excitement of wracking up large bonuses over the last decade, few people wanted to be bogged down by the careful, detail-oriented work of getting the documentation right.

And throughout Wall Street and beyond, the very people who were disdainful  of documentation, eventually assumed leadership of their firms.  Everyone knows, that the tone is set at the top.

Tens of thousands of mortgages, middlemen, issuers of securities, underwriters and sales people —the fact that there is a mess, does not surprise me.

Go take a poll of in-house lawyers.  I’m sure they read the various accounts of the mortgage mess simply shaking their heads with a profound sense of understanding.

As a lawyer, and as a fiduciary, I know in my gut (in my kishkes) that documentation is crucial.  For when the dust settles, all that is left are the documents.  Lawyers know that, and so do judges.

Fiduciaries have an obligation to act prudently on behalf of their clients.  There is no excuse and no tolerance for the lack of diligence in assuring that all documentation is perfect.  That is our duty.

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Securities Lending Pays for Custody

Louise Story’s original article was the subject of an editorial in Friday’s New York Times, The Bank Wins.  Both the original article and the editorial use the opportunity to engage in the popular and easy task of bank bashing.   However, jumping onto this bandwagon simplifies and overlooks otherwise complicated dynamics underlying our financial system.

Securities Lending– typically knows as Sec Lending — most often is tied to the custody services provided by banks. In fact, in the early days of Sec Lending, the Sec Lending units of banks were often housed within the custody area of banks. And custody sales people often sold Sec Lending relationships.  It wasn’t until the explosive growth area of the late 1990’s when they were granted status as separate divisions or areas within a financial firm.

Sec Lending became a very hot “valued-added” service for the custody banks.   First, pension plans hate paying custody fees.  But they have no choice because ERISA requires that plan assets be held by a custodian (either a bank or an insurance company).  Second, from the bank’s perspective there is little sexy or exciting in the realm of custody other than various accounting and record-keepping services — essentially commodity type products.  Sec Lending, however, holds out the prospect of significant fees.

Pension plans which engage in  Sec Lending can net the revenue generated by Sec Lending against custody fees.  The tight relationship between custody and Sec Lending is reflected in  Mercer consultant, Jay Love’s statement that,”Whenever we say no Securities Lending,” then they say ‘well, we need to talk to you about your custodial fees.'”

Ms. Story also states that “Banks often pressure pension funds to participate in securities lending, pensions consultants say.”   Yes, banks clearly want to sell Sec Lending services, but focusing on “pressure”  seriously mischaracterizes the relationships between banks and pension fund decision-makers.

The custody and Sec Lending business is highly competitive.  Banks don’t like to lose customers … especially to competitors.  Fees and relationship are highly negotiable.

Pension plans have enormous leverage.  They do not have to accept the terms foisted upon them by banks.  And, they have the ability to shop terms around the various banks.  This happens all the time.  There are few secrets in custody/Sec Lending marketplace.   Remember, the pension plans always have the option of saying “no”.  Nothing requires Sec Lending.  This is a powerful position from which to negotiate.

Ms. Story, and the Times editorial, paint a picture of hapless powerless pension plans who are manipulated and at the mercy of the big bad banks.

This simply isn’t the case.  Pension plans must simply exert their fiduciary powers.  Plan fiduciaries must assess  the various risks posed by financial products and accept those risks when they are being adequately compensated.  In order to assess risks, however,  the risks have to be understood.  And this is the rub.  If Mr. Davis (see, Part I) of the New Orleans municipal employees fund is representative of pension decision makers, then assessing risk will be a daunting task.  Clearly, he never understood Sec Lending and therefore was in no position to assess the risk.

To be fair, there were abuses by the banks in Sec Lending.  Investment guidelines with respect to the investment of cash collateral were violated and if many of the facts set out by Ms. Story are corroborated then serious conflicts of interest arose.  Absent these abuses, however, Sec Lending works.  Plan fiduciaries simply have to exercise their fiduciary duties and decide whether they are adequately compensated for these risks.

In light of the abuses, Ms. Story and others suggest that further regulations might prevent future abuses.  No new regulation is needed. Both ERISA and the current Securities Laws are very effective regulatory schemes.  Instead, we need a system in which fiduciaries pose a force as strong as Wall Street’s. http://harrisonfiduciary.com/about/

Attention should be focused on the thousands of plan fiduciaries –many of whom are no different than Mr. Davis.  As Ms. Story states, “no one would take Jerry Davis for a financial hotshot.”  This is a difficult statement to parse.  For it suggests an element of ridicule or even a patronizing attitude.  No, Mr. Davis isn’t a financial hot shot.  But, this isn’t a joke.  He is in the position of making fiduciary decisions on behalf of thousands of workers.  This is not about being a hotshot.  This is about the prudent investment of hard earned retirement dollars.

With over $16 trillion held in retirement plans, it is not surprising that Wall Street devotes significant resources to developing products and services for this market.  The people on Wall Street are both smart and aggressive.   It’s not enough to state that Mr. Davis isn’t a financial hot shot.  Plan participants deserve fiduciaries who are as well versed in investment products as the salesman of Wall Street.

Ms. Story has focused attention on a little understood, but highly profitable product for Wall Street.   This spotlight is critically important.  However, she should follow up her efforts by digging into the qualifications and competence of the fiduciaries overseeing America’s retirement plans.  My prediction is that many would be shocked at what passes for fiduciary oversight. Strong, well trained investment fiduciaries could effect significant financial reform without a single new statute or regulation.

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Securities Lending Was Much Misunderstood

On the front page of yesterday’s New York Times, Louise Story unravels the complicated and profitable securities lending product offered by many banks.  Notwithstanding the slightly biased or misleading headline, Banks Shared Clients’ Profits, But Not Losses, Ms. Story does an excellent job of explaining the complex and somewhat arcane details of securities lending.

However, she misses a critical point  —  no one forced pension plans to engage in these transactions.  While she tends to focus on the missteps or questionable activities by the banks, there seems to be little attention paid to the investors — many of whom simply didn’t understand the basics of securities lending.

Without outlining the intricacies of a securities lending transaction in this space (see the above story and diagram), suffice it to say that securities lending entails leverage and a sophisticated investment management strategy.  Unfortunately, Jerry D. Davis, Chairman of the municipal employee pension fund of New Orleans,  explained that “fund officials did not consider securities lending to be risky.”  Furthermore, “It was, he said, ‘almost like free money'”.

Let’s run through this one again.  Mr. Davis and his colleagues, in their capacity as fiduciaries, agreed to implement a leveraged investment strategy by the pension plan because it was “almost like free money”.  While Ms. Story highlights various allegations against the Banks, she doesn’t point out that Mr. Davis didn’t have a clue as to what he was approving.  No doubt, in light of all of the litigation, there are scores of fiduciaries throughout the pension system who were equally ignorant of the risks posed by Securities Lending.

To truly appreciate this financial narrative, a little history, or context is needed. We’ve seen this movie before. The recent financial crisis was not the first time the Securities Lending industry hit a proverbial bump in the road.

Way back in the spring of 1994 when interest rates reversed a long decline, the uptick in rates generated havoc in the Securities Lending Collateral pools.  The culprits were not sub-prime mortgages, but instruments known as “reverse floaters”.  As the name implies, these products of financial wizardly fluctuated in the reverse direction of interest rates.  Not surprisingly, in a long-term falling interest rate environment, Securities Lending collateral pools were chock full of reverse floaters.

Surprise, surprise.  Interest rates tick up and reverse floaters plummeted.  Securities Lending collateral pools collapsed in values.  In fact, the Boston Company supported it’s collateral pools so that they did not “break a buck”.

Investors were outraged and claimed the investment risk of loss on the collateral pools lay with the banks.  Claims were made, negotiations ensued and various settlements were reached.

In light of some of the ambiguities which surfaced in the 1994 Securities Lending crisis, banks systematically clarified in their documentation that the risk of loss with respect to the investment performance of the collateral resided with the pension fund/client.

The specific allocation of investment risk to the pension fund/client is a key element of the securities lending process.  In fact, many banks offer investment pools with varying degrees of investment risk, and require the pension plan to select a collateral pool which reflects the pension plan’s risk tolerance.

The principle is very simple :  the securities belong to the plan.  If the plan chooses to lend out the securities, then the plan needs to invest the collateral in order to earn a return.  At all times, the securities remain assets of the plans and the plans retain the investment risk.  This risk is never transferred to the Banks.

Finally, the Banks are paid a fee usually a percentage of the investment return generated by the collateral pool.

Now, as Story’s article points out, the Banks run their own risks — they can breach investment guidelines or they can engage in activities which might give rise to conflicts of interest.   But these are risks separate and apart from the investment risk on the collateral.

Far from “free money”, anyone familiar with Securities Lending understands that it is a levered investment strategy with various inter-connecting components.  The documentation reflecting these transactions is dense and very technical.  However, for a fiduciary, complexity is not an excuse for ignorance.  Whether it is securities lending, investing in a hedge fund or commodity ETF’s, Fiduciaries have an obligation and a duty to understand the investments they authorize on behalf of plan participants.

In 1994 it was inverse floaters, in 2007/8 it was sub-prime mortgages, in 2013, who knows what?   But, it is safe to say that Wall Street will invent new products.  Fiduciaries must stay on top of these developments.

(Next Post will be on the relationship between Custody Services and Securities Lending)

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