Harrison Fiduciary

“All the News That’s Fit to Print” and More

Who doesn’t love a deal, especially in today’s economic environment?  This past Sunday’s NY Times, 23 October 2011, not only offered an update on global current events, but also serves as a virtual handbook for retirement plan fiduciaries.  [Go fish it out of the re-cycling bin … yes, I still read the physical newspaper; one of life’s daily pleasures.]

Starting with a bold graphic representation of the European credit crisis sprawling across two pages of the Sunday Review, Bill Miller’s,  It’s all Connected: An Overview of the Euro Crisis is clearly worth more than 1000 words.   At first blush, it seems too confusing … just too much to get one’s head around.  It’s much easier to turn the page.  Better yet, flip to the Travel or Arts & Leisure Section.

Retirement plan fiduciaries, however, don’t have that luxury.  Ignoring the financial issues brewing in Europe would be irresponsible and imprudent.

And yet, even for a responsible fiduciary, where does one begin?  If only there were a true sage, who had all the answers and could predict the outsome.

Fiduciaries don’t have to be sages.  They simply need to be prudent and responsible.  At the very least, every fiduciary committee, whether for state & local plans or for corporate plans, should be exploring the impact of the European issues on their plans and on their investment policies.

A daunting proposition, but plan fiduciaries don’t have to operate in a vacuum.  Instead, they should turn to each of their investment fiduciaries and pose the following questions:

1. What is your analysis of the European debt crisis?
2. Does this analysis have any impact on your investment strategy and our portfolio?
3. What’s the weakest link in your analysis?
4. Have you constructed contingency plans?

No doubt, every investment advisor will have a different answer, and fiduciaries will need to piece together conflicting data points.  But, in the end, plan fiduciaires must make sure that their investment fiduciaries are themselves being prudent.  Fiduciaries can’t predict investment results, but they can, and must, ensure prudent processes and decision making.

If the above advice seems too general, and therefore too simplistic, and maybe even worthless, then let’s turn to the front page.  Gretchen Morgenson and Louise Story’s, Bank’s Collapse in Europe Points to Global Risks, examines the bailout of  Dexia Bank whose problems, in part, stem from gorging on too much sovereign debt.  Using Dexia as an example, Morgenson and Story extrapolate various scenarios, and related policy issues, raised by potential rounds of bailouts of banks and their trading counter-parties.

I’d supplement their analysis by drilling down to an equally ominous set of challenges to which they allude: repos, securities lending and short-term commercial paper.  Most all banks (domestic and foreign) fund their operations, in large part, through repos and other forms of commercial paper.  Remember what happend to Lehman when no one would fund their short term paper?  And, what about securities lending pools stuck with rapidly declining collateral?  Just ask plan fiduciaries who were unable to terminate investment managers becaus securities were tied up in frozen securities lending pools.

Need more questions to ask?

Let’s not forget about money market funds.  Gretchen Morgenson, in the Business Section,  How Mr. Volker Would Fix It, also wrote about Paul Volker’s blunt recommendations about reforming the financial system; starting with money market funds and the residential mortgage market. Money market funds are huge purchasers of sovereign and bank debt.  As has also been previously reported, many of these funds have been paring back their European exposure.  Plan fiduciaries overseeing 401(k) plans holding money market funds need to be questioning their managers about strategies for addressing these global banking issues.

Plan fiduciaries, however, also have to ask about STIF’s (short-term investment funds).   Every custodial bank runs $ Billions in STIF’s, unregulated funds which no doubt are also chock full of sovereign and bank debt. Fiduciaries, are you asking your custodian banks about their STIFs?

If Miller’s graphics and Morgenson”s and Story’s articles don’t arm fiduciaries with sufficient questions, then turn to The Little State With the Big Mess, an eye opening article about Rhode Island.  The tiniest state, but the biggest pension woes.  Hard to know where to begin asking questions about the Rhode Island mess, but how about starting with the newly revised investment return assumption of 7.5%, down from 8.25%?  Is that a prudent decision?  Where did that number come from?  An easy question to ask, but maybe the answer is not so simple.

Finally, turning from the newsprint to the magazine, Daniel Kahneman, Nobel prize winner in Economics, Don’t Blink! The Hazards of Confidence, writes about the behavioral phenomena that confidence in our own judgments creates a bias that can lead us to ignore hard facts which contradict our judgments.  Focusing on investment performance, Kahneman explains that notwithstanding quantitative proof that certain investment managers added zero value to the investment process, these managers were nonetheless awarded bonuses on the assumptions that they “added value.”  Assumptions die hard.

By the way, maybe someone should forward a copy of Kahneman’s article to the fiduciaries of the Rhode Island state and local pension plans.  I’m still struggling with 7.5%.

Fiduciaries beware.  Don’t be so confident.  Ask lots of questions and work hard not to be so confident in your assumptions.  You are not just investing your own assets … instead, you are investing on behalf of hard working plan participants and retirees.

And I thought that I’d relax with a cup of coffee and a leisurely read of the Sunday paper.

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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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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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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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