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Cliche or Aspiration?

A $ Trillion Platinum Coin.  Sounds preposterous, no?  The idea was seriously being promoted by people who are not crackpots.  Paul Krugman, Nobel Prize winning economist and Mohamed El-Erian, CEO and co-chief investment officer of PIMCO have both publicly endorsed the idea.  Neither love the idea, but recognize that the current political environment demands, an “out of the box” solution.

“Out of the box” thinking… a term invented by business consultants, has now become a cliche, its use is so wide-spread it has become meaningless.  And, yet, every successful business person and investment professional know that novel and unconventional ideas or approaches lay the foundation for their success.

Like all cliches.  “Out of the box” thinking contains a germ of truth.

Harrison Fiduciary Group’s business model represents an “out of the box” business model for the management and oversight of retirement and pension plans.  However, time and time again, people say “but that is not how we do it.”   In fact, a few weeks ago I was proposing an idea to someone at a private equity firm.  He had degrees from two Ivy League universities, no doubt earned a sizable income, and yet, all he wanted to know was “who else is doing this?”.  He didn’t want to consider something slightly different.  He simply wanted to blend in with effort else.  Kinda reminds me of adolescence.

Unless circumstances demand novel and creative approaches, most people avoid them.   To use another cliche, most people are more comfortable with the “same ol’, same ‘ol”.

However, today’s economic, and investment environment demand an “out of the box” response. Corporate earnings are lack luster.  As I discuss in my prior post, interest rates are bound to increase and create a new investment environment never experienced by a generation of investment professionals.  And, in the midst of these pressures, there is talk of the Treasury Department issuing a $ Trillion Platinum Coin.

Things can’t get more topsy turvy.

How are corporate fiduciaries responding?  Do they have the time and the skills necessary to fashion appropriate investment responses?  But, more importantly, wouldn’t their time be better spent on executing their business strategies?  All too often fiduciary oversight deflects corporate focus from core business initiatives to the ancillary role of

At Harrison Fiduciary Group we are fiduciaries.  We are not investment consultants nor are we investment managers.  We are not “selling” a particular investment strategy nor are we merely offering advice to plan sponsors.

Instead, we are professional fiduciaries who will make and implement decisions on behalf of a plan.  And, most importantly we will stand by these decisions in a fiduciary capacity.  Our sole mission is to act in the best interests of plan participants and retirees.

Yes, HFG provides an “out of the box” solution to corporate fiduciaries.  Plan participants deserve no less.

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Can We Learn from History?

In the summer of 1982 Henry Kaufman, the legendary Dr Doom announced that interest rates had peaked.  I was a summer associate working at a law firm, but I remember that the stock market instantly skyrocketed.  Interest rates had peaked, inflation was licked, and it was smooth sailing ahead.

Essentially, my entire career (and the careers of an entire generation of investment professionals) has been spent in a falling interest rate environment.  From 1981 through 2012, the yield on the Treasury Bond has fallen from just below 16% to below 1.5%.

This decline in interest rates corresponds with an explosion in stock prices, both here in the US and globally; in developed markets and developing markets a like.  Furthermore, this same period is also reflects a benign inflationary period in the U.S.

I’m not stating anything new or earth shattering.  However, I do wonder about the effects of this generational experience upon the professional investment industry.  There are few advisors or managers out there who successfully managed assets in a steadily increasing rate environment or during periods of rapidly increasing inflation.

Are rates rising?  What about inflation? Who knows?  And, I certainly do not even begin to posses the skills to analyze these issues.

However, I can look at a simple graph and see trends … or the lack of trends…. and it flies in the face of reason to think that low interest rates and low inflation will continue forever. Therefore, if nothing else, fiduciaries should begin thinking maybe even worrying about inflation and an eventual upturn in interest rates.

While I would never shill on behalf of one manager over another, I nonetheless attended a very impressive presentation by a highly regarded investment management firm in which they laid out their case for the building inflationary pressures and their proposed solutions for this potentially new environment.

Historically, certain asset classes perform well in an inflationary environment: inflation linked bonds, currencies, gold, commodities, real estate. While they are not suggesting a dramatic shift to these asset classes, they nonetheless do recommend gradually incorporating exposure to these assets.

Fiduciaries should evaluate these proposals.  If they choose, they should also feel free to reject them in favor of other perspectives or strategies.  The real issue is that Fiduciaries should not simply rely on the “same ol’, same ol’” practices.  To do so, would be imprudent.

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Are Fiduciaries Paying Attention?

There are always naysayers.  Prognosticators and analysts who even in the best of times foresee disasters looming on the horizons.  I am very prone to be influenced by those cautious advisors.

However, over the course of my 25 year career, I have learned that more often than not the extremes rarely materialize and decisions based upon more moderate outlooks usually prevail.

And yet, right now, the magnetic pull of impending disaster and hyper-vigilant caution feels overwhelming.

Where will a crisis materialize? To name just a few potential catalysts, some of which were identified by global leaders at a recent gathering in Lake Como, Italy:

  1. Collapse of the Euro
  2. US Fiscal Cliff
  3. Middle East — either the Arab Spring or Israel/Iran
  4. Hard Landing in China
  5. Hyper-inflation.

Any one of these factors alone could trigger financial and/or political upheaval the likes of which our generation has never experienced.  But, what if 2 or 3 erupt concurrently.  I shudder to imagine.

As a fiduciary I worry about these things.  I’m required to make prudent decisions which can have long lasting implications for people’s retirements.  I take this responsibility very seriously.  Workers and retirees have worked long and hard to assemble their retirement nest eggs.

Of course, I can’t predict which crisis will occur or the consequences of any of these crises.  And, I’m very skeptical of anyone who offers any predictions, especially predictions with specificity.

Ever cautious, however, I’m trying to understand how to plan around these various potential crises.  Most importantly, I want to know how other investment fiduciaries are planning;. or if not planning, whether they are thinking about each of these various factors as they manage other people’s money.

I’m particularly concerned due to the general herd-like mentality of Wall Street, investment professionals and retirement professionals.   For the most part everyone does the same thing.

For example, before the 2007 financial crisis, and as $billions were being directed into various mortgage-backed securities and derivatives, industry professionals from various disciplines were all taking comfort in VAR — Value At Risk.

I never understood VAR, and I still don’t.   However, it was a numerical representation of the “risk” inherent in an investment portfolio.  Investment professionals cited VAR as if it was the holy grail. Everyone felt that they had mastered risk because the VAR calculations indicated so.

In retrospect, VAR proved to be overly narrow and somewhat simplistic.  VAR was meaningless as markets plunged and portfolios were depleted.  VAR was ephemeral, but the losses were real.

I’m nervous about today’s equivalent of VAR, and I don’t even know what it is.

Today’s $18.9 trillion of ERISA assets (as reported as of March 31, 2012 by the Investment Company Institute), are all generally managed the same way.  Steeped in the principles of Modern Portfolio Theory, retirement plans hire consultants who develop intricate asset allocations, spreading risk among all the asset classes.  Plan sponsors then hire multiple managers with proven track records in the specific asset class.  The industry supporting this system is gigantic.

This system has been in place for 25+ years.  In the explosive boom years beginning in 1982 all has worked well — for the most part.  However, the 2007 Financial Crisis revealed fissures in the extraordinarily complicated and intricate edifice constructed by the retirement investment industry.

What about the storm clouds forming on the horizon?  Are the foundations of the edifice strong enough?  Are fiduciaries exploring whether any levees are in place, and if so, whether the levees are capable of weathering the storm.

At a minimum fiduciaries should be talking about these issues.  They should demand that other investment fiduciaries outline their analyses and their proposed responses.  The debate on these issues should be robust and rigorous.

Unfortunately, my sense is that many are simply hoping that the clouds dissipate never gaining the force of a full fledged storm.

Personally, I often carry an umbrella when there is the slightest hint of rain.  Now, I’m concerned that an umbrella will be a mere cipher in an upcoming devastating storm.

Fiduciaries, what do you think?

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Fiduciary Values

To our Clients, Friends and Supporters –

Thank you for your trust, confidence and support in 2011.  We are looking forward to a strong and robust 2012 and hope to enhance our reputation for integrity and judicious investment decision making.

Over the holidays, I read High Financier, The Lives and Time of Siegmund Warburg, by Niall Ferguson.    Siegmund Warburg was part of the extended Warburg banking family.  After his Hamburg bank was Aryanized by the Nazis in the 1930’s, Warburg moved to London and started his new firm from scratch, S. G. Warburg & Co.  Hewing to traditional values of trust, honor and client service, he built not the largest nor the most profitable merchant bank, but probably one of the most innovative and trusted financial firms.

For Warburg, corporate values were not merely a matter of branding or marketing.  Instead, they were the very organizing principles of his personal and professional life.

The reputation of a banking firm for integrity, generosity and thorough service is its most important asset, more important than any financial item.  Moreover, the reputation of a firm is like a very delicate living organism which can easily be damaged and which has to be taken care of incessantly, being mainly a matter of human behavior and human standards. [SG Warburg's personal papers, Box 64; Ferguson, p. 233]

These words leapt off the page at me.  They capture the essence of my vision and goals for Harrision Fiduciary Group.  Warburg speaks of banking, but in today’s world, banking now includes, trading, private equity, hedge funds and all aspects of investment management.

Simply put, in each of these endeavors, professionals are entrusted with assets properly belonging to others.  It is an honor to be put in such a position of trust.

However, words like Trust, Honor, and Integrity have been excessively diluted in our current culture and financial system.  Either they are scoffed at as relics from a bygone era or they have been turned into cliches by facile marketing campaigns on behalf of firms whose conduct actually belies these very values.

Given the prevailing financial excesses and market volatility, an understandably cynical view pervades our financial markets and the various players in these markets.  We need to recapture the meaning and behaviors embraced by these values.

Ours is a small firm. Our vision and mission are simple to articulate.  We want to be the industry leaders and set the standard for fiduciary services with respect to Trust, Honor and Integrity.   At HFG we will always put the interests of our clients ahead of our own.  We will never stand on the other side of a transaction from a client.  We will never engage in a conflict of interest, and will never use client information or positions to advance our own.

While these ideals may sound lofty and therefore beyond one’s grasp, they actually are easy to implement.   Like S.G. Warburg & Co, Harrison Fiduciary will neither be the richest nor the largest fiduciary services firm.  However, we hope to be known as a firm which always acts in the best interest of its clients.

We wish all of our clients and friends the best for 2012.

With appreciation.

Mitchell

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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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The Prudent Experts

Published on 22 March 2010 by Mitchell Shames in Thought Leadership

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Welcome to the first post by the Prudent Experts, Mitchell Shames and Sean Flannery.

Our overriding mission at Harrison Fiduciary Group (HFG) is to provide professionalized investment fiduciary services on behalf of retirement plans.  With our combined 50 years of experience in investment and fiduciary matters, we have found all too often that while the term “fiduciary” can be tossed around a great deal, there are few individuals and firms devoted exclusively to providing investment fiduciary experiences.

We are committed to the principle that the role of a fiduciary is professional discipline in its own right.  Serving as a fiduciary is not simply ancillary to providing another service such as providing investment or consulting advice.

This blog will be devoted to identifying current issues confronting investment fiduciaries as well as directing readers to other professionals and organizations which are advancing fiduciary issues.   With Mitch’s background as a fiduciary lawyer, and Sean’s as an investment professional, each of our posts will be focused in our particular areas of expertise.  (For greater details on our backgrounds, please see the About Us tab on our website.)

HFG is proposing a new business model with respect to the management and oversight of retirement plans.  The role of serving as an investment fiduciary has enormous benefits both to plans sponsors as well as to plan participants.  We are firmly convinced that sponsors and participants will derive quantifiable value from our services.

Finally, we look forward to your thoughts, comments and questions pertaining to the issues and concepts which we present.  Please, challenge our assumptions, processes and conclusions.  We welcome the debate.

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