Harrison Fiduciary

“No one can serve two masters.”

Although the tradition is not mine, I can appreciate the rabbinic-like wisdom in the statement. Unfortunately, it appears that ERISA lawyers, on the whole, have not embraced this learning.

The statute, however, clearly is not agnostic on this topic.  Consistent with traditional trust-law concepts, and possibly not unaware of theology, ERISA demands a “duty of loyalty” by a fiduciary to the plan on whose behalf it is acting.

The language of statue is clear.  Dual loyalties are prohibited.  Nonetheless, ERISA lawyers (with the blessing of the courts) still continue to abide by the “two hat” doctrine.

Let me explain.

Two weeks ago, at a national conference of ERISA lawyers, a panel of in-house ERISA lawyers, reviewed a variety of issues that they encounter on a regular basis.  When the discussion shifted to fiduciary practices, one of lawyers explained the care and diligence that she employs when counseling the plan sponsor’s investment committee. This committee, of course, serves as a fiduciary to the retirement plans.  She said that she repeatedly recites or invokes the “two-hat” doctrine.

That is, in the day-to-day exercise of their corporate responsibilities, the officers owe a duty of loyalty to the shareholders of the corporation.  However, in the context of an investment committee meeting, they needed to “remove” their “corporate hat” and replace it with their “fiduciary hat”.  All decisions need to be made “in the best interests of the plan participants.”  They must disregard their duties to the corporation.

Upon recital of the two-hat catechism, every single participant on the panel nodded his or her head in agreement.   An ERISA truth had been proclaimed and knowledgable members of the ERISA bar mustered all of their reverential professionalism and genuflected at this statement of the canon.

Yes, it is commonly accepted that a corporate officer can “wear two hats”.  A chief financial officer, or a director of marketing, can spend his days (and often nights) toiling rigorously on behalf of the corporation (and shareholders), but during certain committee meetings they must shed this hat and instead, make a decision “solely in the interest of the participants and beneficiaries.”

Regularly, in corporations though out America, decisions are made related to $ trillions of retirement assets under this “two hat” theory.

For many years, I too sang from the two-hat hymnal, often a solo, just like the panel member.  However, with a bit of middle-aged experience and having weathered a systemic financial crisis, I have learned at times it can be valuable to question received wisdom, to question the hymnal.  And, sometimes even acknowledge the wisdom of traditions not my own.

For a moment, let’s set aside legal principles, theology, as well as editorial sarcasm, and examine the “real” world.

Another participant on that morning’s panel, explained that the retirement assets of her corporate plan (in excess of $15 billion) are “so important that the CEO personally appoints the members of the fiduciary committee.”

When a CEO handpicks members of a committee, everyone takes notice.   While CEO lieutenants may be adept at various technical and managerial skills, often, intense loyalty to the CEO is a common attribute.  (Dissidents typically do not typically rise to the C-suite).

This loyalty often includes a precise understanding of the CEO’s goals and priorities with respect to corporate strategy and is often rewarded by promotions, committee appointments, raises, bonuses, stock options and other assorted perks.  The senior managers are properly incentivized to advance the vision of the CEO.

Upon assuming a spot on a fiduciary committee, however, these same senior managers are required to shed the very skills that contributed to their corporate rise.  When making decisions on behalf of the plans, they are suppose to set aside any allegiance to the CEO, forget about the stock options they may have patiently accumulated over the years, and make decisions irrespective of an impact on corporate earnings.

The potential for conflicts of interest are real; they are not the abstract musings of lawyers and academics.   Many transactions squarely put the corporation and the plan on opposite sides, with competing goals.

So, can these corporate offices so deftly switch hats as ERISA lawyers assume?   Are fiduciary committee members so professional, so trustworthy, so ethical, that they are immune to the human impulses which gave rise to: “No one can serve two masters.”

Aren’t we all engaged in a collective willing suspension of disbelief as to the artifice of the two-hat theory?  Isn’t it time to say enough?  Let’s bring meaningful independence to the fiduciary oversight of the nation’s retirement plans.  The stakes are way too large not to.

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Emphasize Quality Over Quantity

Retirement plan fiduciaries are hiring independent fiduciaries with greater frequency.  Structured properly, the plan fiduciaries and senior management, should be insulated from liability for the actions of the Independent Fiduciary, provided that the process of selecting and hiring the Independent Fiduciary is prudent.

The process need not be tedious or cumbersome.  Furthermore, it should not be delegated to junior professionals with a mere rubber stamp approval provided by senior management.   A robust process, conducted with integrity, serves as an important foundation for fiduciary decision-making.

1.  Meet and interview the Independent Fiduciary candidate.

There is nothing more important than meeting with the potential Independent Fiduciary.   Most advisors, I suspect, would say that compiling data through an RFP process is the most important part of the process.  I disagree.

Data is important, but it does not take the place of a face to face meeting. Serving in a fiduciary capacity is a position of trust.   While technical skills can be assessed through an RFP response, trust can not.   Trust should be determine through a face to face meeting in which the hiring fiduciary attempts to gauge the way in which the Independent Fiduciary will analyze problems and execute fiduciary decisions.

2.  Assess the Fiduciary’s Independence.

The best laid plans of fiduciary protection will fail if the fiduciary is not independent.

The industry serving the retirement plans is vast and interconnected, a veritable spider web of relationships.  Hiring fiduciaries must be assured that the Independent Fiduciary does not have any relationships with the plans that could give rise to a prohibited transaction.  Focus on the receipt and payment of fees among the plans sponsor, the plan, the Independent Fiduciary and any affiliates of the above.

3. Review the Independent Fiduciary’s Procedures.

Every fiduciary should have a set of written procedures that it follows for a fiduciary engagement.  Request a copy of these procedures and evaluate them.  Ask the candidate whether they certify that the Procedures were followed.  Be assured that the  procedures are specifically tailored to the particular engagement and that they are not simply boiler-plate lists of tasks.

4. Inquire about Fiduciary Litigation.

Explore the candidate’s litigation experience.   The plaintiff’s bar is very active.  Qualified fiduciary candidates may have both been sued for breach of fiduciary duty and have won the case based on the facts; that is, a finding of the court that the fiduciary acted prudently.   Specifically, question whether the fiduciary’s procedures withstood the scrutiny of litigation.

5.  Is the Fiduciary an Expert?

Fiduciaries must be prudent experts.  Under take the requisite due diligence to determine that the fiduciary is both an expert with respect to the specific engagement and with respect to ERISA principles.   Investment/financial skills as well as fiduciary expertise are critical.  Compilation of data through an RFP can be helpful in this process.

Most importantly maintain a detailed written record of the selection and hiring process.  This documentation could be valuable if the process ever needs to be defended.

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An Independent Fiduciary Protects All Parties

With rising interest rates and CEO’s tired of pension-related balance sheet surprises, the volume and size of annuity transactions is bound to explode.

Experience teaches that exuberance in financial markets and products can lead to some very painful losses.  The Department of Labor is concerned.  It has seen this movie more than once.

Multiple factors go into the corporate decision to “de-risk” the balance sheet by purchasing annuity contracts.  Months of work go into this decision.  One key factor is the cost of the annuity, as well as the cost of executing the transaction.  While these transactions can be expensive to execute, senior corporate managers are also incentivized, and have a duty of loyalty to the company, to minimize these expenses.  Lower expenses enhance earnings.

However, annuity pricing is efficiently correlated to the credit quality of the issuer of the annuity.   In other words, lower credit-quality issuers charge less for their products.  The corollary is also true; higher credit-quality annuities are more expensive.

Left to their own devices, corporate managers are incentivized to purchase the cheapest annuity available even if it reduces the credit quality of the issuer.  This pressure is very strong.

Plan fiduciaries and participants, however, have a different view.  They are interested in the strongest credit quality issuer available, price be damned.  Remember, prior to the annuity purchase, the pension plan is funded by a diversified pool of assets, thereby mitigating investment risk.

An annuity purchase,however, substitutes a single issuer for this diversified pool.   The pensions of thousands of plan participants are dependent on this single issuer.  The issuer goes bankrupt, the pensions are lost… forever.

The conflicts for senior managers (some of whom are plan fiduciaries) in executing these transactions are real.  Should they pay up for higher credit quality; or, should they sacrifice credit to enhance earnings.

ERISA provides a single answer.  Fiduciaries must act in the interests of participants.

In the early 1990’s the bankruptcy of Executive Life Insurance Co. provided a huge wake-up call.   Many plans were invested in Exec Life products and they absorbed huge losses.

In response,  the DOL issued guidelines in IB 95-1 setting forth numerous requirements regarding the purchase of annuity contracts.  Post-Executive Life,  the DOL requires that a plan purchases the “safest available annuity”.   In reaching this determination, the DOL requires that 6 six factors be analyzed, price of the annuity is not one of the factors.

Recognizing the potential conflicts of interest and the competing pressures of corporate managers, these IB 95-1 suggests that an independent fiduciary be hired to make the the “safest available annuity” determination.

Unfortunately, plan sponsors don’t like hiring Independent Fiduciaries. They don’t like paying the fees and they don’t like a second set of eyes reviewing their judgments.  If corporate managers want to purchase an annuity from XYZ Insurance Co, they don’t want a third party telling them that they should purchase the annuity from DEF Insurance Co.  And, they really don’t like that an Independent Fiduciary will retain its own lawyers and advisors for the transaction.

Ironically,  the intensity of the resistance by senior managers to hiring an Independent Fiduciary actually illustrates and proves the very conflicts of interest outlined above.

Corporate managers who forgo an Independent Fiduciary might one day be in the position of having to prove to the Department of Labor that they transcended these conflicts and acted in the interests of plan participants.  In the context of large losses (possibly $ billions) That will be a hard argument to make.  The DOL will be very suspicious.  Remember, there is personal liability for breaches of fiduciary duty.

In the end, an Independent Fiduciary will make decisions in the interest of the plan participants.  However, the corporate managers can take great comfort from knowing that the conflict of interest is significantly mitigated by the hiring of the Independent Fiduciary.  Whether they understand it or not, the Independent Fiduciary provider significant protections to the corporate managers.

Corporate managers should focus on executing their corporate strategies.  Let the Independent Fiduciaries wrestle with the complexities of purchasing annuity contracts.

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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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Only if We Let It Be

As one year ends and the next begins, it is important to ask whether the past predicts the future.  Ironically, the investment management industry is built upon a widely disclosed truism: “PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE PERFORMANCE”.  Warnings of this nature accompany every investment product.

While the past does not predict the future, actions taken in ignorance of the past can be risky, and dare I say, imprudent.  In my last post I focused on inflation, however, the concern goes way beyond inflation.

Floyd Norris reviews over 60 years of bond market history, Reading Pessimism in the Market for Bonds, and without resorting to overwhelmingly sophisticated analysis (an analysis that even I, a mere lawyer can follow) identifies 30 year swings in the bond market.   From the the bear market of 1946-1981 and the bull market from 1981- present, he anticipates the start of another 30 year long grinding bear market in bonds.

Given this trend, the mere flip of the calendar page from 2012 to 2013 should give us pause.  If this is not sufficient to cause some hesitation and concern, look to the historically meager interest rates being paid to bondholders.  At some point, and probably some time sooner rather than later, the deluge of investment into bonds will reverse its course. The reverse tidal wave could be devastating to investment portfolios of all stripes. .

While the practical implications of a down bond market concern me, I am even more concerned about whether the investment managers and other decision making fiduciaries are up to the task of making the significant intellectual paradigm shift from bull market to bear market.

Within Norris’ column, Michael Gavin, the head of U.S. asset allocation for Barclasys, identifies a fact which I have also addressed before… with great concern.   Most investment fiduciaries have never operated in a bear bond market.  The skills that they have honed and perfected (whether in equities, fixed income or alternatives) are all products of a 30 year bull market in bonds.

What happens when that market changes, fundamentally? Not a mere blip such as 1994 which saw a short-term uptick in interest rates, only to be followed by the overwhelming bull market trend which has lasted almost another 20 years, but the real McCoy;  a long 30 year trend of rising interest rates and falling bond prices.

Let me be clear.  I am not suggesting that I have the answers.  However, when I turn to other investment fiduciaries, I am not looking for the same re-heated, cliched solutions of the last 30 years. Instead, I am looking for managers and advisors who are able to look at the past 60+ years of investment management trends and investment philosophies and extract principles and lessons which are applicable today.

And yet, it is not all about the past.  The present presents challenges and a new world.  In 1982 as the bond market started its ascent, baby boomers were hitting the work force and engaged in their own ascent up the corporate ladder.  Today, retirement looms, pension savings must be accessed thereby putting even further downward pressure on the bond market.  Debt explodes everywhere: invididuals, corporations and sovereign nations.  These are merely a few of the most obvious challenges.

For the past not to be prologue, I am keeping my eyes open for the investment managers who know their history, are fluent with the challenges of the present, and most importantly, have fashioned an investment approach with a full understanding of both.

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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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Never Underestimate the Power of Negotiation

Banks and asset managers sell products and services.  While they might wrap themselves in impressive jargon, complicated charts and graphs, and high-powered brand names, they still just sell stuff.  Like any salesman, they hate losing a sale.

In How Banks Could Return the Favor, Gretchen Morgenson reports that many municipal bonds could be re-financed at much lower interest rates, and therefore lower costs to taxpayers, except for derivatives contracts buried in the bond offering.

Terminating the derivatives would give rise to significant termination fees.  Public administrators are loathe to incur these fees.

Surprisingly …. almost shockingly … Morgenson also explains that many public fund administrators are hesitant to negotiate fee reductions with the banks.  In essence, it appears that the administrators are intimated by the Banks.

However, imagine if you will, the reverse.  Imagine that Bank A was on the bad end of a deal with Bank B.   Do you think that Bank A would simply paying higher costs ad infinitum?   Of course not.

Instead, Bank A would bring every bit of leverage into play in renegotiating the deal.  In fact, that’s what bankers do.  They love to negotiate, particularly where money is involved.  It is a truism.

So, the public administrators should do a couple of things: project their banking needs for the next 5 years, contact multiple banks, begin a bidding war …. and, tell the bank which currently holds the derivatives contract that the entire banking relationship is up for review and that it is has been put out to bid.  Furthermore, explain that re-negotiating the derivatives contract needs to part of their counter-proposal.

Then, let the chips fall where they may.

Remember, banks hate to lose customers; especially to competitors.   I suspect that there are great savings to be reaped.

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Are Plan Sponsors Up to the Task?

The responsibility for managing and overseeing a corporate retirement plan use to be back a backwater support function at most companies.  The Department of Labor, however, has just significantly upped the ante for overseeing these plans.

Yesterday, Gretchen Morgenson reported on the new fee disclosure requirements pertaining to $401(k) plans, The Curtain Opens on 401(k) Fees.  As the open curtain metaphor suggests, transparency will be important.  However, the new rules can’t simply be fulfilled through transparency.  It’s going to take more… a lot more.

Morgenson explains that the new rules will require plan sponsors to calculate and disclose expense ratios for each of the investment options offered to the plan participants.  With access to greater information, it is assumed that plan participants will be able to make more informed decisions with respect to their investment selections.  For everyone knows, that higher expenses eat into investment returns.

Just as plan sponsors are being required to assume additional responsibilities, however, Morgenson also reports that many managers of corporate plans are shockingly ignorant about the nuts and bolts of the operation of their retirement plans; specifically, on the expense structure of the plans. I have previously commented on then dangers of executive ignorance with respect to retirement plans. Fees & Expenses: A Perfect Storm.

The importance of these new regulations, however, is not simply that they demand greater transparency.  The significant challenge lurking under the surface for corporate managers or retirement plans is that they will now be fiduciaries with respect to the fees and expenses paid by the plans.

That is, it is not enough that they properly disclose all the various fees and expenses paid by the plan.  In addition, they will also have to sign off on the reasonableness of these fees and expenses.

Disclosure is a somewhat passive activity.  If it were merely a matter of disclosure, then plan sponsors would simply hire consultants to calculate the expense ratios and then pass those ratios along to the participants.

As fiduciaries, however, the plan sponsors must make the affirmative decision that the fees and expenses are reasonable.  This requires that they understand the economics and the entire expense structure of the plans, and affirm that the charged expenses are reasonable.

Approving fees and expenses will require a thorough understanding of the range of services and pricing for all aspects of maintaining and operating retirement plans.  The fiduciaries must make their decisions in their capacities as prudent experts.

No doubt, plan sponsors will hire consultants to assist with these determinations.  However, it is axiomatic under ERISA that plan fiduciaries cannot merely rubber stamp a recommendation made by consultants.  Or, if in fact plan fiduciaries do rubber stamp consultant recommendations, they are opening themselves up to liability.

And remember, under ERISA, fiduciaries are personally liable for breaches of fiduciary liability.

Maybe it is time for companies to get out of the plan management business.  The best course of action would be to delegate the responsibility for management and oversight of plans to proven fiduciary experts.   Independent professionals who are experts in the business of maintaining and operating plans.

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Is Still a Conflict

JP Morgan sold credit default insurance and a mutual fund managed by JP Morgan’s Asset Management Group bought the insurance.   That’s a conflict of interest.  No way around it. See, As One JPMorgan Trader Sold Risky Contracts, And One Bought Them.

Surprisingly, however, the article by Azam Ahmed implicitly condones, and even praises the transaction.   Rather than finding any criticism of this transaction, Ahmed quotes a researcher at the Brookings Institute who states,  “the lesson is that the asset management firms really do act like different different bodies”.  Apparently this is a good thing.

I disagree.

Conflicts of interest undermine the trust upon which our financial system is built.  Simply put:  one party/individual cannot represent both sides of a transaction.  Or, to put it more colloquially, no one can serve two masters.

In the context of the JP Morgan trade, the credit default swap is a contract.  This contract imposes rights and obligations on each of the parties. These are obligations “with teeth”.  Remember when Goldman and AIG were fighting over collateral which needed to be segregated to support similar derivative-type contracts?.

Suppose similar conflicts arose with respect to the JP Morgan trade.   Would the Asset Management Group, on behalf of the mutual fund and its investors, sue the bank to enforce the credit default swap?   Imagine all of the judgments which would have to be made in this context.   Are the investors in the mutual fund confident that the Asset Management Group would have represented them (the Investors) aggressively against their (the Asset Management Group’s)  employer?

To further highlight this conflict, imagine if the trade had gone the other way.  Assume that JP Morgan Bank earned a huge profit and the mutual fund lost $2 billion on its investments.  In that scenario the Bank would have earned a huge profit at the expense of its clients.  I suspect very different articles and columns would be written.

The most disturbing aspect of the Article, however, is the absolute lack of sensitivity to the conflict issue.  Reflecting the approach of an adolescent kid beseeching her parent “but everyone does it!”, Ahmed explains “That one hand of the bank was selling while another was buying is not uncommon in the dog-eat-dog-world of Wall Street”.  I guess if “everyone does it”, its OK.

The fact of the matter is, it is not OK.  The very foundation of the financial system depends on trust.  One element of this trust is that advisors (or rather agents) will act for exclusively for the benefit of investors (principals), that they will avoid conflicts of interest. While transactions can be structured to meet various legal requirements (and I’ve done tons of “structuring” in my career) and possibly fall within various exemptions or special rules, the reality is that, a conflict is a conflict is a conflict.

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