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Let’s Remember Who Owns the Assets

“At base, having a small elite with vast wealth is good for the poor and middle class”, explains Edward Conard, former partner of Mitt Romney and author of the soon-to-be published, Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong. Conard’s views are explored in an article in yesterday’s Magazine Section of the New York Times, by Adam Davidson, The Purpose of Spectacular Wealth, According to a Spectacularly Wealthy Guy.

As befits a private equity guy, and a graduate of an Ivy League business school, Conard’s argument is simply that the rich are smarter than you and me, and the “poor and middle class” would be in a better place if they, the elite, were left alone to run it.

Let’s for a moment assume that Mr. Conard and his various colleagues in the super elite are very smart,  there is, however, one glaring factual inaccuracy which woefully undermines his argument.

Davidson, after illustrating Conard’s enthusiasm about the virtues of eliminating a fraction of a penny on the cost of every can of soda, further explains that according to Conrad there are other investor looking to make similar “micro improvements”; “They are also wealthy investors like him who are willing to risk their own money to finance improvements that may or may not work.”

Wait a second.  “Willing to to risk their own money.”  Let’s stop and pause.  I would venture a guess that Mr. Conard never risks his own money in his deals and potential improvements.   Or, as I’ll explain in a minute, if he invests his own money, then likely it is all the “house’s” money anyway.  So, it is not really much of a risk.

I’ve never met Mr. Conard, but I’m going to assume for a moment that Mr. Conrad is an archetype of a prevalent, albeit elite, cohort pounding the streets of New York in the early 1980’s.  Armed with a business degree from Harvard, but probably not much capital of his own, he first landed a job at Bain & Company, then moved along to a stint at Wassserstein Perella, and then landed back at Bain Capital.  While I’m sure that he made a very good salary and received good bonuses in his pre-Bain Capital days, the odds are pretty slim that he would have amassed a large enough fortune to become an “investor willing to risk [their] own money to improvements that may or may not work.”

Instead, he became a hard working, no doubt diligent private equity guy in the early days of the private equity bonanza.  Eventually, he made a fortune, not by putting his money at risk, but rather by putting other people’s money at risk.  The classic OPM game.

Private equity typically works as follows.  A Private Equity Firm (PEF) creates a partnership, it raises money from investors as Limited Partners, and then typically creates an entity to serve as the General Partner.  The General Partner is usually thinly capitalized (at least compared to the size of the entire fund), and its stake holders are typically insiders at PEF.  As a last step, the General Partner, on behalf of the fund, enters into a management agreement with PEF.  Included within these inter-locking relationships are various fee structures which compensate  PEF and the General Partner.  This compensation consists of the holy grail of all fees, the “2 & 20”, a 2% management fee and a 20% carried interest.  This is how fortunes are built in private equity.

Once the capital is raised from investors, the fund then goes out and borrows additional capital, usually multiples of the original equity investments.  That’s why these transactions use to be called leveraged buyouts.  In fact, most of the money “put at risk to finance improvements that may or may not work” is borrowed money …. and, the investors, including the General Partners are not on the hook if they lose it.

With Mitt Romney’s presidential bid, the whole discipline of private equity has come under scrutiny and no doubt will be dissected under a microscope in the coming months.  I’m not interested in getting into the argument as to whether private equity is good thing.  That is a subject for another time.

However, I am objecting to the notion that professionals such as Mr. Conard create a false narrative suggesting that they are great investors putting their money at risk.  No doubt, after 15 years of managing private equity deals in a wild bull market, private equity professionals have likely amassed great fortunes.   And, no doubt, they do re-invest in their own deals.  However, as I said above, they are essentially investing with “house money”… it’s easy to double-down, once you’ve assured yourself a nest egg (with multiple homes and private planes), to leave money in the deals.

The real investors are not the Ivy League MBA’s.  Instead, the real investors are you and me.  A significant portion of the capital for private equity comes from pension plans, both public and private.  In fact, public pension plans tend to be some of the most coveted clients for private equity firms.

The reality is that the true investors, people with money at risk, are not an elite group of risk assessing and risk taking investors.  Instead, they are hard working employees of large corporations and public entities.  These are the same employees who stand by helplessly as their jobs are eliminated or they learn that their pension plans are underfunded by staggering amounts.

These are the real investors in “improvements that may or may not work”.  And, these are the real investors who have funded the private equity industry.

Don’t get me wrong, some of my best friends are private equity professionals.  They are hard working, some of them are charitable and they are good citizens.  And, some firms have generated significant returns for their investors.  This is good and beneficial.  But, let’s not glorify them into a power wielding elite who “know” best for American.

I am further skeptical about an elite which potentially doesn’t understand  the distinction between personal assets and client assets.  In my judgment it is enough to disqualify someone from the elite.

Warren Buffet, arguably the greatest allocator of capital ever, always acknowledges that he invests capital on behalf of the Berkshire shareholders.   Go back to his oldest shareholder letters and he refers to shareholders as his partners.  He means this not in a legal sense, but it an ethical sense.

If Mr. Conard is hell bent on supporting an elite of master investors, then lets make sure that this elite embraces the proper values and behavior which in fact would be best for the poor and middle class. Let’s create an elite of financial experts who also understand and abide by fiduciary principles.  Professionals who at all times know that they work for plan participants and beneficiaries, and subordinate their self-interests to the interests of the clients.  Professionals who tolerate no conflicts of interest, and importantly, who don’t rig the game for outsized profits for their own benefit.  Yes, we may need an elite, but let’s have an elite of ethical and prudent behavior.

As a fiduciary, I recognize that my prescription may be viewed as self-serving, but one can only wonder if certainly elements of the Financial Crisis may have been avoided or tempered, if the leadership of the financial community took their roles as fiduciaries seriously.

Let’s judge the elite by their values and ethics, not by the size of their assets.

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Heighten Regulation and Executive
Ignorance:  A Bad Combination

Pension & Investment reports that many executives are “clueless” about the plans they oversee, DC Execs Clueless About Key Plan Data.

The P&I article is shocking.  Survey data reveals that on multiple levels Plan Execs don’t know the nuts & bolts of the business of running and administering their plans.  And, worse, some have just “thrown-up their hands”.

In many cases these execs are plan fiduciaries, or advise plan fiduciaries.  The problem is that plan fiduciaries can’t just “throw-up their hands”.

And yet, the role of overseeing retirement plans keeps getting more complex and sophisticated, not less.

The Investment Company Institute just reported that as of Q3, 2011, total US retirement assets were $17 trillion.   That is a big pool of assets against which various service providers can charge fees.

As the financial services industry has exploded over the past decades, the Department of Labor has finally focused the spot light on the fees and expenses charged against plans. New regulations go into effect this summer under which plan fiduciaries must approve the reasonableness of fees and expense charged to plans.

Notsurprisingly, these regulations are very intricate and complicated.  In effect, the regulations reflect the elaborate fee structures and business models which have evolved enabling various service providers to increase their revenue streams from retirement plans.

And so, a “perfect storm”, rages.  Complexity increases, the government is demanding greater oversight, and key executives and fiduciaries remain ignorant on basic facts and details with respect to the plans they oversee.

Of course consultants stand ready to advise plan executives and fiduciaries.  But, before the consultants can provide advice, the plan executives and fiduciaries MUST understand the business models for administering their plans. Otherwise, the advice is being delivered into a vacuum. How can one evaluate the advice if they don’t even understand the basic features and terms of their plans and do not understand the business of administering a plan?

At Harrison Fiduciary Group, we are proponents of an entirely  new model for the delivery of fiduciary services.  With respect to Fees & Expenses, we are experts. Our combined 30+ years in the retirement-industry has provided us with the experience and knowledge to analyze plan structures and the related fees.  The devil is in the details, and we understand the details.

By delegating this authority to HFG, plan executives and fiduciaries will not have to become experts on an area that bears little impact on their core business competency.

Perfect storms need to be heeded wisely.  Allowing ignorant plan execs and fiduciaries to make significant fiduciary decisions can lead to disasters.

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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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Plan Fiduciaries Should be Paying Attention

Will the European Central Bank step into the market and buy European Sovereign Debt?   That’s the $ trillion question.

Articles abound trying to predict the future.  Will the ECB cave or not?   No one can be responsible for an accurate prediction of the future.

These debates have been brewing for 18 months.  Bankers, however, are getting nervous.In Banks Build Contingency For Breakup Of the Euro, Liz Alderman reports that banks are developing plans in the event that unimaginable break of the Euro in fact comes to pass.

While analysis and hand-wringing serve a purpose to highlight and issue, nothing takes the place of contingency planning.

Beginning with my blog post on July 25, 2010, Debt, Debt, Debt, I have been warning plan fiduciaries that they need to be monitoring the impact of the European debt crisis on their own portfolios and trading strategies.

If the Banks, which were universally “asleep at the switch” in the lead up to the sub-prime crisis are now wrestling with contingent planning with respect to the impact of European sovereign debt, it behooves plan fiduciaries to be engaged in similar planning.

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“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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An Independent Fiduciary Can Be Your Best Friend (and Security Blanket)

No one has the right answer.  This weekend’s news papers and financial blogs are filled with every prediction imaginable (from economic disaster to boons) and financial advice to fit each prediction.

With the markets swinging 500 points in opposite directions, this is not the time to embark on market predictions and changes in investment strategies.

Steep, drastic price plunges are not fun.  Like the free-fall drop on a roller-coaster when your stomach does its own loop-de-loop, these prices plunges elicit a real and physical reaction.  Panic is scary.  A racing heart beat, cold sweats and sleepless nights are subjects of cliches.  But, when you are experiencing it yourself, it ain’t a cliche.  It is very real.

From the deepest wells of our very being, panic surges forward.  The visceral emotional response becomes its own reality.  Emotion as reality.  That is never a good place to be. And certainly, not a time to be making decisions.

Prudence on the other hand, provides the required antidote to panic.  In the perennial push and pull between heart and mind, prudence provides the counter-weight to panic. Defined as “care, caution and good judgment, as well as wisdom in looking ahead” (see, www.dictionary.com), prudence requires the mind to prevail over the heart.

The key to extracting oneself from the distorted reality of pure emotions, one needs a trigger, or a technique to break the panic spiral.  Within the world of managing and overseeing retirement assets, care, caution and good judgment can be supplied by an Independent Fiduciary who can review and assess your portfolios against the plan’s Investment Policy Statement (IPS).  Call her.  She is paid to be prudent.

Hopefully drafted with the assistance of professionals and during a period of lessened volatility and other external pressures, an IPS reflects the prudent judgment of plan fiduciaries.  The IPS, in effect, is the road map for wisdom in looking ahead.  An Independent Fiduciary should always have the IPS in hand.

Have the investment performance of each of the plans’s asset classes evaluated.  Determine if any portfolios need to be re-balanced in order to reflect the allocation among assets classes envisioned by the IPS.  Instruct your Independent Fiduciary to make certain recommendations and then implement them.

Taking specific prescribed actions can deflate the power and energy of panic.  The key is to make sure that these actions had been well thought through before the specter of panic arises on the horizon.  An Independent Fiduciary can help allay the fear and the imprudent actions which a volatile market environment can inspire.

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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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Does Anyone Really Know?

Everyone takes money market funds for granted.  Don’t know where to invest idle cash?   Stick it in a money market fund, right?  Our entire financial system treats money market funds as safe and secure investments.

And, they are safe.  Until they are not.

Today’s NYT, Hopeful, but Wary at Money Markets, prudently identifies the fault lines and risks associated with money market funds.   Fortunately, Edward Wyatt’s reporting is not a Chicken Little,  the-sky-is falling rendition of risks inherent in the financial markets.  [The press and blogosphere are filled with too many of these.]  Instead, Wyatt effectively outlines and explains the risks inherent in money market funds in the context of extreme volatility in treasury securities.

Money market funds exist solely by virtue of a vastly complicated regulatory structure.  Anyone interested in the risks associated with money market funds must be familiar both with the regulations as well as with the investment securities.  One without the other is simply half-the-story.

And, as the Wyatt’s article points out, money market funds are not free from risk.  During the financial crisis of ’08-’09 one of the largest money-market funds, Reserve Primary Money Market Fund, “broke the buck”.  That is, investors lost money.

Plan Sponsors often are not familiar with all of the intricacies surrounding money market funds.  As fiduciaries, however, they should understand the general parameters of the risks.  And, more importantly they should make sure that the experts they have hired are in fact experts on every intricacy and beyond.  The hired experts, however, do not take the plan fiduciaries off the hook.  Everyone needs to be doing their job.

Wyatt, quoting an executive from Fidelity Investments, reports that Fidelity, which manages $440 billion in money market assets, has had “a contingency team focused on this since the end of May.”  Fidelity recognizes that “we have to be prepared to respond to the unthinkable”.

In light of the Reserve Primary Fund’s experiences just a few short years ago, the previously unthinkable is not so unthinkable.

If Fidelity is engaged in contingency planning, prudent dictates that all plan fiduciaries should be engaged in similar contingency planning.  In the financial world, the unthinkable can happen.  Plan sponsors must plan accordingly.

http://nyti.ms/qufP8p

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