Harrison Fiduciary

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.

Continue Reading

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)

Continue Reading

Too Tough Too Call

For Joe Nocera, of the NY Times, it’s an easy one.  He’s rooting for the billionaire — even if the billionaire is not “someone for whom one’s heart instinctively bleeds”.

According to Mr. Nocera’s most recent column, A Billionaire Army of One vs. a Bank, Mr. Blavatnik, a Russian born American citizen, gave JP Morgan $1 billion to manage in a short-term cash portfolio.  A sizable portion of the portfolio was invested in tranches of mortgage-backed securities, as well as securities backed by home equity loans. This was all in the spring of 2006, flash forward to July 2007 and the securities begin loosing value.  All in, by April 2008, Mr. Blavatnik lost $100 million.

Mr. Blavatnik naturally sues JP Morgan.

Mr. Nocera admits in his conclusion that he is “looking for ways for banks to pay for their sins”.  This quest for retribution, however, quite possibly glosses over some complicating facts or questions — which in my mind makes this case too close to call.  Admittedly, my perspective is informed (or maybe clouded) by the fact that I am a lawyer, and I worked for a financial institution which reported that it settled similar types of claims with institutional investors.

My position in short:  there’s more than enough blame to go around.  It’s not so clear that the Billionaire comes to this dispute without bearing some significant responsibility for his own actions.  We must leave it to the judge to determine how much.

In 2006, interest rates were low, very low — “miniscule” — according to Mr. Nocera. At that time, Mr. Blavatnik along with scores of investors (major institutions: pension funds, endowments, and super high net worth individuals) were looking to increase their yields.  In other words, they wanted above average yields.  Specifically, Mr. Blavatnik wanted “just a quarter of a percent more than a typical money market fund”.  While Mr. Nocera downplays this stretch for yeild, by referencing an expert who suggests that this investment goal was “unambitious”, 25 basis points, in an environment when yields are “miniscule”, might not be so unambitious.

With these unambitious investment goals in mind, and supposedly directing JP Morgan that the account had to be “no-risk”, Mr. Blavatnik nonetheless signed investment guidelines (negotiated by “Mr. Blavatnik’s executives”) which authorized an allocation of 20% of the portfolio to mortgage-backed securities and 20% to asset-backed securities.

What?  Wait a second — here’s the rub — if Mr. Blavatnik was truly risk adverse, why would he have agreed to allocate 40% of his portfolio to non-traditional, or alternative assets.  I’m merely a lawyer, but that is not an unambitious allocation of assets.

Furthermore, who were these “executives” who negotiated on behalf of Mr. Blavatnik? Were they investment professionals?  Were they experts in alternative asset classes? What questions did they ask?

Mr. Nocera dismisses the “sophisticated investor” defense rather summarily with a reference to the Goldman Abacus lawsuit and auction rate securities sold by banks.  But, it’s important to be very clear that this situation is not analogous to the auction rate securities where retail investors lost money in no-risk accounts.  Mr. Blavatnik’s executives negotiated very specific and detailed investment guidelines.  With a net worth of supposedly $7.5 billion, the JP Morgan account executives would have made themselves available to answer every single one of his questions.

And, what about the monthly reports which were provided to Mr. Blavatnik, did he read them?  Did he understand them?  If he didn’t understand them did he ask any questions?  Again, what about his experts?  What was their analysis of the monthly reports?

I am not an apologist for the banks.  Far from it. No doubt if JP Morgan breached the investment guidelines, that is very problematic.  Also, no doubt the JP Morgan account executives where deep in a sales mode when presenting this strategy to Mr. Blatnick.  It is critical to understand the representations which were made in assessing responsibility.  Furthermore, I am equally troubled by the fact that a client who purported to be risk-adverse, was nonetheless presented with a set of investment guidelines which allocated 40% of the portfolio to alternatives.  I’d like to hear an unbiased expert on this.

Sins may have been committed by the Banks and Financial Institutions, but investing money on behalf of a Billionaire (absent misleading statements, etc) is not one of them.  Outside of the ear-shot of attorney’s, I suspect that Mr. Blavatnik

Continue Reading