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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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.

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Don’t Just Blame the Rating Agencies

The Financial Stability Act of 2010 includes various provisions relating to Nationally Recognized Statistical Rating Organizations (NRSRO) — Rating Agencies — ranging from Senators LeMieux and Cantwell’s laissez faire elimination of NRSROS to Senator Franken’s governmental assignment of NRSRO’s to specific bond offerings. While the extremes are covered, a middle of the road approach is missing.

Fortunately, we have been through this dance with the role of Rating Agencies once before, and the SEC came out with a prudent solution.

Every mutual fund lawyer knows that advisors to money market funds cannot blindly rely upon the the Ratings Agencies’ assessment of a debt instrument. Instead, money market fund advisors must do their own credit homework in analyzing debt instruments.  They may take into account a Rating Agency’s rating as one factor in their own analysis, but the rating can not be a substitute for their own analysis.

This issue was firmly put to bed in the early 1990’s.

A little background.  Money Market Funds are allowed to keep their share prices valued at $1.00 per share (irrespective of slight movements of net asset value of the fund) provided they abide by certain credit and diversification rules. (Set forth in Rule 2a-7).  In other words, money market funds are exempt from the basic rule that the share price of a mutual fund must fluctuate and reflect the net asset value of the assets held by the fund.

One of the core provisions of Rule 2a-7, is that a money market fund must “limit its portfolio investments … to instruments which … present minimal credit risks”. After a series of commercial paper defaults in the late 1980’s, the SEC substantially modified Rule 2a-7 in 1991.  Among other changes, the SEC, for the first time amended the “minimal credit risk” requirement, by adding the following parenthetical; “(which determination must be based on factors pertaining to credit quality in addition to the rating assigned to such instruments by a NRSRO)”.  The Commission explained that the language was designed to emphasize that:

Possession of a certain rating by a NRSRO is not a “safe harbor.” Where the security is rated, having the requisite NRSRO rating is a necessary but not sufficient condition for investing in the security and cannot be the sole factor in determining whether a security has minimal credit risks.

This simple amendment transformed the management of money market funds. For over 15 years, money market fund advisers have had to undertake their own credit analysis.  Rather than relying on the Rating Agencies, investment firms had to develop their own staff of credit analysts.

Investors burned by investments in mortgage-backed-securities and CDO’s cannot place all of the blame on the Rating Agencies for the investment losses that they incurred.  I am hardly an apologist for the Rating Agencies given the various allegations of collusion between the Rating Agencies and Wall Street firms, as well as the conflict of interest inherent in their business model in which the issuers of securities pay the fees of the Rating Agencies.  Nonetheless, investors must take some responsibility for their investment decisions.

The unanswered question in the subprime financial crisis is whether investors did their own credit analysis with respect to the various mortgage-related instruements.  Those who did, not only likely sidestepped the crashing market for these instruments, but  some made fortunes on their bets against these instruments.

Michael Burry, Steve Eisman and Robert Rodriguez, profiled in Michael Lewis’s, The Big Short and Roger Lowenstein’s, The End of Wall Street, are examples of investment professionals who did their homework and did not blindly rely upon the pronouncement or ratings of Wall Street’s standard bearers.

In my mind, the lesson is simple, particularly for investing fiduciaries.  Do your homework.  In the constellation of jobs within the financial services industry, credit analysis is neither glamorous nor high paying.  Everyone would rather be a deal-maker or a hedge fund maestro.  But with complicated investment products and volatile global markets, I want to stick with the guy who does his credit homework.  Rigorous credit analysis can never be a bad thing.  Whereas as blaming the other guy — such as the Rating Agencies — seems, shall we say … a bit unfiduciary-like.  Instead, we need fiduciaries who will raise their hands and say, “I did my homework and I take responsibility for my decisions.”

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