Not In-House Lawyers

Any lawyer who has worked in-house in a financial services firm, no doubt, is not surprised about the mortgage documentation mess.  Articles abound in the newspapers:  Gretchen Morgenson, One Mess That Can’t be Papered Over; Joe Nocera, Big Problems for Banks: Due Process; and a NYTimes editorial, More on the Mortgage Mess.

As I have experienced, and many, many friends and colleagues have confirmed, few issues command less respect than properly documenting a transaction, a process or a meeting.  Everyone on Wall Street, and throughout the financial services industry views themselves as a deal-maker, a trader, a big-picture gal or guy.  Documentation is clearly beneath them.  (Yes, this condition crosses gender lines).

I will never forget in the early 90’s when equity swaps and other over –the –counter trades were gaining in popularity.  We were wrestling with the documentation process … executing confirms as well as master agreements.  Admittedly, it is a tedious process.

The Wall Street model had junior associates who worked directly on the trading desks who were responsible for completing first drafts of trading documents.  Deals were only kicked up to the legal department in the event that negotiations broke down over issues like indemnification or other liability limiting provisions.

Not so in our organization.  Notwithstanding my otherwise well-honed skills of persuasion, no one on the trading desk wanted anything to do with documentation.  Any piece of paper with more than 2 paragraphs of written English clearly was a “legal document” and belonged with “Legal”.

I tried to explain that understanding the legal documentation between two parties provided a junior person with valuable training.  Certainly someone who aspired to be an equity or fixed income trader would gain insight into their roles if they understood the contractual nature of the obligations they were creating.

I might as well have been from Mars.   Everyone just wanted to “do deals”.  Very few people were interested in “dotting the ‘I’s’ or crossing the ‘T’s’”.  In the excitement of wracking up large bonuses over the last decade, few people wanted to be bogged down by the careful, detail-oriented work of getting the documentation right.

And throughout Wall Street and beyond, the very people who were disdainful  of documentation, eventually assumed leadership of their firms.  Everyone knows, that the tone is set at the top.

Tens of thousands of mortgages, middlemen, issuers of securities, underwriters and sales people —the fact that there is a mess, does not surprise me.

Go take a poll of in-house lawyers.  I’m sure they read the various accounts of the mortgage mess simply shaking their heads with a profound sense of understanding.

As a lawyer, and as a fiduciary, I know in my gut (in my kishkes) that documentation is crucial.  For when the dust settles, all that is left are the documents.  Lawyers know that, and so do judges.

Fiduciaries have an obligation to act prudently on behalf of their clients.  There is no excuse and no tolerance for the lack of diligence in assuring that all documentation is perfect.  That is our duty.

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Securities Lending Pays for Custody

Louise Story’s original article was the subject of an editorial in Friday’s New York Times, The Bank Wins.  Both the original article and the editorial use the opportunity to engage in the popular and easy task of bank bashing.   However, jumping onto this bandwagon simplifies and overlooks otherwise complicated dynamics underlying our financial system.

Securities Lending– typically knows as Sec Lending — most often is tied to the custody services provided by banks. In fact, in the early days of Sec Lending, the Sec Lending units of banks were often housed within the custody area of banks. And custody sales people often sold Sec Lending relationships.  It wasn’t until the explosive growth area of the late 1990’s when they were granted status as separate divisions or areas within a financial firm.

Sec Lending became a very hot “valued-added” service for the custody banks.   First, pension plans hate paying custody fees.  But they have no choice because ERISA requires that plan assets be held by a custodian (either a bank or an insurance company).  Second, from the bank’s perspective there is little sexy or exciting in the realm of custody other than various accounting and record-keepping services — essentially commodity type products.  Sec Lending, however, holds out the prospect of significant fees.

Pension plans which engage in  Sec Lending can net the revenue generated by Sec Lending against custody fees.  The tight relationship between custody and Sec Lending is reflected in  Mercer consultant, Jay Love’s statement that,”Whenever we say no Securities Lending,” then they say ‘well, we need to talk to you about your custodial fees.'”

Ms. Story also states that “Banks often pressure pension funds to participate in securities lending, pensions consultants say.”   Yes, banks clearly want to sell Sec Lending services, but focusing on “pressure”  seriously mischaracterizes the relationships between banks and pension fund decision-makers.

The custody and Sec Lending business is highly competitive.  Banks don’t like to lose customers … especially to competitors.  Fees and relationship are highly negotiable.

Pension plans have enormous leverage.  They do not have to accept the terms foisted upon them by banks.  And, they have the ability to shop terms around the various banks.  This happens all the time.  There are few secrets in custody/Sec Lending marketplace.   Remember, the pension plans always have the option of saying “no”.  Nothing requires Sec Lending.  This is a powerful position from which to negotiate.

Ms. Story, and the Times editorial, paint a picture of hapless powerless pension plans who are manipulated and at the mercy of the big bad banks.

This simply isn’t the case.  Pension plans must simply exert their fiduciary powers.  Plan fiduciaries must assess  the various risks posed by financial products and accept those risks when they are being adequately compensated.  In order to assess risks, however,  the risks have to be understood.  And this is the rub.  If Mr. Davis (see, Part I) of the New Orleans municipal employees fund is representative of pension decision makers, then assessing risk will be a daunting task.  Clearly, he never understood Sec Lending and therefore was in no position to assess the risk.

To be fair, there were abuses by the banks in Sec Lending.  Investment guidelines with respect to the investment of cash collateral were violated and if many of the facts set out by Ms. Story are corroborated then serious conflicts of interest arose.  Absent these abuses, however, Sec Lending works.  Plan fiduciaries simply have to exercise their fiduciary duties and decide whether they are adequately compensated for these risks.

In light of the abuses, Ms. Story and others suggest that further regulations might prevent future abuses.  No new regulation is needed. Both ERISA and the current Securities Laws are very effective regulatory schemes.  Instead, we need a system in which fiduciaries pose a force as strong as Wall Street’s. http://harrisonfiduciary.com/about/

Attention should be focused on the thousands of plan fiduciaries –many of whom are no different than Mr. Davis.  As Ms. Story states, “no one would take Jerry Davis for a financial hotshot.”  This is a difficult statement to parse.  For it suggests an element of ridicule or even a patronizing attitude.  No, Mr. Davis isn’t a financial hot shot.  But, this isn’t a joke.  He is in the position of making fiduciary decisions on behalf of thousands of workers.  This is not about being a hotshot.  This is about the prudent investment of hard earned retirement dollars.

With over $16 trillion held in retirement plans, it is not surprising that Wall Street devotes significant resources to developing products and services for this market.  The people on Wall Street are both smart and aggressive.   It’s not enough to state that Mr. Davis isn’t a financial hot shot.  Plan participants deserve fiduciaries who are as well versed in investment products as the salesman of Wall Street.

Ms. Story has focused attention on a little understood, but highly profitable product for Wall Street.   This spotlight is critically important.  However, she should follow up her efforts by digging into the qualifications and competence of the fiduciaries overseeing America’s retirement plans.  My prediction is that many would be shocked at what passes for fiduciary oversight. Strong, well trained investment fiduciaries could effect significant financial reform without a single new statute or regulation.

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Securities Lending Was Much Misunderstood

On the front page of yesterday’s New York Times, Louise Story unravels the complicated and profitable securities lending product offered by many banks.  Notwithstanding the slightly biased or misleading headline, Banks Shared Clients’ Profits, But Not Losses, Ms. Story does an excellent job of explaining the complex and somewhat arcane details of securities lending.

However, she misses a critical point  —  no one forced pension plans to engage in these transactions.  While she tends to focus on the missteps or questionable activities by the banks, there seems to be little attention paid to the investors — many of whom simply didn’t understand the basics of securities lending.

Without outlining the intricacies of a securities lending transaction in this space (see the above story and diagram), suffice it to say that securities lending entails leverage and a sophisticated investment management strategy.  Unfortunately, Jerry D. Davis, Chairman of the municipal employee pension fund of New Orleans,  explained that “fund officials did not consider securities lending to be risky.”  Furthermore, “It was, he said, ‘almost like free money'”.

Let’s run through this one again.  Mr. Davis and his colleagues, in their capacity as fiduciaries, agreed to implement a leveraged investment strategy by the pension plan because it was “almost like free money”.  While Ms. Story highlights various allegations against the Banks, she doesn’t point out that Mr. Davis didn’t have a clue as to what he was approving.  No doubt, in light of all of the litigation, there are scores of fiduciaries throughout the pension system who were equally ignorant of the risks posed by Securities Lending.

To truly appreciate this financial narrative, a little history, or context is needed. We’ve seen this movie before. The recent financial crisis was not the first time the Securities Lending industry hit a proverbial bump in the road.

Way back in the spring of 1994 when interest rates reversed a long decline, the uptick in rates generated havoc in the Securities Lending Collateral pools.  The culprits were not sub-prime mortgages, but instruments known as “reverse floaters”.  As the name implies, these products of financial wizardly fluctuated in the reverse direction of interest rates.  Not surprisingly, in a long-term falling interest rate environment, Securities Lending collateral pools were chock full of reverse floaters.

Surprise, surprise.  Interest rates tick up and reverse floaters plummeted.  Securities Lending collateral pools collapsed in values.  In fact, the Boston Company supported it’s collateral pools so that they did not “break a buck”.

Investors were outraged and claimed the investment risk of loss on the collateral pools lay with the banks.  Claims were made, negotiations ensued and various settlements were reached.

In light of some of the ambiguities which surfaced in the 1994 Securities Lending crisis, banks systematically clarified in their documentation that the risk of loss with respect to the investment performance of the collateral resided with the pension fund/client.

The specific allocation of investment risk to the pension fund/client is a key element of the securities lending process.  In fact, many banks offer investment pools with varying degrees of investment risk, and require the pension plan to select a collateral pool which reflects the pension plan’s risk tolerance.

The principle is very simple :  the securities belong to the plan.  If the plan chooses to lend out the securities, then the plan needs to invest the collateral in order to earn a return.  At all times, the securities remain assets of the plans and the plans retain the investment risk.  This risk is never transferred to the Banks.

Finally, the Banks are paid a fee usually a percentage of the investment return generated by the collateral pool.

Now, as Story’s article points out, the Banks run their own risks — they can breach investment guidelines or they can engage in activities which might give rise to conflicts of interest.   But these are risks separate and apart from the investment risk on the collateral.

Far from “free money”, anyone familiar with Securities Lending understands that it is a levered investment strategy with various inter-connecting components.  The documentation reflecting these transactions is dense and very technical.  However, for a fiduciary, complexity is not an excuse for ignorance.  Whether it is securities lending, investing in a hedge fund or commodity ETF’s, Fiduciaries have an obligation and a duty to understand the investments they authorize on behalf of plan participants.

In 1994 it was inverse floaters, in 2007/8 it was sub-prime mortgages, in 2013, who knows what?   But, it is safe to say that Wall Street will invent new products.  Fiduciaries must stay on top of these developments.

(Next Post will be on the relationship between Custody Services and Securities Lending)

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Pension Plans Must be Overseen by Real Investment Fiduciaries

Jeannie Kaplan, a member of the board of education of the City of Denver, explains that when she reviewed and approved a complicated financial transaction on behalf of the Denver teachers’ pension plan, “I sat there wanting to believe what they (Mssrs Bennet and Boasberg, respecitively, the superintendent and chief operation officer of the school system) were saying”.  This was Ms. Kaplan’s way of addressing a $400 million hole in the pension plan and assessing JP Morgan Chase’s proposed solution.

In retrospect she concludes, “The board probably should have had their own financial consultant.”

This revelation is buried deep in Gretchen Morgenson’s article, Exotic Deals Put Denver Schools Deeper in Debt, on the front page of today’s NY Times.  In great detail, Morgenson outlines the deal which the Denver public school system entered into with JP Morgan in order to address the $400 million dollar underfunding of the system’s pension plan. Not surprisingly the terms of the deal (for Denver) have turned south and are going to be costly.  Again, not surprisingly, it will likely turn out to be a rich deal for JP Morgan Chase.

Ms. Kaplan’s statements reveal a dark secret about the $ trillions held by private and public pension funds.  Many (and I would venture the vast majority) are overseen by people with little investment experience and knowledge.  In all likelihood, a review of the transaction by financial consultants would not have produced a different result.  My suspicion is that Ms. Kaplan and her colleagues would have rubber stamped the recommendations made by a consultant in the same way they rubber stamped the recommendations of Bennet and Boasberg.

Would Ms. Kaplan have asked a consultant penetrating questions about the assumptions, potential conflicts of interest or risks inherent in the transaction?  Probably not.  Because the chances are that Ms. Kaplan wouldn’t even know where to begin in asking these questions.

This is the shocking truth.  Many people serve as pension plan fiduciaries who do not even possess a rudimentary understanding of investment and financial principles.

Quite frankly, the participants in the Denver plan, along with the taxpayers deserve far better.  They deserve real fiduciary experts who understand the complexities of managing and overseeing pension plans.  Experts adept in assessing risk, prudent portfolio construction and monitoring various service providers to the plan.

Wall Street professionals are very smart and creative.  Probably much smarter on financial and investment matters than Ms. Kaplan and her colleagues.  Pension plans need fiduciaries who are an equal match to Wall Street.  I’m not suggesting, at all, that everyone on Wall Street is pedaling a scam transaction.  In fact, many Wall Street innovations have proven beneficial to markets and investors.

Instead, fiduciaries, acting on behalf of plan participants need to assess the risks they are assuming on behalf of the plans and assure that the plans are being properly compensated for these risks.  No doubt, any deal proposed by Wall Street, will be good for Wall Street.   Plan fiduciaries need to make sure that the deal is also good for the plan.

There is nothing to cause me to doubt Ms. Kaplan’s capabilities as an effective school board member.  However, she, and countless others, should recognize the limitations of the their skills and delegate their investment responsibilities to experts.  I’m not suggestion that they simply rely upon and rubber stamp recommendations by consultants, but rather delegate responsibility to those who will stand by the fiduciary decisions which they make on behalf of the plan participants.

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Corporate Officers Reluctant to Serve on Fiduciary Committees

Employee Benefit News, reports that HR managers face challenges in attracting and retaining the best employees to serve on fiduciary committees.  Potential committee members are concerned when they learn that fiduciary responsibilities open them up to personal liability for breaches of conduct.

Simply put, who needs that headache?  Even when indemnification is provided, being a defendant in a lawsuit is not what people what people bargained for when accepting the “honor” of serving on a fiduciary committee.  Years after the settlement of a lawsuit, a Google search will reveal this nugget of a committee members professional history.

These concerns are justified.  However, the hidden and unspoken concern is that many plan sponsors lack the infra-structure to support this fiduciary responsibility.  Without a doubt, the most important component of this infra-structure is the culture of fiduciary integrity.  Does the organization value the fiduciary obligations and the processes required to support these fiduciary roles?

Corporate officers may often feel that they cannot turn down appointment to  these committees — declining such a high profile committee assignment could be career-limiting.  Anyone who feels such pressure should take this as the “canary in the coal mine”, that possibly their organization neither understands nor respects the importance of these roles.

Anyone nominated to serve on a fiduciary committee should have an opportunity to ask questions about the role and the opportunity to decline.  Asking questions about a position reflects the very prudence required for the position.  At a minimum, the fiduciary candidate should ask the following questions:

1.  What does the role entail and why have I been selected?

2.  What professional staff will be available to assist and suport the committee?

3.  What training will I receive?

4.  How much time will I need to devote to this and how will it impact my other responsibilities?

5.  Can I review the charter of the committee as well as the fiduciary policies and procedures?

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Compensation expressed as a Percentage of Assets Under Management Needs to be Evaluated

Michael Travaglini  announced his intention to retire as Executive Director of the Massachusetts Pension Reserve Investment Management to join Grosvernor Capital Management.  With remarkable candor, Travaglini explained to the Globe; “it’s an entirely personal (decision) one.  I have a wife and three children and I’m going to provide for them.”

Simply put, it appears that he wants to make more money.  No one can fault a guy for wanting to provide for his family.

Nonetheless, Mr. Travaglini’s career evolution and ambitions raise a significant issue pertaining to compensation and fees in the world of the pension industrial complex.  With $15.6 trillion of assets held by retirement funds (both public and private), everyone wants a slice of this staggeringly huge pie.

Scanning the landscape of various players in the pension market place reveals a common methodology for calculating fees: a percentage of the assets under the control or management of a vendor.  Custodians, record-keepers, administrators, investment managers of all stripes (long-only, private equity, venture capital, real estate, funds of funds and hedge funds), in one way or another, try to tie their fees (whether an annual fee or performance based fee) to the size of the pool of assets they oversee.

In fact, the bonus element of Mr. Travaglini’s compensation arrangement reveals that this culture of compensation tied to the size and performance of an asset pool has even injected itself into government.  Public servants can now expect a performance bonus.  Does that mean that Deval Patrick should get a performance bonus if he increases employment in the Commonwealth?  What about Ben Bernanke and Tim Geithner, should they get a fee based upon the size or growth of GDP?

Admittedly, the examples of Patrick, Geithner and Bernanke are ridiculous.  But, we must ask the question, why is providing Travaglini a performance bonus not equally ridiculous?  For some reason, it appears to be more acceptable that he and his staff be eligible for a bonus.

The standard response is that bonuses are needed to attract talented professionals;  otherwise, the private sector will attract the top talent.  I don’t buy that explanation.  First, even with the bonuses paid to either Travagliani or his staff, the private sector pays many multiples of what is offered by state government.  Second, the likes of Patrick, Geitner and Bernanke, and countless other public servants could all make more money in the private sector.  Nonetheless, they choose public service.

Whether consciously or not, it is now accepted practice that many retirement plan service providers are entitled to bonuses and compensation tied to performance and the size of asset pools.  The great irony, however, is that over the past few decades, many of these services have become commodities.  Practically, everyone is doing the same thing.  There are few secrets in the pension industry.

Custody, record-keeping and administration services are almost identical from bank to bank, consultants hype the same or similar analysis and methodologies, and certainly indexing is the same all over.

In light of these accepted compensation practices, the earnings of many members of the pension industrial complex have sky rocketed beyond belief.  In his best seller from the 1940’s, Fred Schwed asked, “Where are the Customers’ Yachts”.  Today, the yachts seem somewhat quaint, now we can point to private planes, ranches in Montana and vineyards in Sonoma or Burgundy.

While compensation has hit the stratosphere, we need to acknowledge that many retirement funds (both public and private) are experiencing severe underfunding.  Let’s not forget, the service providers are being paid by the retirement plans.  Every dollar paid to a consultant or fund manager is a dollar out of the pocket of a pensioner — especially in times of underfunding.

The system is out of balance.  There is no easy prescription for a quick fix.

At a minimum, those people who have assumed stewardship roles over funds, whether as trustees or fiduciaries, must begin holding service providers more accountable on issues of compensation.  As an industry, we must seriously examine the role of bonus fees and asset-based compensation arrangements.  They must be the exception not the rule.  An overall reassessment of these compensation arrangements will no doubt lead to significant compression of fees.  As John Bogle has proselytized for years, reduced fees over time result in higher investment returns.

Finally, as for Mr. Travaglini, while he might not be satisfied with the long term prospects of his current compensation package, he must have realized that the non-financial compensation he has received from the Commonwealth has been invaluable.  Under the current system, he will leverage his years of public service, including the many contacts that he made at public funds across the country, into a lucrative career selling the services of Grosvenor Capital Management.  Compensation is a broad concept.  Not everything can be reduced to dollars and cents.

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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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Banks fight to maintain $22.6 Billion in Derivatives Trading Revenues

The New York Times reports today that bank lobbyists are fighting desperately to save the trading revenues from their derivatives desks.  http://nyti.ms/aaGgen.   Considering 5 banks (Bank of America, Morgan Stanley, JP Morgan, Goldman Sachs, Citigroup) dominate the derivatives business, that’s $4.5 billion per bank.  I’d also fight like hell to save those revenues.

According to the Article, “the financial industry says that derivatives are a valuable product used by more than 95 percent of Fortune 1000 companies to hedge against risks, including price changes.”  However, the issue is not whether Fortune 1000 companies view derivatives as a valuable risk management tool, but whether banks which benefit from federal safeguards should provide these products.

Yes, derivatives are a core banking product.  And yes, they provide significant profits to banks.  The question is:  Should this continue?

As I wrote in a prior post, Goldman’s Clients — Caveat Emptor, the largest banks rely upon a significant conflict of interest within their basic business model.  No where is this more evident than with trading derivatives.  And as the above numbers reflect, huge bucks depend on this.

First, we must be mindful of the fact that derivatives come in all shapes and sizes, from the most simple to the most esoteric.  And, as always, when we speak in generalities we must be careful.  Nonetheless, it is safe to assume that derivatives are risk reducing tools.  These tools can be used to assist clients with managing their own risks, and they can be used among the banks themselves (and other financial institutions) to apportion risk.   I am more focused on the former than the later.

As my prior post outlined in greater detail, Goldman explains that its risk business (e.g. derivatives business) grows out of its investment banking relationships with clients.  In other words, once Goldman has secured a relationship as an advisor to a client, it then introduces the client to various derivatives strategies.

Upon entering into a derivatives contract with Goldman, the client has evolved from an advisory relationship to an adversarial one.  Counter-parties to a contract, by definition are adversaries.   If Goldman continues to cultivate the advisory relationship (which of course it will), while at the same time maintains and cultivates additional counter-party relationships with the same client, it has entered into significant conflicts with this client.

On the one hand, where the derivatives are plain vanilla interest rate swaps, there are fewer concerns.  That is, many Fortune 1000 companies have expertise within their own treasury departments to make informed decisions about entering into a derivatives contract.  However, quite frankly, the banks don’t make a lot of money of these transactions. Instead, it is in the highly “bespoke” arrangements where the banks both earn the most money and undoubtedly where the clients rely upon the bank’s advice the most.  This is precisely where the greatest conflicts lie.

Again, I don’t mean to pick on Goldman, this is rampant throughout the industry. Not only is it rampant, but these very conflicts help to turn on the lights every day.  For instance, JP Morgan Chase reported $3.3 billion in earnings for Q1 2010 on revenues of $8.3 Billion.  Therefore its $4.5 billion share of derivatives revenue, constitutes about 12% of its revenues (assuming Q1 revenue numbers are annualized).   We are not talking about insignificant numbers, here.  This is worth fighting for.

The other point is that in light of Goldman’s recent challenges concerning the ABACUS deal, many people think of complicated synthetic mortgage backed instruments when the topic of derivatives is raised.  However, the term derivatives encompasses many types of instruments which are sprinkled throughout corporate America.  They are not some isolated, esoteric, rarely used instrument.  They have become a bedrock of the financial industry.   That is why the battle is so heated.

Whether the banking lobbyists are successful in retaining the derivatives trading desks within the banks, or whether the desks get pushed out into affiliated entities, in my mind, the most insidious aspects of derivatives trading will continue — the fact that the bank serves both as advisor and counter-party.

Clients, commentators, policy makers, advisors and bankers themselves need to be aware of these conflicts.   As Justice Brandeis once said, “sunlight is the best disinfectant”.

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Let me see if I get this.

Lehman takes the position that the repo transactions it entered into in order to reduce the size of its balance sheet, constituted a sale transaction rather than a loan.  (See, Floyd Norris, NY Times, April 2, 2010, Demystify the Lehman Shell Game). The argument is that since the value of the securities exchanged by Lehman were greater than the amount of cash it received in the transaction, it would never purchase these securities for the same price.  In other words, it would never “overpay” for these assets, therefore, the transaction had to be a sale.

But wait a second, forget for a moment about the repurchase part of the transaction, doesn’t that mean that Lehman “sold” the securities for less than adequate consideration?  If I’m understanding this correctly, the logic is that it is OK to sell an asset for less than its value, but not OK to overpay for an asset.

This feels like Alice in Wonderland.

If I were a Lehman shareholder or a board member, I’d be very happy that my smart, hard-charging Wall Street financiers were not willing to overpay for assets. But, I’d be distressed that these same investment professionals were willing to sell corporate assets for less than fair value.  Great business franchises are not built upon selling assets for less than fair value.

The convoluted logic put forth by Lehman is likely supported by well articulated legal and accounting documentation.  The problem is that we have a generation of talented, lawyers, accountants and investment professionals who are adroit at mastering complicated concepts and principles for the purposes of erecting extraordinarily complicated and sophisticated legal structures.  All too often, however, these professionals get lost in the brilliance of their creativity and problem solving capability.

This is the proverbial forest and trees issue.  Everyone gets so caught up in the composition and structure of the trees, that they lose sight of the forrest.

How could it ever be acceptable to assume less than adequate consideration upon the sale of an asset and yet refuse to pay more than fair value upon buying the exact same asset.  Lehman is asking us to accept that 1+1=3.

As fiduciaries, it is our responsibility not to loose sight of the forest.  We need to be able to both assess complicated products and structures, but we also to be able to step back and ask a simple question: Does this make sense?  Or, more specifically, using the language of fiduciaries:  Is this prudent?

Ostensible a simple question:  Is this prudent?   However, when certain practices and assumptions become common place throughout an industry and culture, it can be a very difficult question to ask.  However the importance of asking the question, is directly related to the difficulty in raising it.

Our entire retirement industry, and even the global financial markets, require fiduciaries to raise their hands and say, “No, 1+1, does not equal 3.”

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“Financial Innovation Boosts Economic Growth,” an Oxford-style debate — featuring Jeremy Grantham, a doyenne of investment management, and author Richard Bookstaber, author of A Demon of Our Own Design: Markets, Hedge Funds and the Perils of Financial Innovation, opposing the proposition, and Myron Scholes, Noble Prize winner, and Robert Reynolds, CEO of Putnam Investments, in favor of the proposition — is summarized in an Appendix to Grantham’s January 2010 Quarterly Newsletter entitled, “What a Decade!”

In offering stinging criticism about the investment management industry, from which he admits he has profited handsomely, Grantham provides:

Clients can’t easily distinguish talent from luck or risk taking.  It’s an unfair contest [between clients and the investment management industry], nothing like the fair fight assumed by standard Economists.  As we add new products, options, futures, CDO’s, hedge funds, and private equity, aggregate fees per dollar rise.  As the layers of fees and layers of agents increase, so too products become more complicated and opaque, causing clients to need us more.

The ultimate industry insider acknowledges that the game is stacked against the clients in favor of the service providers.  Ironically, however, he includes that the high fees, complexity and opacity, create greater reliance upon the industry itself.

Au Contraire!!  The trifecta of high fees, complexity and opacity cries out for the role of professional fiduciaries to cut through the jargon, smokescreens and hype surrounding the investment of plan assets.

To focus momentarily just on fees, as fiduciaries, with respect to administrative expenses, we clearly have an obligation to “defray reasonable expenses.”  The explosion of fee litigation clearly bears this out.  However, with respect to investment management fees the directive is not as explicit, but nonetheless the obligation to monitor fees is critical.  Certainly there is an obligation to make sure that fees are reasonable, but the exclusive benefit language in ERISA also suggests that where possible, fiduciaries should work to reduce fees wherever possible.  Simply put, any reduction in fees is an increase in the assets available for plan participants and beneficiaries.

The current shock to the financial system, as well as to client portfolios across the board, provides a unique opportunity for fiduciaries to review all of their investment relationships not only with respect to investment performance, but also with respect to fees.  Fiduciaries must ask themselves a hard question; are the fees being charged by private equity, real estate, venture and hedge funds justified by the investment returns being generated and the risks assumed?

The current financial environment levels the playing field between the investment management industry on the one hand, and plan fiduciaries on the other.  Plan fiduciaries must jump at this opportunity to exercise responsibility to strike deals in the best interest of their plans. Negotiate, negotiate, negotiate!

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