The Billionaire vs. The Bank

Published on 15 October 2010 by in Uncategorized


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

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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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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.   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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