Are Fiduciaries Paying Enough Attention to Default Risk?
According to Wall Street Journal reporters Kate Kelly, Liam Pleven and James R. Hagerty, at least ten funds struggle with sub-prime loan woes in the form of diminished portfolio values. As if that isn't bad enough, some institutional investors are being given the unhappy news that withdrawals are suspended. For pension funds in search of liquidity, look elsewhere. (See "Wall Street, Bear Stearns Hit Again By Investors Fleeing Mortgage Sector," Wall Street Journal, August 1, 2007.)
As the fallout continues, with no end in sight, it is worth repeating that fiduciaries are on the hook for creating, and then following, a prudent process with respect to investment selection. ERISA itself mandates that employee benefit plan fiduciaries must carry out their duties in the sole interest of the plan's participants and with the "care, skill, prudence and diligence under the circumstances then prevailing that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims."
These few words speak volumes about the many things a plan sponsor must consider before committing money to a particular instrument, strategy or asset manager. Questions naturally arise. A few of them are shown below.
1. Have plan sponsors sufficiently queried asset managers about how they measure default risk ?
2. How are structured financial transactions collateralized?
3. Who is responsible for collateral management?
4. What safeguards exist to enforce collateral quality and amount?
5. Do asset managers make their policies and procedures available to plan sponsors who want to know more about valuation, operational controls, collateral issues and trading limits?
6. Are positions being marked to model?
7. Who reviews the integrity of the model and related data inputs?
8. What could cause estimated default risk to rise for "questionable" borrowers and how are asset managers tracking identified risk drivers?
9. What are the investors' rights to withdraw funds?
10. Does an asset manager reserve any capital against its expected risk exposure, voluntarily or otherwise?
Several observations are in order. First, investment problems are not unique to small funds. To the contrary, some large mortgage-related funds (in terms of assets) are currently in crisis mode. Second, recent market drops and rising credit spreads are forcing companies to delay IPOs or incur higher costs of capital. This means that all investors are invariably impacted. Third, the fallout is global, with several prominent non-U.S. funds announcing big hits.
This may be the beginning of the end for easy credit and the start of a "brave new world" for plan sponsors who cannot afford a "see no evil, hear no evil, speak no evil" approach.
