Pension Risk Matters : Pension Risk News & Analysis : Investment Governance, Inc. : Pension Risk & Investment

Reporter Fabrice Taylor authors an interesting article in the January 30, 2007 issue of Globe and Mail. It's not  a paper I regularly read though I may start.  (This blog's author happens to be in Toronto right now as a speaker about U.S. pension litigation trends, part of the Canadian Institute's conference on Pension Law, Litigation and Governance).

Anyhow, I digress.

"The minefield of derivatives" points out a somewhat dramatic irony. How could a well-read UK risk publication have known that showcasing Societe Generale as the "Equity Derivatives House of the Year" in its January 2008 issue would later raise eyebrows? Taylor continues that derivatives are not inherently bad unless used by those "who don't understand them or have the wrong incentives." Touche!

He urges readers not to scare in the presence of the very large numbers that characterize the global derivatives market. I concur. As I discuss in Risk Management for Pensions, Endowments and Foundations, notional principal amount is often a far cry from the economic exposure at stake. Another point which resonates is his comment that "Most derivative explosions happen when a trader thinks he understands the co-relationships between a basket of related derivatives and learns, painfully, that his computer models were wrong." Indeed.

Model risk is a story in bad need of being told again and again. This blog's author has written a few articles on the subject. Drop a line if you'd like a copy. There is MUCH more to be said here, including what constitutes a good model and, by extension, when a model may be ill-suited or entirely inappropriate for a given situation.

Taylor concludes that greed drives many bad trades, frequently caught long after the damage has been done. Comparing last year's Wall Street bonuses of $33 billion to $100 billion of reported credit write-downs, he adds "Shareholders lost that money; rest assured the bonuses won't be repaid to them."

Interesting take from the land of the maple!

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World business glitterati leave Davos, Switzerland with a renewed vigor to tackle problems du jour. Not surprisingly, those who attended the World Economic Forum had plenty to say about financial markets and risk.  

According to Clara Ferreira-Marques and Sue Thomas of Reuters, Raymond McDaniel, Chairman and CEO of Moody's, declared that "A lot of things could have been done better - some are the responsibility of rating agencies, some of other participants in the market." Guillermo Ortiz, Governor of the Central Bank of Mexico, urged more transparency. "The complexity of the products and financial innovation made it more difficult -- even the regulators failed to understand. It was an exercise in collective confusion."

For those who stayed home, a trip to the conference website is telling. Part of a panel about financial markets, Dominique Strauss-Kahn, Managing Director of the International Monetary Fund, described "low interest rates, high liquidity, a breakdown in credit and risk management practices, and a shortcoming in US financial regulation and supervision" as culprits. Central bankers concluded that the "causes behind the latest financial crisis were complex" with "some time before regulators and market players can fully grasp what went wrong."  A session moderated by CNBC's Maria Bartiromo (who interviewed me about pension investing on June 14, 2007) included a comment by Walter Kielholz, Chairman of the Board of Directors, Credit Suisse about the struggle for banks to generate returns even though "for four to five years, financial institutions have believed there is too much of an appetite for risk in the market."

Here are a few of my favorite "you don't say" quotes about risk.

• “The only perfect hedge is in a Japanese garden.” (Gene Rotberg, former treasurer, World Bank)
• “Due to my inexperience, I placed a great deal of reliance on the advice of market professionals…" (Robert Citron, former treasurer, Orange County, California)
• "There is no such thing as a free lunch." (Milton Friedman, Nobel Prize winning economist and author)

If you know of any interesting statements about financial risk (including those which defy rational belief), we'd love to receive them. Similarly, it would be great to get your feedback about the role of regulation. Do we need more rules to govern investing? Click here to send us an email.

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Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. This program is pending approval for 1.5 PD credit hours as granted by CFA Institute.

Join us on March 3, 2008 from 11 am to 12:15 pm EST for a lively discussion about ways to mitigate transaction risk.

Description: Fiduciary duties mandate oversight of external asset manager selection. This includes a proper vetting of trading-related controls and the process used to determine limits, authorized persons, style drift, early warning signals and liquidity traps.

Who Should Attend: Plan sponsors, plan administrators, pension consultants, board members with responsibilities for selection of investment fiduciary advisors, regulators, bankers, mutual fund and hedge fund managers with (or seeking to attract) pension fund investors

Learning Points: Topics covered during this 75 minute online and telephone event are shown below.

• What Constitutes "Must Have" Elements of Effective Risk Management Systems
• Ways to Detect Deviation from Management Style and/or Excess Position Concentration
• Red Flags Regarding Possible Rogue Trading
• Industry Best Practices for Trading Controls
• Lessons Learned About What to Avoid

Speakers:

• Dr. Susan M. Mangiero, AIFA, AVA, CFA, FRM - Moderator
  President
  Pension Governance, LLC
• Mr. W. Anthony Turner - Speaker
  Principal
  Financial Tracking, LLC
• Mr. Gavin W. Watson – Speaker
  Business Manager for Asset Managers, Pensions and Insurance
  RiskMetrics Group, Inc.

To register, click here. There is a modest charge of $125 per person. If you are interested in a discounted rate for multiple attendees, email PG-Info@pensiongovernance.com.

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The news broke on January 24, 2008 that a rogue trader at Societe Generale was allegedly responsible for nearly US $7 billion (4.9 billion euros) in fraudulent transactions. Hours later, Bank of France governor, Christian Noyer, tried to allay fears. Refuting any connection between sub-prime exposure and the situation at hand, Reuters reports Noyer as saying that "nobody could have foreseen the loss" but acknowledged that risk controls should have been a barrier. "Today we have seen there was a glitch in the system that was exploited by someone who I think got around five successive risk control systems." See "Bank of France head reassures after SocGen fraud" (January 24, 2008).

When contacted for comments by www.pensionriskmatters.com, Mr. Tony Turner, principal with Financial Tracking, LLC asks - "Who was watching the store and who was watching the watchers? This highlights the need for automated and consistent monitoring and alerting."

What's interesting (at least based on preliminary public information) is that the identified bad player was supposedly an expert in operations and able to use that knowledge to his advantage. Many questions arise. 

• How should back office, middle office and front office controls change to avoid a repeat occurrence?
• What role do humans play with respect to monitoring computer systems thought to be otherwise safe from attack?
• Who should ultimately bear responsibility for le rogue trader?
• Is this type of fraud a "black swan" event or can we expect more trouble?
• What can pension fund decision-makers do to better vet their banks' risk controls?

This will not be the last time we read about fraud and its potentially devastasting impact on related parties.

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In "Investing in Good Governance: Subprime-Related Losses Stir Up the Conversation," reporter Rachel McMurdie addresses the growing number of lawsuits in pensionland, along with an urgent focus to identify improvements that can and should be made. Interviewing this blog's author and fellow blogger, attorney Stephen Rosenberg, McMurdie describes recent attempts to codify pension governance standards. One initiative, the Clapman Report, is something I analyzed at length when it was published in the summer of 2007.

Click to read the full text of "Investing in Good Governance" (The Institutional Real Estate Letter, January 2008). Click for our take on the Clapman Report. 

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According to Canada.com, NatBank Brokerage will pay $750,000 (assume this is Canadian dollars) to medical doctor, Gilles Dussault. Representing lost income and interest on such, the court-determined fine follows a rough and tumble relationship between the physician and his brokers, a father and daughter team. Advised to short $2 million of savings bonds and then left to make his own decisions when prices rose, Dussault's losses grew until, two and a half years later, his holdings were liquidated to "cover what he owed in 1996." As a result, Dr. Dussault sued, alleging that the "original short sale was contrary to his investment objectives and financial interests." The bank countered, asserting that he knew the risks all along and that his losses would have been smaller had he closed his position sooner than occurred. In a 29-page opinion, Judge Mark Peacock described the plaintiff as "a man alone in a rowboat in a storm in the mid-Atlantic," adding that "The firm had always been his guiding light in the past and now that the waves were towering over him, the beacon was gone." He further characterized the transaction as conflicting with the investor's objectives and lambasted the brokers for not providing adequate information about the riskiness of the short sale. (See "Bitter pill for NatBank brokerage, Canada.com, January 16, 2008 for the full text of the article.)

Thanks to Mr. Carlos Panksep, General Manager of the Centre for Fiduciary Excellence, for pointing out this item. When asked what caught his attention about this news story, Carlos responded as follows. "In reading about this case, I could sense the lack of fiduciary accountability on the part of the advisor, possibly due to her inexperience. However, a firm which promotes a high priority to fiduciary education and sensitivity would have possibly avoided this outcome. I hope this firm will improve its practices as a result rather than bury this incident as unimportant or rare."

On the institutional front, Massachusetts Secretary of State William F. Galvin is asking Merrill Lynch about a $12+ million loss incurred by the City of Springfield. According to The Republican, the Springfield Control Board accuses the brokerage firm of "investing funds in an unsafe manner not permitted by state law." Focus on a collateralized debt obligation ("CDO") known as "Centre Square" ("a fund based in the Cayman Islands and Delaware") will logically examine why a $12.6 million spring 2007 outlay fell to $1.2 million by November. Reporters Peter Goonan and Dan Ring write that Merrill Lynch has declared the city responsible for making "its own investment decisions." (See "State subpoenas Merrill Lynch officials in Springfield investment loss," January 14, 2008). 

Expect more articles along these lines of "he said, she said." Inevitably losses (especially big ones) are going to result in lawsuits. Determining who bears ultimate responsibility is far from trivial and opens the door to other inquiries. Disclosure is a factor. Education is another consideration.

• Suppose a broker (advisor) provides significant information about risk drivers but the investor is unable to digest it properly. Should the broker (advisor) turn down the business even if it means that he (she) might lose his (her) job for not bringing in enough clients? How will he (she) know that a client is ill-equipped to invest in a particular instrument or strategy?
• In the absence of mandatory education and experiential requirements to sit on a city board (or state or company equivalent), what controls should be in place to preclude individuals from being able to inappropriately commit funds? How should the institution better vet the broker (advisor) at the outset and during the investment period?
• What constitutes fraud on the part of the broker (advisor) for not "properly" disclosing risk factors?
• Will the typical broker (advisor) be able to adequately explain the risk trouble spots associated with a complex investment instrument or strategy? If not, why are they promoting such to investors?
• For individuals or institutions, what safeguards (action steps) should kick in as an investment is heading south, if at all? (Value may plummet only to rise again as long as the position is not liquidated before recovery.)
• How should regulators better define and enforce suitability?
• What role should the market play in terms of "lessons learned" by various players? 
• Will attorneys have a different take on suitability than that of brokers (advisors)?

A recent article about UK trustees suggests that fiduciaries may acknowledge a problem but not feel comfortable moving towards a solution. In "Trustees ask for help," Global Pensions reporter Heather Dale (January 21, 2008) cites grim statistics from Hewitt Associates. Requests from British plan decision-makers "have doubled over the past 18 months" at the same time that more work, due to increased regulatory scrutiny, adds pressure. Do the math. More work, more complexity, more pressure, more scrutiny = big challenges. Does this mean that trustees must forge an even closer relationship with the fund's broker (advisor)? If so, how will questions of responsibility be impacted?

Caveat emptor will surely be the watchword for months to come. At what point are individuals (institutions) considered "duped" into investing in "excessively risky" assets and on what basis? How should suitability vary by type of institution? How can plan participants, shareholders and taxpayers better inform themselves about the risks being taken by a particular city, state or company pension?

The questions are endless. The answers are important.

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• In a liberalized environment, Farmer A gets a new cow. Farmer B admires his neighbor's addition and works hard to buy a cow of his own.
• In a state-run society, Farmer A gets a new cow. Farmer B realizes that he must work to pay taxes to feed Farmer A's cow. With a fixed wealth pie, levies diminish Farmer B's money pot, thereby giving Farmer B an incentive to destroy what he must support. He plots to get rid of Ms. Moo, making Farmer A worse off and arguably costing Farmer B time and money to pursue his wicked ways.

Friction is inevitable when players are encouraged to abide by a "you win, I lose" mentality. Reward silo decision-making and don't be surprised that people behave accordingly.

If the "me generation" characterizes your place of work, look out. Risk management is going to be a tough challenge. Effective enterprise wealth creation requires fluid communication and seamless operations. One hand must know what the other is doing in order to properly identify how various determinants of economic value either offset (hedge) or accelerate loss (leverage, correlation, lack of diversification).

Given its historic, just announced, write-down of $16+ billion, Merrill Lynch is taking the cow tale to heart. When asked by the Wall Street Journal to address "what shocked" the new CEO the most when he took the reins, John Thain replied - "Two things. One was the lack of understanding of the risk in these positions, and the lack of balance-sheet control. The balance sheet really got out of control, and traders were able to put on positions that were way too big, and I don't (think) there was a good understanding of what the risk was." He also added that "Merrill had a risk committee" but that "It just didn't function." (See "Merrill's Risk Manager" by Susane Craig and Randall Smith, January 18, 2008.)

Thain's response? Don't kill the cow. Encourage people to work together. In the same interview, Thain describes a newly mandated weekly meeting with the respective heads of fixed income, equity and risk. The goal is to avoid undue risk-taking that could bring down the house, not just for one group but for everyone - employees, shareholders and so on.

Pension fund managers can learn a few things from the Parable of the Bovine and Merrill's painful progress in managing large losses.

• Acknowledge the value of working across divisions and job functions. Don't make investment or plan design decisions in a vacuum.
• Don't empower one or more players to "run away" on their own. Internal controls are imperative. That includes a proper assessment of how external asset managers, custodians, consultants and the like manage their own financial process. If they are exposed to potential trouble spots, so are you.
• Understand that a buy-in of good risk management practices by you and your peers raises the bar for everyone. Good team players should be rewarded by how the organization fares, not a particular division.

The Cow Theory may not push the Dow Theory off the investment map but it should be heeded nevertheless.

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Featured in the January 2008 issue of Emerging Manager Focus ("People to Know"), this blog's author reiterates the need for investors to verify how a hedge fund marks its positions to market (or model). An excerpt is provided below. To read more, download the pdf file by clicking here.

"Mangiero admonishes institutional investors to steer clear of any fund that provides their own marks for infrequently traded instruments. “Traders are encouraged to inflate asset values if their bonus emphasizes return and ignores the risk side of the equation. Those responsible for due diligence cannot look the other way. Independent third party providers must be involved in the valuation process. Surprisingly, this message is only beginning to resonate because it’s not always clear who is doing what. A pension fund may hire a consultant or fund of funds manager, thinking that they are investigating how numbers for ‘hard to value’ assets are determined, only to discover that neither they nor the administrator, custodian or prime broker do anything more than accept inputs from the traders.” Other elements of good valuation process are addressed in her newly developed course on hedge fund valuation for the National Association of Certified Valuation Analysts, including an overview of the part of the Pension Protection Act of 2006 that addresses valuation."

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Boston ERISA & Insurance Litigation blogger, attorney Stephen Rosenberg, gives our just launched litigation database passing marks. In his January 17, 2008 post, Stephen writes:

<< Dying is easy, comedy is hard? No, ERISA is hard. I tell people all the time that there is almost no such thing as a simple answer to an ERISA related question, or at least no such thing as a straightforward answer. There are entire chapters in ERISA treatises dedicated to the seemingly, but actually not, question of the proper manner in which to request plan documents so as to invoke the statutory obligations, upon financial penalty, imposed on administrators to produce them. Or take the question of equitable relief in a cause of action brought under ERISA; in almost every other area of the law, we all know what equitable relief is, but in ERISA, we have to engage in a historical inquiry into the development of the law of remedies to know if a particular claim is equitable or not.

Now when you add in on top the fact that ERISA and its imposition of fiduciary obligations is beginning to supplant securities litigation theories as a method for suing corporations and investment banks for subprime, stock drop and other investment losses, as discussed here for instance, you can see just how complicated the topic becomes, as well as how potentially dangerous for fiduciaries and plan sponsors are the issues raised by ERISA. And of course, that’s what makes practicing in this area fun for those of us who handle these types of cases. But it also makes thorough and timely analysis of litigation risks and exposures crucially important, and what looks to be a promising new internet based research tool to help with this is now available. Pension Litigation Data is now up and running on line, and is meant to be a tool that will allow up to the minute research into the numerous pension related lawsuits pending in United States courts. The subscriber based site “debuts with over 1,500 retirement plan legal actions, each classified by nearly 100 fields, including court circuit, type of allegation, plaintiff, defendant and date [and provides a] continuously updated and searchable database” on the subject. A joint venture of a couple of companies, including fellow blogger Susan Mangiero of Pension Governance LLC, I think it looks promising, and you may want to take a look. >>

Editor's Notes:

1. Click here to access Stephen's interesting blog.

2. PensionLitigationData.com is a joint venture of The Michel-Shaked Group and Pension Governance, LLC.

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According to Global Pensions (January 10, 2008), Canadian, US and UK public pension fund investors are satisfied private equity investors. Surveying 108 institutions, Private Equity Intelligence Ltd (Preqin) found that "private equity out-performed for these pension plans in 82% of cases." In another survey, Preqin found that "95% of these investors predicted their private equity investments would out perform public market returns from a 2% advantge to over 4% in coming years."

Acknowledging the huge amount of money making its way into private equity, this blog's author wrote about the 4P's on December 31, 2007 - Pensions, Private Equity, Performance and Placement. We urged readers to study the risks, alongside the expected benefits, adding that valuation of private company economic interests can be challenging.

In response, Mr. Doug Miles, CEO of Globalprivatequity.com, Inc. wrote that life has surely changed when it comes to estimating value. We hope you find his commentary interesting. We welcome guest bloggers on any topic related to pension investing and risk management (which importantly includes the topic of valuation). Drop us a line if you want to share your thoughts with our fast-growing audience.

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                             Commentary by Doug Miles, CEO of Globalprivatequity.com, Inc.

For the first 15 years of my investment banking career, the typical rule of thumb for pricing private equity assets was to apply a 25 percent discount to a publicly traded comparable company or adjust the relevant industry multiple. New accounting rules such as FAS 157 make it difficult to take this easy way out.

An analyst is sometimes hard pressed to find data about public offerings that closely mirror the economic characteristics of a particular private equity investment. When that occurs, news announcements that convey buying interest can be helpful. Recent headlines about CALPERS' purchase of a 9.9 percent stake in technology buyout fund Silver Lake Partners illustrate. No longer sitting on the sidelines, CALPERS has a chance to recover 10 percent (or more) of its net cost in allocating to non-public companies by participating in deal-related income such as acquisition loans originated by Silver Lake.

Playing the role of private equity banker is not new. Ontario Teachers illustrates this "soup to nuts" with its furnishing of both debt and equity for Bell Canada. (See "Bell Canada Agrees to Purchase by Ontario Teachers - July 2, 2007.) General partners save on fees they pay. Moreover, they have flexibility to take a company public again or sell to a strategic buyer for many times the original commitment. Being an operator additionally empowers the "new paradigm" owner on the governance front. Did the Bell Canada deal improve the IRR for Ontario's plan participants? You bet.

Capital market players benefit too since such deals arguably enhance liquidity and promote valuation transparency. Given the brave new world of valuation compliance (FAS 157 and international equivalents), anything that gets us closer to marketability is a good thing. Anecdotally, we see an emerging consensus among our private investor clients to access better numbers. Applying arbitrary discounts is ill-advised. Being open to better process may explain why we've seen recent private company discounts narrow to 6.5 to 7 percent, relative to public comparables, for some sectors. In our own work (creating synthetic data prices for "hard to value" instruments such as whole loans), we employ an algorithm that estimates the private-public company differential by examining factors such as the rate of completed private company asset buyouts, how they are financed and the change in IPO values over the last twelve months.

Discounts vary over time. The current environment  (i.e. depressed high yield bond prices and fewer M&A transactions) could lead to the widening of lack of marketability discounts, particularly in those industries hard hit by credit problems. Monitoring performance by industry or sector, and for a variety of cycles and calendar time periods, is paramount. Global consolidation when steel or aluminum production sectors are hot (e.g. RUSAL) reduces the liquidity premium attached to public companies as increased deal flow sheds light on when and where buyers are willing to sign checks. Will this be true next year? Only time will tell. That is why it is so important to track the changing behavior of valuation adjustments.

With a need to enhance returns, alternatives like private equity will continue to attract retirement plan money. Look for more announcements as other pension funds follow the lead of CALPERS and Ontario Teachers. Hedge funds may even seek to organize groups of pension funds to execute large M&A deals, thereby adding to their treasure chest.

Editor's Note: As pension plans become even bigger players in global capital markets, it will be interesting to watch the inevitable fiduciary schizophrenia unfold. How will pension general partners deal with doing the right thing for limited partners when doing so conflicts with their duties to plan participants?

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Unfortunately, few of us are ready to retire. Savings rates are low. Credit card debt is large. A pronounced migration away from traditional pension plans puts more responsibility on the employee to save early and often.

As you plan what we hope are your golden years (as opposed to financial struggles), consider mogul Bill Gates' fictional last day in the office. The video is a lighthearted look at this Microsoft superstar's transition into retirement.

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PensionLitigationData.com debuts with over 1,500 retirement plan legal actions, each classified by nearly 100 fields, including court circuit, type of allegation, plaintiff, defendant and date. A joint venture of Pension Governance, LLC and The Michel-Shaked Group, this continuously updated and searchable database reflects the dramatic rise in pension lawsuits. Market volatility, complex investment strategies, new accounting rules, federal regulations and heightened scrutiny of financial decision-making are a few of the many reasons that explain the addition of hundreds more cases each quarter.

This unique web-enabled tool helps attorneys, trustees, board members and policy-makers to better understand the nature of individual pension lawsuits and related litigation trends, thereby encouraging improved practices. “We’re excited to introduce PensionLitigationData.com as a way to stimulate the conversation about fiduciary responsibilities,” said Dr. Susan Mangiero, President and CEO of Pension Governance, LLC. “Litigation is a fact of life now. Regardless of plan type, those in charge need to understand the personal and professional liability. Our hope is that subscribers can learn valuable lessons about what to avoid.” Co-founder of The Michel-Shaked Group, Dr. Israel Shaked urges outside and corporate counsel to pay close attention to ERISA cases, adding “These lawsuits are greater in number, more severe and often accompany securities litigation filings, including class actions.”

A charter annual subscription rate of $695 provides unlimited access to the site, saves decision-makers countless hours of research time and offers otherwise hard-to-find intelligence about pension litigation issues. Users will find cases about a variety of topics such as prudence, duty to monitor, reasonableness of fees and plan design. Circuit commentaries written by and for attorneys are available and cover numerous retirement plan pain points that challenge sitting fiduciaries and their service providers. Assessing statistical patterns, evaluating case precedents, tracking fiduciary hot button issues by circuit, case type and time to settlement are just a few of the information tools you will find here.

For more information, visit www.pensionlitigationdata.com.

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Early editions of today's business papers describe an imminent sale of roughly 10 percent of technology private equity fund Silver Lake to pension giant, the California Public Employees’ Retirement System ("Calpers"). With a price tag of $275 million, Calpers will have a say in managing Silver Lake and also receive a pro-rata share of their earned investment fees. Private equity investors typically pay 2 percent of assets under management per annum plus 20 percent of gains in excess of an agreed upon benchmark. (See "California Pension Fund Expected to Take Big Stake in Silver Lake, at $275 Million" by Andrew Ross Sorkin, New York Times, January 9, 2007).  

A direct investment stake in Silver Lake creates new challenges, not the least of which is the subsequent negotiating power of Calpers with other private equity funds.

• Will this $260+ billion institutional investor now have greater sway with alternative fund managers, bargaining hard for fewer restrictions on transferability?
• If so, how will that impact the riskiness of its investment portfolio?
• Will Calpers ask Silver Lake to be more institution-friendly with respect to greater disclosure, lower fees, asset selection that reflects suitability, better risk controls and so on (assuming that Silver Lake is not already doing everything it can in these areas)?
• Will Calpers be exposed to fiduciary liability in the event of a Silver Lake buy-out gone bad?
• How will Calpers change its internal risk management policies and procedures as a result of this investment in Silver Lake? This includes the process by which "hard to value" holdings are marked to model or market.
• How will Calpers recognize the Silver Lake investment in terms of strategic asset allocation?

Notwithstanding these unanswered questions, this announcement is fascinating news to some, especially on the heels of a January 7, 2007 Financial Times article that quotes representatives of pension funds such as the Oregon Public Employees Retirement System and the California State Teachers' Retirement System as saying "never mind" to eroded returns. Acting defiantly, these institutional investors are in no mood to make private equity executives whole for higher taxes that may soon be mandated by Washington. (The current tax rate of 15 percent could rise to 35 percent.) (See "Pension funds in threat over private equity fees" by Francesco Guerrera and James Politi.)

Editor's Note: We talked about private equity on December 31,2007. Read "Pensions, Private Equity, Performance and Placement."

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New York Times reporter Vikas Bajaj writes that a State Street Corporation senior executive has been ousted due to sub-prime woes, and that the company has set aside "$618 million to cover legal claims stemming from investments tied to mortgage securities." (See "State Street Corp. Is Sued Over Pension Fund Losses," January 4, 2007.) 

Various other news accounts over the last few months name State Street as defendant in five separate pension-related cases. Plaintiffs' attorneys seek redress under the Employee Retirement Security Act ("ERISA"), citing allegations of fiduciary breach. Critics counter that proving bad faith on the part of investment managers (i.e. not acting "exclusively on behalf of plan participants") will be difficult. They further add that "sophisticated" pension funds should know better.

This blog's author predicts that caveat emptor will pop up in many cases to come. A legal outcome in the matter currently before NY jurists, with San Diego's pension plan going after former hedge fund Amaranath Advisors, goes to this very point (among others).

The stakes for defendants and plaintiffs alike are huge. Whatever happens in several of these big cases will open the door to a flood of similar lawsuits. If defendants are found culpable, it will be open season on service providers. Critical questions abound. Are money managers functional fiduciaries even when they disclaim such status? I wrote about this in my article entitled "Can Pension Clients Be Hazardous to Your Financial Healh?" (Mann on the Street, August 2007 and later reprinted in Journal of Pension Benefits, January 2007).

If defendants claim victory, pension investors will be seriously on the hook for ensuring that they fully understand the nature of their investments. Equally grave will be the need to demonstrate that a retirement plan decision-maker has fully vetted external money managers for risk controls, adequate disclosures and suitability in terms of permitted investment strategies.

Watch for more legal news.

Big Questions - Big Money - Big Consequences!

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It's always hard to get back to work after a few days off. It's especially difficult when economic uncertainty is casting a cloud of gloom over financial markets. As a result, investment risk continues to rank high as a "must do," making lapses seem even more questionable.

Our December 29, 2007 post talked about a risk management post-audit at Morgan Stanley ("Lonely CROs - Why Pensions Should Care"). A few weeks ago, Financial Times reporters Chris Hughes and Haig Simonian wrote about UBS woes, with the chairman admitting that the "Swiss bank's risk and finance unit had failed to understand the sub-prime mortgage positions that led to its $10bn writedown, even though it was aware of the massive figures involved."

In "CIBC plummets after 'underestimating' subprime risk," Financial Post reporter Duncan Mavin (December 6, 2007) cites multi-billion dollar losses due to sub-prime assets and a "hedged subprime exposure" of nearly US$10 billion, "including US$3.5-billion in a CDO with a counterparty that is single-A-rated and ratings-watch-negative." Peter Routledge, senior credit officer with Moody's, is quoted as saying that "The existence of concentrated risks in [CIBC's derivatives] portfolio points to weaknesses in strategic risk decision-making at the bank and indicate that improvements in the bank's risk management discipline have not permeated the organization as fully as Moody's had expected." A read of the CIBC Risk Management Committee Mandate suggests a focus, however incomplete, on process. In fact, a prominent risk expert sits on that committee, prompting Globe and Mail's Fabrice Taylor to write "The multibillion-dollar question: Who's minding the shop at CIBC?" (December 21, 2007). 

From the outside looking in, one can only surmise what might have happened. Lessons learned, as details are made public, will be invaluable to 401(k) and defined benefit plan fiduciaries who rely on banks all the time and for many reasons.

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