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

Since the inception of www.pensionriskmatters.com in late March 2006, we have never received any negative comments. To the contrary, feedback from readers around the world has been very positive and insightful. However, there is a first time for everything and I am not one to avoid taking responsibility for my actions. In this case, a reader took me to task for the use of the word "tubby" in a June 25, 2008 post about employee benefits and weight. Out of respect for that reader and anyone else who might have been upset (despite no intent on my part to offend - I have used the word to describe my own efforts to keep excess pounds at bay), I have retitled that post. Let me also apologize sincerely and thank that reader for sending comments our way.

The topic of employee benefit mix is an important one for many reasons. As timely news events occur, we will cover them in subsequent blog posts.

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In "UK Pension Fund Goes Green" (June 28, 2008 post), this blogger cites diversification as one element of the decision to allocate monies to "socially responsible" investments. Anticipated performance is another consideration and not just for "virtuous" stocks.

In "CalSTRS wavers on its ban on tobacco investments" (June 5, 2008) Sacramento Bee journalist Jon Ortiz writes that the board of the California State Teachers' Retirement System is mulling over whether to reverse its earlier divestment of $238 million in tobacco company equities. Thinking that the industry is no longer vulnerable to massive lawsuits and/or government mandates, the $169 billion public pension fund estimates it would have earned $1 billion more had it stayed the original course.

An excerpt from its "Statement of Investment Responsibility" puts "preservation of principal and maximization of income" as "the primary and underlying crieria for the selection and retention of securities." The "CALSTRS 20 RISK FACTORS" do not expressly preclude investing in any particular industry. According to "CalSTRS rethinks tobacco taboo" by Jon Ortiz (June 4,2008), gambling and alcohol company stocks remain part of the pension fund's equity portfolio.

While CalSTRS ponders an add-back of tobacco, the University of Toronto announced on April 9, 2008 that it will be dropping its investments for ethical reasons. According to "University of Toronto to Sell-Off Tobacco Industry Holdings," the school will be the "first institution of higher education in Canada to divest from the tobacco industry."

Editor's Note: For articles about tobacco-related investing, visit Tobacco.org. On a related note, and if you appreciate a good satire, check out a movie entitled "Thank You for Smoking." This gal has laughed through the film version of the popular Christopher Buckley novel at least four times.

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According to Institutional Investor ("Buying into Green Investing" by Henry Teitelbaum, June 2008), green is good for at least one large UK pension fund, the Universities Superannuation Scheme Limited ("USS"). Joined by three other organizations (Alliance Trust PLC, SNS REAAL N.V. and Mitsui & Co Ltd), this trustee company with 30+ billion GBP in assets is part of a 56 million GBP financing round for the Climate Change Capital Group, a London investment bank "dedicated to the low carbon economy." Teitelbaum adds that the USS is already sold on the commercial viability of environmentalism, demonstrated by its membership in the Enhanced Analytics Initiative. According to research done by this blogger, the USS is credited with taking "ethical, social and environmental considerations" into account when "assessing the merits of investment in a given company" as early as 2001. (See "Pension funds can get more from 'green investing' - SRI expert" by Nat Mankelow, bfinance, May 12, 2001.)

While few dispute the merits of considering a Socially Responsible Investing ("SRI") component for portfolio diversification purposes, it would be helpful to know how USS determines its strategic commitment to SRI economic interests as a separate asset class. Moreover, how does this pension giant consider "green" or "vice" factors before taking direct equity stakes in oil or tobacco companies? Top 100 USS equity holdings, as of March 31, 2008, include Royal Dutch Shell (position 1 with an estimated market value of 705.8 million GBP), BP (position 3 with an estimated market value of 625.2 million GBP) and British American Tobacco (position 14 with an estimated market value of 194 million GBP). This blogger is not maing a value judgment about investing in the stocks of these or other companies but rather simply thinking out loud about diversification analysis as it relates to SRI exposures.

Valuation is yet another consideration. As pension plans invest in environmental companies, how do (should) they properly determine the probability (and amounts) of revenue realization for start-ups and/or firms that depend on relatively new technologies to generate income? In the absence of accounting rules (across countries) or new regulations that mandate periodic assessments of value, the challenge is significant. Add the time pressures of compliance and these already important questions demand good answers.

Editor's Note: According to the EAI website, membership is "open to institutional investors and asset managers who commit to allocate individually at least 5% of their brokerage commissions to extra-financial research" or said, another way, the assessment of externalities on long-term investment performance. Most members are non-US organizations. The New York City Employees' Retirement System ("NYCERS") is a member.)

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In response to my June 25, 2008 post ("Is There a Link Between Weights and Benefits?") about the fiduciary ramifications of asking employees to lose weight or otherwise change their lifestyle, law professor Paul Secunda writes the following:

<< I agree with Susan on this, of course, but wouldn't it be funny hearing someone say: "I am not going to eat that muffin because I might get fired or my health premiums may go up?" >>

Check out what else the creator of the popular "Workplace Prof Blog" has to say on this topic. 

• "Do Workplace Smoking Bans Have a Multiplier Effect?" (April 25,2008)
• "Higher Insurance Premiums On the Way for Obese Workers?" (July 9, 2007)
• "Obesity Regulation in the Workplace?" (November 24, 2005)

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Sacramento Bee investigative journalist Jon Ortiz reports that the giant California Public Employees' Retirement System ("CalPERS") has just announced an 8 percent rise in "its Kaiser basic premiums." According to "Rate outlook dismal for individual health plan subscribers" (June 24, 2008), roughly 2.5 million individuals will feel the pinch. Citing Dr. Michael Kraten, Connecticut-based industry expert, relatively healthier baby boomers and cheaper generic drugs have helped to stave off premium increases, but not for long. Even if large organizations like CalPERS are able to drive a hard bargain, "Whatever price breaks the big players get are passed down the line as providers haggle with doctors and hospitals over payment for services and raise or lower rates on other policy purchasers."

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A few weeks ago, en route to speak at a valuation conference about hedge fund issues, I sat next to a health-conscious surgeon. For nearly an hour, he spoke passionately about spiraling hospital and pharmaceutical costs, due in large part to what he described as an obesity epidemic. He offered several compelling examples of procedures that could have been done at a much lower cost, had patients been smaller in girth. Though I consider myself a healthy person (low-fat diet, regular exercise), I do admit to a few pounds of excess baggage. You can therefore imagine my discomfort as I munched on my Power Bar, wondering - Is he addressing non-skinny people like me or outright weight-challenged children and adults?

It was no surprise then that this Sunday's New York Times addressed this problem, said to be costing employers big-time. In her piece, reporter Kelley Holland links to an "aha moment" map, courtesy of the Centers for Disease Control and Prevention. Based on 2006 data, all but four of fifty states clearly struggle with obesity, with at least 20 percent of adults having a Body Mass Index ("BMI") in excess of 30. (According to the Department of Health and Human Services, BMI is a gauge of body fat. BMI numbers above 25 place an individual in the overweight category. Use the online calculator to get a rough estimate of your BMI.) Holland continues to grab attention with some sobering statistics.

• More than 25 cents of every dollar spent on medical services is due to excess weight complications (based on research conducted by Emory University Professor Kenneth Thorpe).
• The corporate tab for too many muffins is $45 billion per year (according to a Conference Board report). See Medical News Today, April 10, 2008.
• Obesity links to chronic health problems more than smoking or excess drinking (based on Rand Corporation research by economist Roland Sturm).

 "Waistlines Expand Into a Workplace Issue" is a scary read. Citing examples of employers that offer incentives to visit the gym and otherwise slim down, Holland writes that more needs to be done, despite the fact that it is a "sensitive" issue. While I'm the last to make a value judgement about weight, some disturbing thoughts come to mind.

• How are longevity patterns (and the related cost of offering healthcare benefits and a traditional pension) impacted when plan participants are officially deemed overweight?
• Do employers experience lower costs if their pension plan covers mostly unhealthy participants?
• For employers that offer both health insurance and a defined benefit plan, do they deem an "optimal" mix of healthy versus not so healthy plan participants? (This assumes that healthier individuals who live longer push pension costs up but keep a lid on healthcare benefit expenses.)
• Should employers figuratively serve "in loco parentis" or does this expose them to allegations of discrimination?

Ban the coffee cake. Carrots anyone? 

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Besides the fact that Liability-Driven Investing ("LDI") takes multiple forms (each of which should be fully evaluated in a risk-return context), there is no universal consent about relevant action steps. As described in "Why LDI is Stuck in Neutral" by Dr. Susan Mangiero, a "roll your shirtsleeves up" approach to gathering and assimilating information makes sense.

The full text of the June 12, 2008 MoneyVoices column, published by Fundfire.com/Money-Media, a Financial Times Company, is presented below, with permission.

                                                                               * * * * * *

Why LDI is Stuck in Neutral

Guest Columnist: Susan Mangiero is president and CEO of Pension Governance, an independent research and analysis company.

Despite the hoopla, pension fund fiduciaries have yet to recognize liability-driven investing (“LDI”) as the ultimate in asset-liability management. No doubt a disappointment to the banking set, there are some legitimate reasons for its slow adoption. For starters, there is no consensus on what the term truly means, tempting one to use “loosely defined investing” as a more apt moniker.

Questions abound. When are derivatives used in lieu of cash assets only? Is a portable alpha engine an integral part of an LDI focus, or is it optional? Can LDI results be meaningfully benchmarked across plans? How does the use of LDI impact the determination of an optimal asset allocation mix? What must fiduciaries consider when assessing whether LDI-related fees are “reasonable?”

Even if everyone agrees on what LDI means, there is never a free lunch. What a plan gains in terms of risk mitigation, it will lose by assuming incremental risk. For example, using an interest rate swap introduces new uncertainties tied to counterparty default, settlement, legal standing and/or operations. A retirement plan that shifts money out of equity into typically lower yielding fixed income securities confronts opportunity cost. Add-ons in the form of alternative investments potentially juice up returns, but could wreak havoc with an existing risk budget. LDI makes sense when expected benefits exceed likely costs (direct and indirect).

Fiduciary literacy is yet another factor. Just as folks begin to ease into “new fangled” offerings, LDI forces decision-makers to take a sophisticated look at the economic funding gap. Understanding the dynamic behavior of asset and liability risk drivers is tough enough. Add a derivative instrument or hedge fund overlay and some decision-makers may dismiss LDI as complex and therefore “too risky.” More education is needed.

Deciding on the appropriateness of liability-driven investing is like anything else. Context and good process count for a lot. In some circumstances, an LDI strategy (however defined) may be a no-brainer. In other situations, its adoption could exacerbate existing problems. Regardless of outcome (“to LDI or not”), pension fiduciaries cannot escape their duty to ask questions, examine its likely risk-return impact (now and under various market scenarios) and oversee external managers’ risk controls (either as counterparties or potential alpha generators).


Disclaimer: The information provided by this article should not be construed as financial or legal advice. The reader should consult with his or her own advisors.

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On January 14, 2008, we announced the launch of www.pensionlitigationdata.com. Since then, we've collected over 2,000 cases that involve pension funds, either as plaintiff or defendant. We are adding about 300 to 400 cases per quarter. 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. Topics include, but are not limited to, prudence, fees, risk management, diversification, suitability and plan design.

Like it or not, lawsuits are growing in number, severity and frequency. If we can learn from attempts to seek legal redress or understand why a case is dismissed, perhaps we can gain a better understanding of fiduciary vulnerabilities and ways to improve bad practices, when they exist. (It should go without saying that the filing of a case does not necessarily equate to culpability.)

We want your feedback in order to make our first trend analysis paper (and those to follow) as helpful as possible to pension fiduciaries and professionals who work with them. We currently use nearly one hundred codes to categorize each case (by court and topic).

• Readers (attorneys or otherwise) - What kind of information about pension litigation do you want to know? Click to send an email with your thoughts.
• Attention attorneys (litigators on either side, general counsel or plan counsel) - If you would like to contribute an analysis or helpful hints to www.pensionlitigationdata.com and our fast-growing www.pensionriskmatters.com audience, send an email with your suggestions and contact information.

We want to hear from you!

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According to ERISA attorney Jason Sheffield, a recent decision by the U.S. Court of Appeals for the Sixth Circuit opens the courtroom doors wider to individual plan participants. In Tullis v. UMB Bank, the Sixth Circuit grants individuals legal standing to sue (rather than have to show damage to the entire plan).

According to the opinion (decided and filed on January 28, 2008 by circuit judges Merritt, Rogers and McKeague), ERISA allows these two Toledo Clinic Employees' 401(k) Profit Sharing Plan participants to proceed with a case against the fiduciaries of UMB Bank. By way of background, in the early 1990's, the two doctors selected an investment advisor affiliated with Continental Capital Corporation. In the fall of 1999, the U.S. Securities and Exchange Commission "entered a Temporary Restraining Order against Capital because two of its brokers were engaged in fraudulent activities. The plaintiffs contend that the defendant, UMB Bank, which served as the Trustee for the plan, knew of the fraud yet failed to inform them."

In the aftermath of a recent U.S. Supreme Court case (LaRue v. DeWolff, Boberg & Associates, Inc.), is it likely that plan fiduciaries are more vulnerable to allegations of breach?

Click to read a copy of the Tullis, et al. v. UMB Bank, 515 F.3d 673, 678-79 (6th Cir. 2008) opinion. For an analysis of this case and many others, visit www.pensionlitigationdata.com, Resources, Analyses by Circuit or Analyses by Topic. (A subscription is required.)

Click to read the LaRue v. DeWolff, Boberg & Associates, Inc. opinion. Click to read "U.S. Supreme Court Rules 9-0 in Major Pension Case" and "LaRue, Corporate Governance and the Next Pension Enron."

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I consider myself a relatively smart person, certainly (hopefully) smart enough to know when I don't know something. What falls in the category of "don't count on me?" Well, besides the fact that my husband begs me NOT to cook EVER again (my efforts being relatively inedible that is), I know very little about sports. Indeed, if ever asked to appear on Jeopardy, "sports" would be my Achilles' Heel. This doesn't mean that I disdain sports. To the contrary, I am learning to play golf, I take yoga classes (not quite a "sport") and I love to exercise. I hope to take up tennis when I have more free time.

That said, what does remain a complete mystery to me is the fascination with fantasy football (and equivalents for other sports). I know it's a popular pastime. My nephews and more than a few colleagues (mostly male) play for hours. WikiAnswers^TM puts the number of worldwide players at 30 million. According to Fox Sports, "While only a select few extremely wealthy individuals have the privilege of owning a real NFL team, anyone can enjoy the thrill of owning a team of NFL players by playing fantasy football." Still, one wonders. Why not just watch football on television or in person or go out and play a game with friends? Doesn't the "real thing" offer a superior experience?

As I ruminated on the mysteries of fantasy football the other day (after the topic arose in conversation), it struck me that pension fiduciaries might learn a thing or two by simulating a "dream team" and watching their progress in moving the "ball" (effective pension governance) down the field. From his comments in "Pension funds get code of conduct from money manager group," it sounds like pension scholar Keith Ambachtsheer agrees that structural changes must be made to ensure proper pension governance. Pensions & Investments reporter Jennifer Byrd quotes this author of Pension Revolution: A Solution to the Pensions Crisis as saying "The truly best practice, and what pension funds need, is a corporate structure" that relies on knowledgeable professionals to run the plan with oversight from the board. This contrasts with "the current system of lay individuals being named trustees and then looking to outside experts for assistance."

(This blog will talk about the final Code of Conduct in a subsequent post.  For now, readers can download the document from the CFA Institute website.)

Fiduciary dysfunction is not a new topic but is nevertheless extremely important. Two years ago, pension professional Wayne Miller and Dr. Susan Mangiero wrote "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?" (Executive Decision, January-February 2006). Here is an excerpt.

<< Imagine a time in the not too distant future. Retirement systems everywhere are in disarray. An outside specialist is asked to diagnose the problem and suggest a cure. A capitalist at heart, solutions-oriented and cognizant of a fiduciary imperative, she identifies the usual suspects—complex regulations, compelling demographics and overly optimistic economic assumptions.

Then, defying conventional wisdom, she asks the unthinkable. Has anyone looked at the role of fiduciary incentives? Do those in charge get rewarded for what they do well or penalized for what they fail to do? Who, if anyone, claims ownership of the retirement issue? Are these individuals empowered to effect meaningful change? How do we measure accountability for achieving plan goals? What alarm bells will ring in time to permit corrective action?

The room is quiet. No one knows what to say. The silence is deafening.

Sadly, current attempts at pension reform are likely to fail because they do not effectively address human behavior. People are motivated by rational self-interest and the promise of recompense for a job well done. This is not a bad thing. To the contrary, it is a cornerstone of a well-functioning market economy. Make it worthwhile and some clever person will figure out how to deliver a better mousetrap at a lower cost with the end result that we all benefit. >>

Click to read the full text of "Do Fiduciaries Need Better Incentives to Make the Retirement System Work?"

What do you think? Do we need a pension version of fantasy football or should organizations hunker down and create the real thing? I vote for the latter! (If your organization already has a pension dream team "for real," take a bow - and tell us more by email.)

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This bloggerette has just learned that www.pensionriskmatters.com is included in "Pensions & Investments' Best Blogs and how they got that way" (Pensions & Investments, June 9, 2008). As an avid fan of this Crain publication (along with its sister periodicals, FinancialWeek and InvestmentNews), I am duly honored. 

Since the inception of this pension blog in late March 2006, I've tried to write about timely topics and issues that (I hope) help to raise the pension investment fiduciary bar. My goal is to both inform and entertain. Sometimes it's tough to be funny about very serious topics but I do believe that humor helps to spice up things. (If you have any jokes or funny stories about compliance, governance, risk management, derivatives, investing or valuation, send them my way. Let me know if I may attribute them to you or if you instead prefer to remain anonymous.)

However much a labor of love for me, this blog importantly represents the sentiments, concerns and realities of hard-working benefit plan fiduciaries (and retirees) around the world. Thanks to the 275,000+ readers, in many countries, who have visited www.pensionriskmatters.com to date. You continue to make great suggestions, point out problem areas and identify "hidden" news.

Comments and suggestions are always welcome and can be emailed to PG-Info@pensiongovernance.com. (While it is not possible to answer every email, please know that all emails are read and appreciated.) If you want to guest blog and are willing to write with the goal of educating readers (versus direct selling), let's talk. (Since www.pensionriskmatters.com is now being syndicated by multiple news blog aggregators, material must be original or otherwise properly credited.)

What topics are of interest to you? Do you favor short or long posts? Is analysis and research of interest or would you prefer more news-oriented posts?

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According to New York Post reporter Dareh Gregorian ("Screw the Pooch," June 16, 2008), Leona Helmsley's furry friend will have to make do with a paltry $2 million trust fund. Allegations that Helmsley may not have had full faculties when she wrote her will, and a single stroke of the pen by Manhattan Surrogate Judge Renee Roth, takes $10 million away from Trouble's nest egg. The remainder goes to the former hotelier's charitable foundation. For pet lovers, don't despair. Apparently, this still leaves ample money to cover her annual expenses of $190,000 for the expected remainder of his life (10 human years or 70 dog years). By the way, the lion's share of per annum costs go for security ($100,000) and guardian fees ($60,000). 

If you are a member of the baby boom generation (and the Federal Reserve Bank of St. Louis counts "79 million Americans born between 1946 and 1964" in this category - plus countless others outside the U.S.), $190,000 per year looks mighty good. With fewer and fewer workers to support national safety net programs, private savings and employer-provided benefits take center stage. Ask yourself this. How "retirement ready" are you? Will you be living in style or struggling to make ends meet? Check out this online retirement calculator, courtesy of the AARP (American Association of Retired Persons).

For pension fiduciaries, a critical question is whether (and to what extent) you have responsibility for empowering your workers to sufficiently fill the piggybank. Even in the absence of legal mandates, how does an organization attract and keep good workers when talent is in short supply around the world? According to a March 2008 survey, conducted by Deloitte Consulting and the International Society of Certified Employee Benefit Specialists, "A shortage of skilled and talented workers has become the most pressing concern among employers." Other worries include "the cost of providing retirement benefits to employees" and the appeal of company reward programs to "attract, motivate, and retain the talented employees" needed to "effectively run" an organization. Click to read the "2008 Top Five Total Rewards Priorities Survey."

If you are a taxpayer, you may be putting money aside for your personal rainy days at the same time that you pay taxes to help finance public pension programs (state, county, city). And if Social Security, Medicare and/or the Pension Benefit Guaranty Corporation needs a bail-out, who ya gonna call? Tax Busters (taxpayers)! 

According to then U.S. Comptroller General, David Walker, "A tsunami is building and ready to hit future generations, but this one won't be set off by earthquakes or other natural disasters. Instead, it will be a fiscal calamity created by the failure of government and business leaders to deal with the financial drain of millions of retiring baby boomers." (Walker now serves as President and CEO of the Peter G. Peterson Foundation.)

So Trouble may be literally living a dog's life but her retirement plan, albeit reduced, will keep the furball cozy. We could all be so fortunate!

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According to "Hedge Funds Gird for Withdrawals As Redemption Requests Roll In, Principals Scramble to Soothe Anxieties" (June 12, 2008), Wall Street Journal reporter Jenny Strasburg describes June 30 as a date to watch. Anticipating a flurry of requests, she writes that hedge funds are bracing for a slew of redemption requests, reaching unprecedented levels. Unfortunately for investors, requests to withdraw partially or fully from a fund may not necessarily equate to cash in hand.

As CNN.com reporter Grace Wong wrote last summer ("Hedge-fund redemption shock
Investors looking to cash out this fall may be met with an unpleasant surprise"), a liquidity event may be wishful thinking in some situations. For one thing, myriad hedge funds have long "lock-up" periods during which no withdrawals are permitted. Second, some require that advance notice of 45 to 90 days be given. When markets are volatile, even a day may seem like an eternity. Third, hedge funds may slow withdrawals or ignore them altogether, urging investors to be patient. In certain cases, the goal is to forestall a collapse that could occur if a manager has too little cash on hand. Fourth, even when redemptions are permitted, they don't always take the form of cash.

For pension funds, problems with redemptions might potentially cascade, wreaking serious havoc in other areas. For example, suppose a plan sponsor has combined an interest rate swap with an investment in a hedge fund (perhaps as part of a Liability-Driven Investing strategy). If the portable alpha generator falls short and the retirement plan wants out, the all-in performance likely suffers, for everyone. What then?

• Does the plan sponsor move away from LDI?
• Does the plan sponsor lick its wounds with the first hedge fund and find a substitute?
• How does the plan sponsor take transaction costs into account?
• Do fiduciaries switch to a different, more redemption-friendly asset allocation mix?

Other questions abound. If a hedge fund cannot easily redeem shares because its portfolio consists of "hard to value" assets, do pension investors make matters worse by pulling out? What are the fiduciary implications related to liquidity risk? (Hint: Fiduciaries don't get a free pass. Most legal experts will confirm that decision-makers MUST ask hedge fund managers lots of questions about the redemption process and worst case liquidity scenarios.)

Liquidity risk is real. To pretend otherwise, makes no sense. The ability to unwind a stake in a hedge fund is very much a function of negotiating favorable terms at the outset. Equally important, fiduciaries are urged to pay attention to hedge fund liquidity risk drivers along the way. What you see on paper may not be what you get later on.  

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Dr. Susan Mangiero, AIFA, Accredited Valuation Analyst, CFA and FRM addresses an audience of valuation practitioners on June 10, 2008 as part of the 15th annual conference sponsored by the National Association of Certified Valuation Analysts.

Part of its 15th annual conference, this mini workshop is a unique offering that combines information about hedge fund industry structure with core valuation concepts. The course will examine the overall structure of a hedge fund, including standard partnership terms, revenue structure, liquidity restrictions, and impact of hedge fund strategy on the value of hedge fund business itself. Special issues such as side pockets and high water marks will be discussed, along with a description of regulatory and accounting initiatives with respect to hedge fund valuation.

Editor's Note: A later posts will cover changes in regulations that directly impact the valuation process, including appraisal penalties now part of the Pension Protection Act of 2006.

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Kudos to Sameer Mishra for winning the Scripps National Spelling Bee 2008 after a momentary setback. Initially confusing numnut ("one of little intelligence or thought") with numnah ("a pad that goes under the saddle to keep the saddle clean and to cushion the horse's or pony's back"), this smart 13-year old recovered with aplomb. Click to view his funny response.

Proper spelling remains a passion of mine. I won a dictionary in a national writing contest while in high school, passed AP English with flair and continue to find delight in the written and spoken word. By the way, for those who rely on your computer's spell check function, take note of Janet Minor's homage lesson in poetry. "Bad spellers, untie."

"I have a spelling checker
It came with my PC;
It plainly marks four my revue
Mistakes I cannot sea.
I've run this poem threw it,
I'm sure your pleased too no,
Its letter perfect in it's weigh,
My checker tolled me sew."

Making innocent mistakes occurs. Hey, we're all human. What about errors of judgement when one should allegedly know better? According to New York Times reporter Gretchen Morgenson ("First Comes the Swap. Then It's the Knives," June 1, 2008), UBS and Paramax Capital are duking it out in court over credit default swaps, now a $62 trillion market (based on statistics provided by the International Swaps and Derivatives Association). At the heart of UBS AG v. Paramax Capital Intl., No. 07604233 (NY Supreme Court, NY County, filed Dec. 26, 2007) is whether this large Swiss bank had the right to demand additional collateral from a Fairfield County, Connecticut hedge fund as market conditions moved.

According to Morgenson, "UBS would pay Paramax 0.155 percent of the $1.31 billion in notes annually for its insurance and Paramax would deposit collateral to back the swap, increasing it if the value of the underlying notes declined." What's astonishing is not that the value of the notes declined (credit crisis anyone?) but that the hedge fund (with "just $200 million in capital") found itself facing a shortfall far in excess of the original $4.6 million it used to capitalize the swap. 

Our team is trying to get the complaint filed by UBS and the counterclaim filed by Paramax so we can verify who supposedly said what. One assertion (according to the June 1 New York Times article) has a bank executive citing a policy of setting "its marks on the basis of 'subjective' evaluations that permitted it to keep market fluctuations from impacting its marks." Does this mean that positions were artificially valued, regardless of changes in risk drivers? If true, such a policy would be mind boggling at best.

In researching this case, I came across a January 23, 2004 press release in which Paramax Capital Group (presumably the same entity as cited in the lawsuit) announces the launch of a "new multi-seller asset-backed commercial paper program." Part of an effort to satisfy a "need and demand for thirdy party conduits in this new structured finance paradigm," the then Chief Investment Officer for Paramax adds "we think we can provide a high value service and funding to our institutional client base as a complement to their structured finance and funding efforts." One wonders if institutional investors (assuming there were some), allocating monies to Paramax, asked any or all of the following questions:

• How did the hedge fund represent its process of valuing complex instruments?
• Did either the bank or hedge fund employ an independent third party pricing service?
• Did the hedge fund have an appropriate capital risk budget in place?
• How did the bank measure its credit exposure to the hedge fund and to the swap class?
• Who established internal controls (at the hedge fund and bank) to avoid undue leverage?
• How did the hedge fund (bank) measure leverage?
• How did the hedge fund (bank) monitor collateral exposure?

Ultimately, only the trier of fact can and will determine fault (if any) and related damages. "Numnut" was the wrong word for our young spelling champion but it may end up being an apt description for someone, in what sounds like an ugly mess.

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