Retail Investors and Derivatives Trading

During a catch-up conversation, a now-retired colleague told me how much money he was making by trading options. Based on several recent articles, it seems that he is not alone in looking to Wall Street instruments in hopes of an income boost or a way to hedge uncertainty. In "Retail Investors Flock to Derivatives for Income and Safety" (TheStreet.com, October 31, 2014), senior reporter Dan Freed describes a growing trend in trading options and futures, with growth rates that exceed the level of purchases and sales of stock. On November 3, 2014, the Options Clearing Corporation reported a 22.32 percent rise in total equity and index option volume in October 2014 from one year earlier, "the second highest monthly volume on record behind the August 2011 record volume of 554,842,463 contracts" or a year-to-date volume of 3,673,768,194 contracts.

Reuters journalist Chris Taylor describes the average options trader as 53 years of age, citing Options Industry Council statistics that put nearly thirty percent of those who trade options at between "the ages of 55 and 64." However, in "New baby boomer hobby: trading options" (July 9, 2013), even retirees with a high net worth are cautioned to educate themselves about the downside of leverage. Mary Savoie, Executive Director of the Options Education Program, talks about the free resources made available by the Options Industry Council.

Critics counter that formal training cannot replace experience and that retirement assets should be invested with a long-term goal in mind, especially for those individuals with a low net worth. What they may not realize is that numerous retirement plans are chockablock with exposure to derivatives in the form of investment funds that trade swaps, options and futures. In mid-September of this year, Bloomberg reporters Miles Weiss and Susanne Walker wrote that then PIMCO senior executive and co-founder of the Pacific Investment Management Company Bill Gross "sold most of the $48 billion of U.S. Treasuries held by his $221.6 billion Pimco Total Return Fund (PTTRX) in the second quarter, replacing them with about $45 billion of futures. In "SEC Preps Mutual Fund Rules," Wall Street Journal reporter Andrew Ackerman (September 7, 2014) cites a concern on the part of the U.S. Securities and Exchange Commission about the use of derivatives by certain mutual funds and could seek "to limit the use of derivatives in mutual funds sold to small investors, including both alternative funds and certain 'leveraged' exchange-traded funds, volatile investments that use derivatives to double or even triple the daily performances of the indexes they track..." 

Over the years, I have traded derivatives, valued derivatives, reviewed financial models, created hedges and stress tested deals for compliance purposes. Throughout that time, the global markets continue to grow, attesting to their popularity. Earlier this summer, the Bank for International Settlements measured the over-the-counter derivatives market as having expanded to outstanding contracts with a value of $710 trillion at yearend 2013, up from $633 trillion in a single year.

Whether singular derivative transactions are appropriate for any one individual plan participant depends on a number of factors. Suffice it to say, derivative instruments are here to stay. It would be incorrect to underestimate the ubiquitous nature of derivatives. Besides asset managers who use derivatives, there are plenty of structured products that layer in derivatives with traditional equity or fixed income securities.

Stay tuned for more from the regulators about the usage of derivatives and asset management. In the aftermath of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, rules about derivatives trading and clearing are changing the operational and technology landscape. Fund directors not already in the know are being urged to pay attention to the economic impact on fund activity when derivatives are used. Click here to download a good risk management checklist. It is part of a November 8, 2007 speech by Gene Gohlke, then Associate Director, Office of Compliance Inspection and Examinations, SEC. Entitled "If I Were a Director of a Fund Investing in Derivatives - Key Areas of Risk on Which I Would Focus," Attorney Gohlke addresses the panoply of due diligence considerations such as custody, pricing and valuation, legal, contractual, settlement, tax, performance calculations, disclosure, investor reporting and compliance. These are important knowledge areas for investors too.

Pension Usage of Swaps

I have been writing, training and consulting about the use of derivatives by pension plans for many years. There is no shortage of topics, especially in the aftermath of the Dodd-Frank Wall Street Reform and Consumer Protection ("Dodd-Frank") and the fact that pension investing and derivatives trading are significant elements of the capital markets. The OECD estimates the size of the private pension system in 2012 at $32.1 trillion. The Bank for International Settlements estimates the June 2013 global derivatives market size at $692.9 trillion.  

Given the importance of the topic of pension risk management and the evolving regulatory landscape, it was a pleasure to have a chance to recently speak with Patrick S. Menasco. A partner with Steptoe Johnson, Attorney Menasco assists plan investors, investment advisers and broker-dealers as they seek to navigate the laws relating to hedging, swaps clearing and much more. Here are a few of the take-away points from that discussion.

Question: Do the swaps provisions embedded in the Dodd-Frank legislation contradict the netting rules that are part of U.S. bankruptcy law?

Answer: No, the netting provisions of the Bankruptcy Code remain intact and should be taken into account in negotiating swap agreements. To the extent feasible, a performing counterparty wants to be able to net obligations in the event of a counterparty insolvency and default.

Question: Your firm obtained Advisory Opinion 2013-01A from the U.S. Department of Labor ("DOL") on February 7, 2013 regarding swaps clearing, plan assets and ERISA fiduciary duties. Explain the importance of identifying plan assets in the clearing context.

Answer: ERISA, including its prohibited transaction rules, governs "plan assets." Thus, it is critical to determine whether margin posted by a plan in connection with swaps clearing and the swap positions held in the plan's account are considered "plan assets" for ERISA purposes. Among other things, Advisory Opinion 2013-01A gives comfort that (1) margin posted by the investor to the clearing agent generally will not be considered a plan asset for ERISA purposes and (2) clearing agents will be able to unilaterally exercise agreed-upon close-out rights on the plan's default without being deemed a fiduciary to the plan, notwithstanding that the positions are plan assets.

Question: The headlines are replete with news articles about swap transactions with pension plans that could be potentially unwound in the event of bankruptcy. Detroit comes to mind. Should non-pension plan counterparties be worried about a possible unwinding in the event of pension plan counterparty distress?

Answer: Yes and no. The case in Detroit (which is currently on appeal) illustrates the risk that, notwithstanding state or local law to the contrary, federal bankruptcy judges may disregard the legal separation between municipal governments and the pension trusts they sponsor, treating those trusts as part of the estate. This may present certain credit and legal risks to the trusts' swap counterparties, although the Bankruptcy Code's swap netting provisions may mitigate some of those risks. I doubt that we will see anything similar to Detroit in the corporate pension plan arena because ERISA not only recognizes, as a matter of federal law, the separate legal existence of such plans, but also affirmatively prohibits the use of plan assets for the benefit of the sponsor. Separately, many broker-dealers negotiate rights to terminate existing swaps upon certain credit events, including the plan sponsor filing for bankruptcy or ceasing to make plan contributions.

Question: How does Dodd-Frank impact the transacting of swaps between an ERISA plan and non-pension plan counterparties such as banks, asset managers or insurance companies?

Answer: Dodd-Frank does a number of things. For one, it adds a layer of protection for ERISA and government plans (and others), through certain "External Business Conduct" standards. Generally, these standards seek to ensure the suitability of the swaps entered into by the investors. Invariably, swap dealers will comply by availing themselves of multiple safe harbors from "trading advisor" status, which triggers various obligations relating to ensuring suitability. Very generally, these safe harbors seek to ensure that the investor is represented by a qualified decision-maker that is independent of, and not reliant upon, the swap dealer. Under protocol documents developed by the International Swaps & Derivatives Association ("ISDA"), the safe harbors are largely ensured through representations and disclosures of the plan, decision-maker and swap dealer (as well as underlying policies and procedures).

Question: Dodd-Frank has a far reach. Would you comment on other relevant requirements?

Answer: Separately, Dodd-Frank imposes various execution and clearing requirements on certain swaps. These requirements raise a number of issues under the prohibited transaction rules of ERISA and Section 4975 of the Internal Revenue Code. Exemptions from those rules will be needed for (1) the swap itself (unless blind) (2) the execution and clearing services (3) the guarantee of the trade by the clearing agent and (4) close-out transactions in the event of a plan default. This last point presents perhaps the thorniest issue, particularly for ERISA plan investors that direct their own trade swaps and thus cannot avail themselves of the Qualified Professional Asset Manager ("QPAM"), In-House Asset Manager ("INHAM") or other "utility" or "investor-based" class exemptions. The DOL expressly blesses the use of the QPAM and INHAM exemptions in the aforementioned Advisory Opinion 2013-01A, under certain conditions. Senior U.S. Department of Labor staff members have informally confirmed that the DOL saw no need to discuss the other utility exemptions (including Prohibited Transaction Class Exemption ("PTCE") 90-1, 91-38 and 95-6) for close-out trades because they assumed they could apply, if their conditions were met.

Question: Is there a solution for those ERISA plans that direct their own swap trading?

Answer: It is unclear. There are only two exemptions, at least currently, that could even conceivably apply: ERISA Section 408(b)(2) and Section 408(b)(17), also known as the Service Provider Exemption. The first covers only services, such as clearing, and the DOL has given no indication that it views close-out trades as so ancillary to the clearing function as to be covered under the exemption. In contrast, the Service Provider Exemption covers all transactions other than services. But it also requires that a fiduciary makes a good faith determination that the subject transaction is for "adequate consideration." If the close-out trades are viewed as the subject transaction, who is the fiduciary making that determination? The DOL's Advisory Opinion 2013-01A says that it isn't the clearing agent. Thus, to make the Service Provider Exemption work, you have to tie the close-out trades back to the original decision by the plan fiduciary to engage the clearing agent and exchange rights and obligations, including close-out rights. That argument has not been well received by the DOL, at least so far.

Many thanks to Patrick S. Menasco, a partner with Steptoe & Johnson LLP, for taking time to share his insights with PensionRiskMatters.com readers. If you would like more information about pension risk management, click to email Dr. Susan Mangiero.

Detroit Swaps, Counterparty Risk and Valuation

When I worked on several swaps and over-the-counter options trading desks, there was always a lot to do in order in order to properly set up a program with an end-user. Sometimes this involved in-person training of a board or asset-liability management committee or otherwise authorized persons who had made an organizational decision to employ derivatives. Credit limits had to be vetted, decisions about collateral had to be made and master agreements were negotiated and signed. Throughout the process, everyone was mindful that big money was at stake and that getting the preliminaries finished on time, with diligence and care, was both crucial and important. The key was (and still is) to plan ahead for a worst case scenario wherein a contractual counterparty cannot or will not perform. Should that occur, the remaining party would likely seek to unwind or offset a given position rather than allow a bad situation to linger. A valuation of the over-the-counter derivative instrument in question, such as an interest rate swap, would be determined and mutually agreed upon. Contractual terms such as the rate of swap exchange, time remaining and the quality and quantity of collateral posted by either or both counterparties would typically be used to determine the amount of money owed by the non-performing entity. An agreement as to when "non-performance" commenced would be yet another factor. In a dispute situation such as a lawsuit, damages might be part of the calculation.

Sounds straightforward, right? Well, things are seldom simple, especially when one counterparty is in financial distress. When a counterparty owes money but cannot pay on a given date or has insufficient monies to settle a swap as part of a buyout, the remaining counterparty has to look to the underlying collateral, consider litigation and/or negotiate for some type of remuneration. Legal decisions can complicate things. Consider the situation with Detroit.

On January 16, 2014, Judge Steven W. Rhodes, U.S. Bankruptcy Court for the Eastern District of Michigan, opined that a $165 million payment to UBS and Bank of America to end certain interest rate swaps was too much money to outlay right now. Refer to "Detroit bankruptcy judge rejects $165M swaps deal with banks" (Crain's Detroit Business, January 16, 2014).

By way of background, these over-the-counter derivative contracts were related to the issuance of pension obligation bonds. The objective at that time was to protect the Detroit issuer (and taxpayers by extension) from higher funding costs if interest rates climbed. By having a swaps overlay, the bank counterparties were to pay Detroit if rates increased above a specified level. Conversely, lower rates would obligate Detroit to make periodic swap payments to the banks involved.

Reporters Nathan Borney and Alisa Priddle describe a 2009 effort to collateralize the swaps with casino-related revenue in "Detroit bankruptcy judge denies proposal to pay off disastrous debt deal" (Detroit Free Press, January 16, 2014). They add that this move was aimed at avoiding "an immediate payment of $300 million to $400 million on the swaps, potentially violating the Gaming Act" since interest rates had not risen. According to "Detroit continues talks with banks after canceling swaps truce" (Bloomberg, February 7, 2014), the swaps have a monthly price tag of about $4 million, "have cost taxpayers more than $200 million since 2009" and are being questioned by the city with respect to their "legitimacy."

Numerous questions come to mind and will no doubt be raised as the banks and city officials continue to talk or the attorneys take over, should litigation ensue. The list includes, but is not limited to, the following:

  • Who had the authority to commit Detroit to the swaps trades? Click to view an interesting visual put together by the Detroit Free Press and entitled "Were The $1.44-Billion Pension Deal And The Pledge Of Casino Tax Revenue Legal?" (September 14, 2013).
  • Were any of the recommending swaps agents subject to a conflict of interest, as has been suggested by The Detroit News?
  • What was the due diligence carried out by city officials before the swaps were put in place?
  • How were the collateral-related terms decided and by whom?
  • How were swap interest rate triggers determined?
  • Was there an independent party in place to regularly review the quality and quantity of posted collateral?
  • What role did the internal and external auditors play with respect to oversight of the reporting of the swaps and related bond financing?
  • Was there an appreciation that rising rates would mean a payment by the swap banks to the city and that this inflow could have been used to offset the higher cost of variable rate debt?
  • Who undertook the analysis of the effectiveness of the swaps as a hedge against rising rates and was the hedge deemed likely to be protective?

There are lessons to be learned aplenty about swaps, contractual protection, collateral valuation, oversight, authority and much more. No doubt there will be much more to say in future posts.

Dodd-Frank, Swaps Clearing and Compliance for Pension Plan Asset Managers

According to the Bank for International Settlements, the notional amount outstanding, as of June 2013, of global over-the-counter derivatives exceeded $692 trillion. Interest rate swaps reflect the largest category at about $425.6 trillion. Given the jumbo size of this market, it is no surprise that regulators have demanded more transparency about the mechanics of the global swaps market, including reporting to regulators and the public dissemination of reported information. It is also no surprise that regulators have demanded what they deem to be risk-reducing measures such as the clearing of these instruments and collateral collection. With the promulgation of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), numerous market participants are now required to clear their swaps. Click here to learn about the three categories of organizations that are required to adhere to swap clearing and trade execution requirements under Section 2(h) of the Commodity Exchange Act (“CEA”). Given the complexity of the prevailing swaps-related rules and regulations as well as the evolving nature of these mandates, any educational insights are welcome.

As an economic consultant, trainer and expert witness who regularly does work in the pension risk management arena and author of Risk Management for Pensions, Endowments and Foundations, I was delighted to have a chance to get comments about this important topic of swaps clearing and trade compliance from Davis Polk attorneys Lanny A. Schwartz and Gabriel D. Rosenberg. Mr. Schwartz is a partner, and Mr. Rosenberg is an associate in Davis Polk’s Trading and Markets practice. Besides the questions and answers provided below, and acknowledging that there is a lot to learn about swaps-related compliance, readers may want to download "Are You Ready? New Swap Trading Requirements For Pension Plan Asset Managers" (August 2013) by Attorneys Schwartz and Rosenberg, in conjunction with BNY Mellon.

Question: What is your motivation for writing about this topic as well as offering educational webinars?

Answer: We continue to receive numerous inquiries from swap market participants, many related to clearing. Swaps dealers were the first to have to demonstrate compliance with Dodd-Frank's swaps clearing mandate in March of last year. Most asset managers were required to clear specified types of interest rate swaps and credit default swaps as of June 2013. Other entities, including ERISA plans, had a deadline of September 2013.

Question: What areas have you identified as requiring more time and attention?

Answer: We are still mid-stream in terms of implementing a wide array of rules. Compliance is not a simple “check the box” exercise. Some swaps are now subject to mandatory clearing, but this is a relatively small part of the universe in terms of instruments traded in the market. Trading on a regulated futures exchange or swap execution facility is currently voluntary. Margin requirements are not yet final. Documentation requirements are similarly critical and require significant attention.

Question: What is a qualified independent representative and why is that important to an asset manager that has pension plan clients?

Answer: Before a swap dealer can act as an advisor to a pension plan regarding swaps, which in this context means making customized recommendations, the plan manager must verify that the pension plan has a qualified independent representative ("QIR") in place. A QIR is an agent of a Special Entity (such as a corporate or public pension plan) that is knowledgeable and independent of any swap dealer counterparty.

Question: It sounds like there is a large amount of due diligence that must be carried out by swaps dealers, asset managers and end-users such as pension plans, respectively. Would you elaborate?

Answer: You are correct that each category of swap market participant has a large amount of due diligence to carry out in order to ensure that they are compliant with Dodd-Frank's trading, clearing and other provisions. Swap dealers will generally require counterparties to adhere to one or more of the International Swaps and Derivatives Association (“ISDA”) protocols and other documentation as relevant to their activity. For example, suppose Big Bank X is a leading dealer of swaps and has been approached by Global Asset Management Firm Y to handle its trades on behalf of various end-users such as pension plans of Fortune 500 companies. Before Big Bank X will speak in detail about swaps with Global Asset Management Firm Y, it generally will need to make sure it has proper documentation in place. Unless Global Asset Management Firm Y can demonstrate adherence (or enters into alternative documentation developed by the swap dealer, Big Bank X will generally not transact with them.

Question: What are some of the action steps that a pension plan must take?

Answer: A pension plan, whether a corporate ERISA plan or government employee benefits plan, must have an account with a Futures Commission Merchant (“FCM”) in order to enter into swaps trades that are subject to clearing. This requires diligence and negotiation of important documentation about the clearing relationship. Pension plans should also consider the trade-offs between using swaps and nearly equivalent futures contracts.

Question: Are there areas of vulnerability that need to be better addressed?

Answer: A firm needs to have people in place who are experienced and knowledgeable about Dodd-Frank, operational processing, legal documentation and the use of technology for data inputting and report generation. None of these areas are trivial and require care and diligence. Additionally, since things are in flux as new rules are being adopted, it is critically important for any swap market participant to stay abreast of compliance mandates.

Question: Headlines are replete these days with news about regulatory investigations and lawsuits about how London Interbank Offer Rates (“LIBOR”) are determined by quoting banks. Inasmuch as the majority of swaps are tied to some type of LIBOR fix, how is swaps trading likely to be impacted?

Answer: The increased scrutiny about LIBOR could result in increased regulatory interest in other indexes that are referenced by swaps.

Question: What is the role of external counsel versus the internal General Counsel?

Answer: It is critical for asset managers to develop an educational program that allows front, middle and back office professionals to understand what rules, policies and procedures need to be established and followed. External counsel can add value by explaining the ISDA Protocols and other documentation and compliance requirements to clients. An end-user’s General Counsel should make sure that everything is in place in order to comply with Dodd-Frank. Plenty of clients say they don’t even know where to start and feel overwhelmed.

Question: There is so much more to discuss. Readers should stay tuned for further updates. At the client level, it sounds like you will both remain quite busy.

Answer: Susan, we appreciate the opportunity to share our insights with readers of your blog. We urge everyone with a stake in good governance to pay attention and do whatever is needed to comply with Dodd-Frank's swaps rules.

Longevity Derivatives Seem Poised For Further Growth

If this photo of senior ski fans is representative of the upward global trend in longevity, creators of derivatives could be on to something big. Deal count suggests that 2013 will be described as a banner year for banks and others types of financial companies as their respective corporate clients, in search of protection against the greying of their plan participants, took the plunge to get rid of risks they find difficult to manage. Financial News reports a December deal for 2.5 GBP between AstraZeneca and Deutsche Bank that "will cover the drug company against the risk that 10,000 of its former employees will live longer than expected." This follows a 1 billion GBP swap between Carillion and Deutsche Bank and a second transaction between BAE Systems and Legal & General, also in December 2013. See "A shot in the arm for longevity swaps" by Mark Cobley (January 6, 2014) for more details.

Certainly the topic is gaining importance in policy-making circles and at an international level. In December 2013, the Bank For International Settlements ("BIS") released an updated version of a study about longevity risk transfer markets. The product of the Joint Forum on longevity risk transfer ("LRT") markets, the report strongly encourages those with regulatory authority to carefully track the nature of deals being done and by which organizations as a way to gauge capacity to handle risks being transferred to the financial sector. Longevity risk exposures should be properly measured and attention should be paid to the extent to which "longevity swaps may expose the banking sector to longevity tail risk, possibly leading to risk transfer chain breakdowns." The study likewise notes the importance of supervisors to be able to evaluate whether those in possession of longevity risk have the "appropriate knowledge, skills, expertise and information to manage it."

These words of caution make sense, especially given the large amounts at stake. In its December 20, 2013 press release, the BIS cites estimates of the aggregate "global amount of annuity- and pension-related longevity risk exposure" as ranging between $15 and $25 trillion. Based on World Bank data, U.S. Gross Domestic Product for 2012 was $16.2 trillion. It was reported at $8.2 trillion for China and $5.9 trillion for Japan. The implication is clear. Get it wrong and it could mean big losses for a delicate global financial system that has had its share of risk management twists and turns. Click to access "Longevity risk transfer markets: market structure, growth drivers and impediments, and potential risks" (Basel Committee on Banking Supervision Joint Forum, December 2013).

As at least one major bank moves forward to develop a longevity derivative instrument that is meant to be traded, expect more news from insurance company and banking regulators about capacity, internal controls, assessment of risk, posting of capital and adequate disclosure about the transfer of large amount of longevity risks to financial intermediaries. Risk Magazine author, Tom Osborn, describes some of the impediments to a full-scale launch of the longevity transfer market, including limited disclosure about how transactions are priced, absence of a liquid index that would facilitate cost-effective hedging and avoid capital adequacy-related basis risk problems and questions about how exposures should be accurately modeled. Click to read "Longevity: Opportunity or flop?" (September 20, 2013).

DOL Issues Advisory Opinion About Use of Swaps by ERISA Plans

ERISA plans have long relied on over-the-counter swaps to hedge or to enhance portfolio returns. Given the high level of attention being paid to de-risking solutions these days, the role of swaps is even more important since these derivative contracts are often used by insurance companies and banks to manage their own risks when an ERISA plan transfers assets and/or liabilities. Big dollars (and other currencies) are at stake. According to its 2012 semi-annual tally of global market size, the Bank for International Settlements ("BIS") estimates the interest rate swap market alone at $379 trillion. Click to access details about the size of the over-the-counter derivatives market as of June 2012. It is therefore noteworthy that regulatory feedback has now been provided with respect to the use of swaps by ERISA plans.

In its long awaited advisory opinion issued by the U.S. Department of Labor, Employee Benefits Security Administration ("EBSA"), ERISA plans can use swaps without fear of undue regulatory costs and diminished supply (due to brokers who do not want to trade if deemed a fiduciary).

In its rather lengthy February 7, 2013 communication with Steptoe & Johnson LLP attorney Melanie Franco Nussdorf (on behalf of the Securities Industry and Financial Markets Association), EBSA officials (Louis J. Campagna, Chief - Division of Fiduciary Interpretations, and Lyssa E. Hall, Director - Office of Exemption Determinations) made several important points about whether a swaps "clearing member" (a) has ERISA 3(21)(A)(i) fiduciary liability if a pension counterparty defaults and the clearing member liquidates its position (b) is a party in interest as described in section 3(14)(B) of ERISA with respect to the pension plan counterparty on the other side of a swaps trade and (c) will have created a prohibited transaction under section 406 of ERISA if it exercises its default rights. These include the following.

  • Margin held by a Futures Commission Merchant ("FCM") or a clearing organization as part of a swap trade with an ERISA plan will not be deemed a plan asset under Title 1 of ERISA. The plan's assets are the contractual rights to which both parties agree (in terms of financial exchanges) as well as any gains that the FCM or clearing member counterparty may realize as a result of its liquidation of a swap with an ERISA plan that has not performed.
  • An FCM or clearing organization should not be labeled a "party in interest" under ERISA as long as the swap agreement(s) with a plan is outside the realm of prohibited transaction rules.

There is much more to say on this topic and future posts will address issues relating to the use of derivatives by ERISA plans. In the meantime, links to this 2013 regulatory document and several worthwhile legal analyses are given below, as well as a link to my book on the topic of risk management. While it was published in late 2004 as a primer for fiduciaries, many of the issues relating to risk governance, risk metrics and risk responsibilities remain the same.

Fiduciary Duty to Hedge

Who would have thunk that a discussion about pension governance and risk management would keep audience members in their seats for nearly three hours? Yet that is what occurred on January 24, 2012 as a panel convened to discuss such weighty issues as whether companies have a fiduciary duty to hedge and whether inaction can lead to litigation.

In his opening remarks as part of a January 24, 2012 event that was hosted by the Hartford CFA Society, ERISA attorney Martin Rosenburgh cautioned that fiduciaries could find themselves open to questions for not taking steps to mitigate risks. Attorney Gordon Eng, a former litigator and now general counsel and Chief Compliance Officer for a high yield bond fund, adds that any investment decision should be supported with ample documentation that reflects a careful and thorough deliberation of the issues at hand.

For more details about this lively, topical and informative event, read "Considering a Duty to Hedge" by Christopher Faille.

Counterparty Credit Risk Guidance From Bank Regulators

On June 29, 2011, the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Board of Governors of the Federal Reserve System and the Office of Thrift Supervision issued its latest thinking on derivatives trading by banks. "Interagency Supervisory Guidance on Counterparty Credit Risk Management" considers the role of senior management, methods to measure risk, ways to manage risk and model validation.

Given the increasing number of institutional investors that deploy derivatives - directly or indirectly via third party organizations - for return enhancement or risk minimization purposes, this twenty-six page document is worth a read. Anything that impacts the costs of major derivatives dealers is likely to have a trickle down impact on pensions, endowments, foundations and family offices.

The list below offers a preview of takeaways from the regulators' perspective.

  • Assessment of counterparty credit risk models should reflect their "conceptual soundness," along with "an ongoing monitoring process that includes verification of processes and benchmarking; and an outcomes-analysis process that includes backtesting."
  • Develop a comprehensive process surrounding bank monitoring of collateral.
  • Discuss how to control "wrong-way risk" which occurs "when the exposure to a particular counterparty is positively correlated with the probability of default of the counterparty itself."
  • Banks need to regularly measure the "largest counterparty-level impacts across portfolios, material concentrations within segments of a portfolio (such as industries or regions), and relevant portfolio-and counterparty-specific trends."

Pension fund investment committee members can use the guide to draft or add to an existing questionnaire for interviews they conduct with their asset managers, banks and consultants.

"Death" Derivatives and Longevity Related Pension Risks

As seniors continue to live hopefully fulfilling lives, plan sponsors grapple with how to best manage the costs. The realities of longer life spans for participants is creating all sorts of innovation on Wall Street, including what Bloomberg journalists recently described as "death derivatives."

In a May 16, 2011 article, Oliver Suess, Carolyn Bandel and Kevin Crowley describe products that could encourage defined benefit plan executives to "outsource" by transferring risks to longevity traders or entering into a financial engineering transaction in order to receive a regular cash flow that mirrors their respective ongoing obligations to retirees. What happens next, depending on how capital market participants respond to a few test cases, could mean the growth of a $23 trillion market in longevity bonds and related derivative instruments.

As with any financial engineering endeavor, education will be paramount in terms of both plan sponsors and securitized pension obligation buyers understanding underlying assumptions and risk-return attributes.

Click to read "Death Derivatives Emerge From Pension Risks of Living Too Long."

Stable Value Risk Management

Kudos to the Stable Value Investment Association for encouraging several days of lively discussions about important topics such as asset allocation, behavioral investing and risk management.

In my comments about stable value risk management, I emphasized the importance of having robust policies and procedures in place across all providers. I likewise mentioned the need for plan sponsors to investigate the use of derivative instruments on the part of both the asset managers and the wrappers, adding that some stable value funds may pose valuation challenges. Given the approximate $700 billion size of the stable value market and the widespread use of these products in 401(k) plans, financial service organizations have a golden opportunity to differentiate themselves from competitors by making their risk stance transparent with investment committee member buyers. This is especially true at a time when plan sponsors are increasingly asked to justify their due diligence and oversight of service providers.

Click to read "Stable Value Risk Management - Remarks Made by Dr. Susan Mangiero Before the Stable Value Investment Association on November 19, 2010."

You might also want to check out "Fiduciary Alert: Stable Value," provided by the team at Harrison Fiduciary. In speaking to Attorney Mitch Shames the other day about stable value risk management, he concurred with many points I made in my speech and added a few of his own. See below for his comments.

"Most of the time stable value ("SV") products are sold by recordkeepers. Often plan fiduciaries simply sign-off, thinking that they are getting a turn-key "stable" product which provides "value".  Plan fiduciaries rarely understand that SV is a hybrid product,   with an investment component and an insurance component. For instance, ask a fiduciary about the crediting rate on the stable value vehicle and they may give you a blank stare. Ask them to identify the wrap provider and describe their crediting rating and they may be equally in the dark. Finally, fiduciaries are sometimes surprised when they find out that traditional HR issues can have an impact on the wrap contract. Most all wrap contracts provide that if the work force is reduced by a certain percentage, then the wrap provider is released from the wrap coverage. So, if a sponsor has a significant plan closing, this can give rise to problems under the SV Program. Similarly, there are often restrictions on the number of participants who can withdraw from an SV plan.  Imagine if participants get sick of low returns and start shifting assets out of the SV program into equities, emerging markets, etc. This can create huge problems for SV programs.The point is that SV is extremely complicated and the devil, as always, is in the details. All fiduciaries must be familiar with the terms of the wrap agreement."

Another noteworthy read is "Risk Controls and the Coming Stable Value Surge." According to the author, Robert Whiteford, Bank of America, "wrappers and asset managers have made great progress in reducing risk in a way that should allow the existing wrappers to increase capacity in the future," adding that "new investment guidelines have been constructed to more faithfully reflect the mission of stable value funds."

Like most industries, the stable value sector is confronted with challenges to be more transparent and thereby lessen the pain for their fiduciary buyers and plan participants.

Pulling Rabbits Out of the Hat At Sea

According to up-to-the minute press accounts, some 100 magicians are stranded in the middle of the ocean on a cruise ship with a faulty engine. Expecting a few days of fun and legerdemain, these tricksters are awaiting rescue and forced to dine on cold goodies with no air conditioning. When a colleague brought this news to my attention tonight, my immediate query was why help was taking so long. In response, I was told that passengers had to wait for a tugboat that could transport over 3,000 people (magicians included). Help is expected in short order with a full refund and a free trip for those affected.

No doubt Jay Leno and others will get a few guffaws out of this unpleasant experience for the sailing "Houdinis" - something to the effect that magicians should be able to snap their way out of trouble. The reality is that bad things can happen, leaving one feel helpless and stressed out. Also true is that adversity should and can be anticipated. That's why stress tests are so important as a way to model the unthinkable and plan accordingly. Maybe the cruise company in question did just that but, if so, why are paying customers forced to hang out for more than a few hours?

If we've learned anything from the financial market rollercoaster of late, it's this. We can't rely on sleight of hand to properly identify, measure and manage risks. Putting a contingency plan in place for any and all of the risk factors considered potentially material is good business sense. In pension land, failure to have tested the limits of a significant negative equity market has cost numerous sponsors big money. Other types of institutional investors and asset managers must heed this cautionary tale too.

Notably, in an in-depth survey conducted by MSCI Barra in 2009, "73% of pension plans and 26% of asset managers surveyed do not currently run stress tests, but cite this as a key focus going forward." This is encouraging. After all, ignoring the tail risk can lead to nasty consequences.

Other results that MSCI Barra uncovered are similar to what I found in a study of over 150 U.S. and Canadian pension plans, done in conjunction with the Society of Actuaries. Like MSCI Barra, few of our queried plan sponsors had Chief Risk Officers in place, considered retirement plan management as part of an enterprise-wide risk exercise and did not always pay close attention to risks such as liquidity. Click to access a full version of this 2008 study about the use of financial derivatives and fiduciary duty.

Pulling rabbits out of the hat is not as easy as it appears. Isn't it better to depend on a systematic and disciplined approach to mitigating those things that have the potential to destroy, if left unchecked?

401(k) Plans, Mutual Funds and Derivatives - Hello SEC

Given that mutual funds are a popular 401(k) plan choice, it's not surprising that further regulatory scrutiny of the use of derivatives by traders is underway.

"SEC Staff Evaluating the Use of Derivatives by Funds" (U.S. Securities and Exchange Commission Release 2010-45, March 25, 2010) talks about a new initiative to review the current practices by pools of capital regulated under the auspices of the Investment Company Act of 1940. Scrutiny will focus on items such as:

  • Leverage, concentration and diversification
  • Existing risk management policies and procedures
  • Oversight of use of derivatives by fund board of directors
  • Rules for proper pricing
  • Prospectus disclosures.

Click here for more information.

Reminder: April 20 Complimentary Webinar About OTC Derivatives

 

To learn more about over-the-counter derivatives and related topical issues, visit  https://www2.gotomeeting.com/register/773492546 .

We hope you can join Investment Governance, Inc. CEO - Dr. Susan Mangiero on April 20, 2010 from Noon to 1:00 PM EST for a timely discussion with executives from Northern Trust, Numerix and Sapient to discuss the current regulatory environment, OTC (over-the-counter) derivative instrument valuation and collateral management.

Negative Swap Spreads - Trouble On the Way?

If you missed "Will negative swap spreads be our coal mine canaries?" by Gillian Tett (Financial Times, March 30, 2010), it's a worthwhile read, especially given the pervasive use of triple A-rated sovereign bond yields as a proxy for the "risk-free" rate of return. A writer known as Bond Girl makes a similar observation in "10-year swap spread turns negative" (self-evident.com, March 23, 2010), adding that plausible explanations take the form of temporary and structural, respectively.

Consider the following:

  • Pension funds and other long-term investors are driving up demand to receive swap fixed payments as part of their asset-liability management strategies.
  • Some investors worry about the viability of governments to pay interest and debt on time.
  • Corporate debt issuers seek to hedge these liabilities.
  • Mortgage risk techniques are in flux, especially as the Federal Reserve Bank is no longer an active buyer of mortgage-backed securities. Read "Large-Scale Asset Purchases by the Federal Reserve: Did They Work?" (Federal Reserve Bank of New York, March 2010).

As if risk managers were not already challenged to deal with moving regulatory targets and market volatility, a negative swap curve adds to their concerns.

Editor's Note: On the topic of sovereign debt, a summary of Dr. Lucjan Orlowski's analysis of the Greek debt crisis and the likely impact on the U.S. dollar and euro will be posted shortly.

Default Swaps Get the Credit

In "It's Time for Swaps to Lose Their Swagger," New York Times reporter Gretchen Morgenson points the finger at regulators for not doing enough to stem the tide of moral hazard with respect to credit default swaps. While this superstar financial analyst rightly points out that risk transference continues to favor "high octane" traders and cost taxpayers and shareholders plenty, I don't agree that more "one size fits all" regulation is the answer. There is simply no evidence that a greater quantity of statutes will bridge the gap between risk management and reward. I don't have to be a behavioral expert to know that financial traders are motivated by the money they can make in a relatively short period of time. New rules beget changed incentives and often times perverse behavior. Does the law of unintended consequences ring a bell? Let's undo all the bad rules in place and focus on incentives that count. Start with bonuses that take into account the risk cost associated with expected return. Risk budgetize trading payouts.

If I'm playing by the rules, doing a great job of risk controls and acting in good faith on behalf of the proper constituencies, why should I be forced to pay for others' folly? Wouldn't my money and time be better spent on trying to encourage prudence on the part of industry participants, while informing the market at large how much my organization is doing right? For those who are in the vanguard of excellent risk management, take a bow. Get out the megaphones. Let the world know!

In December 1994, I was honored by the International Association of Financial Engineers with first place for my student paper presentation. Entitled "In Defence of a Free Financial Derivatives Market," I cite chapter and verse about why free markets trump. Though the statistics are fifteen years old, the philosophical and economic reasons remain valid to this day. I have listed a few tidbits below.

  • Compliance costs are high and divert precious resources away from shareholder wealth creation.
  • When buy-sell preferences are masked, it is difficult, sometimes impossible, to come to terms on a particular trade. The net result could be reduced volume which could lower liquidity.
  • Not all risks are equal and to treat them that way makes no sense.
  • Derivatives, used properly, can help to reduce risk.
  • Inovation is the lifeblood of economic growth. Regulation that is designed in the dark, away from public view, discourages problem-solving.
  • The right to contract with another party is part of free enterprise. Do you really want regulators to pick and choose your business partners?

 This is not to say that the status quo works. Far from it, change is needed and fast. As a shareholder, I would like to know more about the risk management policies and procedures in place at all major financial services organizations, not to mention the knowledge and experience of their board members with respect to internal controls, leverage and complex securities trading. Disclose how changes are made to strategy and tactics and on what basis.

Let the sunshine in. Information is a great equalizer.

The View From The Other Side - Regulatory Insight

Sometimes seeing over the other side of the desk is difficult, if not impossible. That's too bad because regulators and those they oversee have a lot to learn from each other. This is especially true if you embrace a primary goal of ultimately allowing for complete self-governing as a way to ensure more efficient markets.

"Pension Funds' Risk-Management Framework: Regulation and Supervisory Oversight" by Fiona Stewart (Working Paper No. 11, International Organisation of Pension Supervisors, November 2009) gets us part of the way. This new compendium of rules and regulations categorizes pension risk rules for Australia, Brazil, Germany, Kenya, Mexico, Netherlands and the UK in four areas - "management oversight and culture, strategy and risk assessment, control systems and information, reporting and communication." An audit checklist that pension supervisors can use in their examination work is offered as an appendix as is a convenient summary table that lays out country-specific risk management regulations about things such as the role of the Chief Risk Officer.

The two sides of the fence may never shake hands but studies like this enhance the understanding as to what is expected of plan sponsors by regulators.

Leverage - I Love You, I Need You - Don't Hurt Me

 

If institutional investors thought of leverage as a bouquet of daisies, they'd be playing "(S)he loves me, (S)he loves me not" and hoping to still be respected in the morning. Now that the worst economic recession of modern times might be abating somewhat, more than a few buy side executives are looking for a sweetheart to help them replenish diminished portfolio values. Let's just hope that the love affair is not fickle, causing more hurt than help.

In "Wall Street's New Flight to Risk" (February 15, 2010), Bloomberg BusinessWeek reporters Shanon D. Harrington, Pierre Paulden and Jody Shenn write that investors are on the prowl for yield. With over $150 billion allocated to U.S. bond funds, returns are low and the only way to add some excitement is with exotics such as "payment-in-kind" bonds that encourage the issuance of more debt than a borrower's operating cash flow would ordinarily support. Derivatives are another Valentine, with banks "again pushing" collateralized debt obligations ("CDO's) that can increase in value (depending on the trade) as defaults increase. 

On January 27, 2010, Wall Street Journal reporter Craig Karmin writes that public pension funds are borrowing money to enhance returns rather than allocating to alternatives such as hedge funds and private equity pools. According to "Public Pensions Look at Leverage Strategy," funds can turn in a good performance with the use of leverage without having to resort to "volatile stocks" or illiquid assets. Others quoted in this recent piece suggest that risks exist and must be acknowledged.

Heartbreak hotel - here we come.

Call me crazy but a move towards leverage (possibly excessive) seems scary UNLESS and UNTIL asset managers and institutional investors alike can demonstrate that they know how to properly measure and manage. For every person who is asked to define investment leverage, the answer is seldom the same. AIMA Canada makes a good effort to add clarity to this important topic. See "An Overview of Leverage" (Strategy Paper Series Companion Document, October 2006, Number 4).

L'amour with leverage - how sweet it is, until it isn't. Then what?

Over the Counter No More - Blessing or Curse for Institutional Investors?

According to the Bank for International Settlements, the global over-the-counter ("OTC") derivatives market toppled $683.7 trillion as of June 2008. See "OTC derivatives market activity in the first half of 2008" (November 2008). It should come as no surprise then that hungry regulators have set their sights on this economic juggernaut. We're regulating almost everything else. Why should OTC instruments be any different?

Hot off the press, the U.S. Department of Treasury today announced plans to regulate "all Over-The-Counter derivatives" with stated objectives that include:

  • "Preventing activities within the OTC markets from posing risk to the financial system
  • Promoting efficiency and transparency within the OTC markets
  • Preventing market manipulation, fraud, and other market abuses
  • Ensuring that OTC derivatives are not marketed inappropriately to unsophisticated parties."

This is not the first time that Washington has tried a D-word power grab. In May 2002, I wrote "Anyone up for OTC Derivatives Regulation?" in which I pondered whether more government intervention would help. (H.R. 4038, mandating derivatives market reform, did not survive a Congressional vote.) Quote me as saying that "Mandatory regulation comes with a hefty price tag. Compliance diverts resources that could be expended elsewhere on behalf of shareholders. The law of unintended consequences loom large and the 'one-size-fits-all' approach encourages adverse selection. This, in turn, rewards imprudent risk-taking and exacerbates problems associated with misuse."

In 1994, the International Association of Financial Engineers selected my student paper for presentation at their annual conference in New York City. Entitled "In Defense of a Free Financial Derivatives Market," I emphasized the costs of compliance and the oft-perverse aftermath, as countless organizations scramble to avoid regulatory problems by seeking loopholes. So far, few have disputed the factors I laid out then as expensive and therefore aptly deemed as "economic bads." I'm not alone in believing that what I scribed then remains true today in terms of the many costs of regulation. The list includes:

  •  "The cost of compliance, related to regulatory recordkeeping
  • The cost associated with creating an asymmetry of market information
  • The cost of creating the problem of adverse selection by treating all risks as equal
  • The cost of abrogating the legal right of individuals to contract with agents and to own private property
  • The cost of making hedge management more difficult, and
  • The cost of stifling product innovation."

Was I prescient in 1994 and 2002? Perhaps but I think many could read the handwriting on the wall. What goes up must come down, right? After all, the topic du jour is whether any market or organization should be allowed to grow "too big to fail."

What does OTC derivative instrument regulation mean for pensions, endowments and foundations? One likely outcome is that the cost of hedging will go up at the same time that some institutional investors favor a more systematic approach to risk management. Will regulation make the world safer? Probably not. There is the danger that some will be lulled into complacency by equating more rules with less uncertainty. I'd much prefer an effort to have OTC derivative buyers and sellers better assess and manage risks. As CPA Michael Jellison wrote in response to "U.S. Lays Out New Derivatives Rules" by Kara Scannell and Corey Boles (Wall Street Journal, May 13, 2009):

"To the investor - if the instrument does not make intuitive sense to you on its face, stay away from it. That's the best form of regulation."

Touche!

Editor's Note: Email your name and fax number if you would like a hard copy of "In Defense Of A Free Financial Derivatives Market" by Susan Mangiero, 1994. Some of the statistics are dated but the principles remain valid.

Does More Financial Regulation Make Us Safer?

 

According to its March 26, 2009 press release, the U.S. Department of Treasury advocates what they call "comprehensive reform" to modernize the U.S. financial system and seek to avoid major meltdowns. Key components include:

  • Addressing systematic risk rather than focusing on "potential insolvency of individual institutions" alone
  • "Strengthen enforcement and improve transparency for all investors" as a way to safeguard consumers and investors
  • Create a "substantive system of regulation that meets the needs of the American people," avoid turf wars and "assign clear authority, resources, and accountability" to those in charge of enforcement
  • Outreach to non-U.S. regulators in order to "address prudential supervision, tax havens, and money laundering issues in weakly-regulated jurisdictions."

For those who think this is all bark and no bite, consider that U.S. Treasury Department Secretary Geithner is calling for (a) registration of hedge fund advisers above a certain size, not to mention additional reporting requirement for said alternatives (b) "comprehensive framework of oversight, protection and disclosure for the OTC derivatives markets" (c) more stringent capital requirements for organizations deemed to be major financial market participants and (d) a single independent regulator to oversee "important" entities. Click to read "Treasury Outlines Framework for Regulatory Reform" (March 26, 2009).

Not everyone thinks that more regulation is smart regulation. During a recent interview with First Business, hedge fund consultant Kristin Fox voiced two problems with a regulatory power grab. Enhanced disclosure may lull people into false security, discouraging them from probing further. Additionally, regulators may struggle to understand the economics of "complex" instruments. Click to view "Financial System Overhaul," written by Beejal Patel (March 26, 2009).

Let me ask what may seem like simple questions.

The point is that we've had more than a trivial amount of regulation in place for years yet we've still had problems. How are new mandates going to trump existing rules?

Vive Le Free Markets - Oh Never Mind!

French economist Frédéric Bastiat must be rolling over in his grave as more and more headlines decry capitalism in favor of stringent regulation. In "Policy Makers Weigh Fed Oversight of Derivatives" (February 2, 2009) Wall Street Journal reporter Deborah Solomon writes that Washington movers and shakers are all a twitter about whether to regulate over-the-counter derivative instruments. (One could argue that some regulation currently applies since federally regulated banks dominate this space but that's a discussion for another post.) House Financial Services Chairman Barney Frank (Democrat, Massachusetts) is quoted as saying that "It's not a brand-new regulation but an expansion of the authority of the Federal Reserve."

According to his official website, Senator Chuck Grassley (Republican, Iowa) - along with Senator Carl Levin (Democrat - Michigan) - have introduced legislation to "close a loophole in securities law that allows hedge funds to operate under a cloak of secrecy." In "Grassley and Levin introduce hedge fund transparency bill" (January 29, 2009), this new legislation, if passed, would empower the U.S. Securities and Exchange Commission ("SEC") to force hedge funds to register, thereby putting them under the auspices of the Investment Company Act of 1940. 

In his January 29, 2009 statement, Senator Levin described three basic elements of The Hedge Fund Transparency Act, besides registration. These include the filing of an annual statement that would be available to the public, the maintenance of books and records as required by the SEC and the cooperation with the SEC as relates to examination or information requests.

Levin adds that "The information to be made available to the public must include, at a minimum, the names of the companies and natural individuals who are the beneficial owners of the hedge fund and an explanation of the ownership structure; the names of any financial institutions with which the hedge fund is affiliated; the minimum investment commitment required from an investor; the total number of investors in the fund; the name of the fund's primary accountant and broker; and the current value of the fund's assets and assets under management. This information is similar to what was required in the disclosure form under the SEC's 2004 regulatory effort. The bill also authorizes the SEC to require additional information it deems appropriate."

About two weeks earlier, the President's Working Group on Financial Markets ("PWG") released its best practices for hedge funds, encouraging market participants to adopt comprehensive policies and procedures to (hopefully) thwart problems. The institutional version, entitled "Principles and Best Practices for Hedge Fund Investors: Report of the Investors' Committee to the President's Working Group on Financial Markets" (January 15, 2009), includes an entire section devoted to fiduciary issues. Some of the text is overly broad but it is a good start in terms of getting people to think hard about subjects such as suitability and oversight.

The industry version, entitled "Best Practices for the Hedge Fund Industry: Report of the Asset Managers' Committee to the President's Working Group on Financial Markets" (January 15, 2009), has a noteworthy section about valuation (a topic near and dear to my heart). I am particularly interested in tracking which hedge funds decide to set up a valuation committee, if one does not currently exist. If hedge fund managers follow the report's recommendations, they will likely be spending lots of money on independent pricing services.

Two key questions loom. Will industry attempts at best practices slow down or possibly ward off increased regulation? If not, will regulation and enforcement parallel or conflict with suggested best practices?

This blogger gal goes on the record as favoring industry self-regulation. Sadly, when too few participants fail to recognize the benefits of taking responsibility to preserve open and fair markets, the strong arm of government is inevitable. Consider what Bastiat wrote in the 1800's, still relevant today:

  • "Everyone wants to live at the expense of the state. They forget that the state wants to live at the expense of everyone."
  • "Taxes must, in the end, fall upon the consumer."
  • "The worst thing that can happen to a good cause is, not to be skillfully attacked, but to be ineptly defended."

Whether we end up talking about "smart" or "better" regulation, financial market participants STILL have a chance to eat, live and breathe best practices, for themselves and for their investors.

Financial Engineering, Forensics and Pension Shareholders

My dad was an aerospace engineer who later switched to mechanical engineering. My sister is an electrical engineer. My husband was an electrical engineer until he earned his PhD in finance and became a professor. They have each advised me in their own way that every problem has a solution. It is a question of digging deep for answers, assimilating sometimes massive amounts of data and then applying a big dose of common sense.

Influenced by these important persons in my life (and many others who have a similar "can do" attitude), I use a building block approach to financial engineering. Having worked in two treasury departments, on four trading desks, as an expert witness, fiduciary trainer and consultant, I know that it is important to ask many questions, understand the context and attempt to connect seemingly disconnected dots.

Applied to pension risk management, what you see is not what you necessarily get. It is critically important for institutional shareholders to understand whether and how much their portfolio companies (either through direct or indirect investing) use leverage (possibly in the form of derivative financial instruments) and how related risk is managed. (I was recently interviewed by a major broadcasting company on this very topic, given some of the lawsuits being filed against companies that allegedly did not do "enough" in the area of risk management. The piece will air in the next several weeks.)

In the meantime, these articles I authored several years ago may be of interest to readers of www.pensionriskmatters.com. The principles still apply today.

"The Role of the Financial Expert in Valuation of Derivative Instruments" (Expert Evidence Report, February 2004)

"Derivatives valuation: One size does not fit all" (Shannon Pratt's Business Valuation Update, December 2004)

"Derivatives and their impact on company value, part 1" (Shannon Pratt's Business Valuation Update, March 2005)

"Derivatives and their impact on company value, part 2" (Shannon Pratt's Business Valuation Update, April 2005)

Private Equity and Derivatives - Double Whammy or Blissful Combo?

According to the U.S. Government Accountability Office, nearly 4 out of 10 surveyed pension plans say they allocate monies to private equity. Allowing that some managers have turned in acceptable returns, respondents also cited numerous "challenges and risks beyond those posed by traditional investments." Valuation and limited transparency are two issues cited in "Defined Benefit Pension Plans: Guidance Needed to Better Information Plans of the Challenges and Risks of Investing in Hedge Funds and Private Equity" (GAO-08-692, August 14, 2008).

 

To shed light on some of the intricacies associated with private equity investments, I authored a case study for the February 2009 issue of PEI Manager, a private equity and venture capital focused publication. The bottom line is that institutions that invest in private equity funds are directly impacted by their portfolio companies' use of derivatives.

 

"Swapping out" by Dr. Susan Mangiero, an Accredited Valuation Analyst and CFA charterholder, is reproduced below. Email Ms. Jennifer Harris, Associate Editor - PEI Manager, for permission to reprint the case study.

 

                                                                       * * * * * *

 

THE CHALLENGE:

 

Private Equity Holdings (“PEH”) is required by its charter to avoid companies that use derivative financial instruments to speculate. In reviewing numbers for FAS 157 reporting purposes, a PEH managing partner notices that one of its portfolio companies, ABC Incorporated (“ABC”), recently included a FAS 133 entry for a $20 million interest rate swap hedge. During a call to the company to query about how the swap is being used, the PEH managing partner is informed that its counterparty is Global Bank Limited (“Global”). Not only has Global just reported a $30 billion loss due to poor valuation of its structured product portfolio, it posted no collateral in favor of ABC while ABC was required to pledge $2 million in U.S. Treasury Bills in order to protect Global in the event that ABC could not make its contractual swap payments to Global. Not being too familiar with derivative instrument pricing and default risk analysis, PEH hires an expert to investigate whether the swaps reflect a hedge versus a market bet and to further assess how PEH should adjust the valuation of its equity stake in ABC. What does the expert need to look at and how should she arrive at an appropriate conclusion?

 

SUSAN MANGIERO'S ANSWER:

 

This fact situation, ripped from the headlines, raises several important valuation questions, including, but not limited to the following:

 

  • Notwithstanding FAS 133 numbers, is the company exposed to changes in interest rates that could adversely impact cash flow, liquidity and net income?
  • Was the swap correctly valued?
  • How might ABC be impacted by Global’s deteriorating health?
  • What adjustments, if any, should PEH make to its initial valuation of ABC equity?

There are several critical issues here, all of which could seriously hamper the fortunes of both ABC shareholders and PEH investors. An inaccurate valuation of the swap leads to a flawed accounting representation for ABC and may lull treasury staff into thinking that the hedge offers full protection against unexpected moves in interest rates. PEH may report a bad FAS 157 number which in turn could lead to flawed asset allocation decisions made by institutional limited partners or the overpayment of performance fees to PEH. A poorly constructed hedge (in economic versus accounting terms) that exposes ABC to negative market conditions could force PEH to violate its prohibition against speculative trades being executed by portfolio companies. If Global does not meet its swap obligations and/or files for bankruptcy protection, ABC may not be able to recover its collateral quickly or could lose it altogether, depending on its standing vis-à-vis other creditors.

 

Swap pricing models can differ depending on the complexity of the transaction. However, for standard fixed to LIBOR swaps, the secondary market is large ($111 trillion, according to the Bank for International Settlements). Active trading makes it easy to readily obtain prices for various maturity interest rate swaps with quotes reflecting the discounting of future projected fixed and floating swap payment amounts. In contrast, the assessment of credit worthiness varies, sometimes considerably, across banks. Unfortunately for ABC, even if they posted more collateral than should have been required, the fact remains that they have no immediate recourse in the event that Global’s distress prevents the bank from paying what it owes to ABC. If Global defaults, ABC will then have to decide on a course of action that could include any or all of the following:

 

  • Enter into a second interest rate swap to replace Global at a now higher fixed rate
  • Attempt to sell the initial swap in the open market and consider another way to hedge against rising interest rates though few will be willing to accept the Global risk
  • Take legal action to reclaim its collateral
  • Write down the value of the swap on its books

There is no ideal situation. The expert will necessarily have to ask ABC what they plan to do in the event of swap non-performance and how it is expected to impact its cash flow, cost of money (which in turn affects capital budget decisions), balance sheet, dividend payments and interest coverage. Once that scenario analysis is conducted, both the expert and PEH will be able to quantify how much of an adjustment downward they will need to make for both accounting and performance reporting purposes.

What People Have to Say About OTC Derivatives

According to the Bank for International Settlements ("BIS"), the global market size for over-the-counter ("OTC") derivatives, as of June 2008, exceeded $683 trillion (yes trillion) or $683,725 billion. (These numbers reflect notional amounts outstanding.) Notably, an expanded use of interest rate swaps helped to push non-exchange traded interest rate derivative product outstandings above $450 trillion, a rise of 17% over the last half-year. It would be helpful to know whether, and to what extent, pensions' use of Liability-Driven Investing strategies influenced the numbers. Click to access "Table 1: The global OTC derivatives market."

Since June, a lot has happened in the global market place. Until BIS reports updated figures, it is hard to quantify how various players have responded to increased volatility with respect to their use of OTC instruments such as swaps, options and structured products. One might logically assume that valuation and liquidity concerns will reflect themselves in lower numbers for H2-2008. On the other hand, uncertainty could encourage hedging, in which case both OTC and exchange-traded activity might see a boost.

In the meantime, I asked a few financial market participants for their feedback. Here is what they had to say in answer to the following query.

Do You Think More Regulations Will Inhibit the Use of OTC Derivatives by Institutional Investors?

  • A director at a non-U.S. financial organization advises regulators not to throw the baby out with the bath water, adding that "Regulation should be framed to drive generic flows into more efficient 'plumbing' systems, while allowing custom-built trades to proceed when standardized terms don't make sense. Unless the market volunteers solutions, one must fear that knee jerk regulation will fail to differentiate, and therefore deprive end-users access to these undeniably valuable risk management tools."
  • Mr. Daniel Chertok, a quant by background, writes that "Any regulation inherently stifles innovation. However, it may deter those who should not be in this business from entering in the first place or encourage someone to rightly exit the market. There is likely to be a loss of liquidity but a drop in defaults should follow. What regulation will not do is eliminate the next bubble that occurs due to reckless derivative trading."
  • Mr. Luis Antonio Rangel, commodity derivatives professional and now President of Rockford Brownstone Rangel, thinks that regulation will inhibit use of OTC swaps and other kinds of derivatives by institutional investors. He adds that "the big downturn in this market recently has less to do with fear of regulation and more to do with counterparty risk. Regulators may help to repair the OTC market if their rules: (a) can improve market transparency as relates to how much leverage a particular manager employs (b) shed light on risk exposures to various counterparties across the spectrum For example, if Company DEF has a plain vanilla swap with Bank ABC but Bank ABC has a complex swap with Hedge Fund XYZ, how is Company DEF potentially hurt if Hedge Fund XYZ goes belly up? (c) improve investors' knowledge of liquidity, especially for instruments that have heretofore been deemed "low risk" and (d) mandate issuers of credit default swaps to reserve capital, in the same way that insurance companies must set aside monies. Too much regulation could push business offshore or impede transactions that, for viable economic reasons, should take place."
  • Mr. Patrick Rooney, Business Analyst at Trading Technologies, writes that "Initially, yes, more regulation will freeze OTC trading. As participants adjust to the new environment, the OTC market will flourish as new participants join. There are many misconceptions regarding the complexities and risks involved associated with OTC transactions. A centralized clearing environment is likely to vastly improve things."

Email us your comments. It would be great to get your feedback.

New Study Addresses Pension Risk Management Gaps

 At a time of great market turmoil, plan participants, shareholders and taxpayers want to know whether their retirement plans are in good hands. Risk is truly a four-letter word unless plan sponsors can demonstrate that a comprehensive pension risk management program is in place. Unfortunately, there is little information that details if, and to what extent, plan sponsors are doing a credible and pro-active job of identifying, measuring and mitigating a variety of risks. The risk alphabet includes, but is not limited to, asset, operational, fiduciary, legal, accounting, longevity and service provider uncertainties.

While no one could have predicted the extreme volatility that characterizes the current state of global capital markets, it has always been known that poor risk management can make the difference between economic survival and failure. Applied to pension schemes, ineffective risk management could prevent individuals from retiring at a certain age and/or leaving the work force with much less than anticipated. Others pay the price too. Taxpayers worry about rate hikes that may be inevitable for grossly underfunded public plans. Shareholders could find themselves on the hook for corporate promises or experience depressed stock prices due to post-employment benefit obligations.

In an attempt to shed some light on this critical topic area, Pension Governance, LLC is pleased to make available a new research report that explores current pension risk management practices. In what is believed to be a unique large-scale assessment of pension risk practices since the publication of a 1998 study by Levich et al, this survey of 162 U.S. and Canadian plan sponsors seeks to: (1) understand why and how pension plans employ derivative instruments, if they are used at all (2) identify what plan sponsors are doing to address investment risk in the context of fiduciary responsibilities and (3) assess if and how plan sponsors vet the way in which their external money managers handle investment risk, including the valuation of instruments which do not trade in a ready market. The report was written by Dr. Susan Mangiero, AIFA, AVA, CFA, FRM, with funding from the Society of Actuaries.

Each survey-taker was asked to self-identify as a USER if he/she works for a plan that trades derivatives in its own name. A NON-USER works for a plan that does not trade derivatives directly but may nevertheless be exposed indirectly if any of the plan's asset managers trade derivatives.

In answering broad questions, a large number of surveyed plan sponsors describe themselves as doing all the right things to manage investment, fiduciary and liability risks. However, answers to subsequent questions - those that query further about risk procedures and policies at a detailed level - do not support the notion that pension risk management is being addressed on a comprehensive basis by all plans represented in the survey sample.

Key findings include the following points:

  • Plan size seems to be one factor that distinguishes USERS from NON-USERS, with 39% of USERS managing plans in excess of $5 billion versus 14% of NON-USERS associated with plans larger than $5 billion.
  • Pension decision-making appears to vary considerably by job function, with 48% (37%) of USERS (NON-USERS) choosing "Other" rather than selecting from given titles such as Actuary, Benefits Committee Member, CFO or Human Resources Officer.
  • Time allocation varies considerably with 64% (40%) of USERS (NON-USERS) saying they devote 75 to 100 percent of their work week on pension issues. In contrast, 37% of NON-USERS say they spend 0 to 24% of their work week on pension issues.
  • A majority of USERS (64%) and NON-USERS (48%) have had discussions about the concept of a fiduciary duty to hedge asset-related risks. A smaller number say they have discussed the concept of a fiduciary duty to hedge liability-related risks.
  • Few plans currently embrace an enterprise risk management approach with 59% (57%) of USERS (NON-USERS) responding that their organization does not use a risk budget. When asked if their organization has or is planning to hire a Chief Risk Officer, 57% (64%) of USERS (NON-USERS) answered "No."
  • NON-USERS cite numerous reasons for not using derivatives directly, including, but not limited to, "Lack of Fiduciary Understanding" (25%), "Perception of Excess Risk" (31%), "Considered Too Complex" (23%), "Prohibition Against Possible Leverage" (19%) and/or "Defined Benefit Plan Risk Not Considered Significant" (28%).
  • A query about whether survey-takers review external money managers' risk management policies results in 70% (58%) of USERS (NON-USERS) responding "Yes." Fifty-two percent (57%) of USERS (NON-USERS) say they review external money managers' valuation policies. This survey did not drill down with respect to the rigor of questions being asked.
  • Survey respondents seem to rely mainly on elementary tools to measure risk. Eighty-three percent (64%) of USERS (NON-USERS) rank Standard Deviation first in importance. Seventy-nine percent (63%) of USERS (NON-USERS) rank Correlation second. Only one-third (38%) of NON-USERS cite Stress Testing (Simulation). Four out of 10 USERS cite Value at Risk in contrast to 23% of NON-USERS who do the same.
  • Survey respondents worry about the future with 58% (60%) of USERS (NON-USERS) ranking "Accounting Impact" as a concern. Other concerns were also noted to include "Regulation," "Longevity of Plan Participants" and "Fiduciary Pressure."

Click to download the 69-page study, entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" by Susan Mangiero. Given the large file size, readers are encouraged to (a) first save the file (right mouse click) and then (b) open the file from wherever you have saved the file. Otherwise, you may receive an error message, depending on your computer configuration. 

The study is also available by visiting www.pensiongovernance.com. Send an email to PG-Info@pensiongovernance.com if you experience any difficulty in downloading the pdf file and/or want to comment about the study.

Risk Management Adventures

Thanks to financial planner David Boczar for sending along a thought-provoking quote from famed commodities trader Ed Seykota. Described as someone who turned $5,000 into $15 million over a dozen years, this uber trend follower Seykota cautions: "Surrender to the reality that volatility exists, or volatility will introduce you to the reality that surrender exists."

As I've written many times, risk management is not the same thing as risk minimization. Risk is neither inherently "good" or "bad" but rather a reality, with potentially crushing economic impact if ignored or given short shrift. As we've seen in recent days, some attempts to tame the risk lion have resulted in serious casualties.

It is no surprise then that pundits and reporters are asking about the whereabouts of risk managers, part of the frenzied blame game afoot. (Is there a "Where's Waldo" equivalent here?) New York Times blogger Saul Hansell pressed a lot of hot buttons with his September 18, 2008 post entitled "How Wall Street Lied to Its Competitors." My response, now one of more than 100 posted responses, is shown below.

<< I concur with much of this article. Effective risk management is much more than quantitative analysis. Many individuals are lulled into false security when given a bunch of computer printouts, accepting numbers as gospel truth. Like the fictional Detective Columbo, decision-makers must search for “hidden” information, not reflected in computer printouts. I recently testified before the ERISA Advisory Council about “hard to value” assets. Click here to read my comments. http://www.pensionriskmatters.com/2008/09/articles/valuation/testimony-of-dr-susan-mangiero-about-hard-to-value-assets/

P.S. Some of the quants sat on boards of financial institutions. It would be helpful to know more about their role as relates to oversight of risk management activities. >>

To my last point (above), it should be noted that litigation risk could be a deterrent for prospective directors with risk management experience. For example, Ms. Leslie Rahl (who is quoted in Hansell's blog post about the perils of underestimating risk of complex mortgage backed-securities) is, according to the Financial Post, named in a lawsuit filed against Canadian Imperial Bank of Commerce (CIBC), along with others such as the former Chief Risk Officer and the current Chief Risk Officer. Journalist Jim Middlemiss quotes the bank as denying allegations and expressing confidence that their conduct was appropriate. (See "CIBC hit by suit over subprime lending," July 24, 2008.) Additionally Rahl, a former Citibank derivatives division head, is listed on the Fannie Mae website as a "Fannie Mae director since February 2004."

For interested readers who want to follow the mounting litigation related to sub-prime activities, check out attorney Kevin LaCroix's blog entitled The D&O Diary. Be forewarned that Kevin posts volumes about Director and Officer (D&O) liability. Should we be disturbed that he has so much news about which to write?

What does this mean for institutional shareholders? Run, don't walk, to the closest risk management analysts who can help you decipher whether a company is doing a "good" job of identifying, measuring and managing a panoply of financial and operational pain points. Send us an email if you want some help.

On the topic of models, my article entitled "Asset Valuation: Not a Trivial Pursuit" (FSA Times, The Institute of Internal Auditors, 2004) still rings true. Check out the 10 prescriptives discussed therein. (This is by no means an exhaustive list.)

  1. Gain an intuitive understanding of the model.
  2. Ask questions of the model builders.
  3. Determine whether or not a model meets regulatory requirements.
  4. Inquire whether or not different models are being used for tax reporting versus financial statement presentation.
  5. Understand the data issues.
  6. Ask about model access.
  7. Evaluate the asset portfolio mix.
  8. Ascertain the extent to which a model incorporates embedded derivatives.
  9. Determine the simulation approach used to value path-dependent securities.
  10. Enlist senior management to assign someone from the finance team to work closely with the auditing team.

Testimony of Dr. Susan Mangiero About "Hard to Value" Assets

 

At the invitation of the ERISA Advisory Council, I presented testimony about "Hard to Value Assets" on September 11, 2008 in Washington, D.C. Some of the questions I was asked to answer are listed below:

  • Should valuation issues play a role in the selection of plan investments, and in achieving proper asset allocation and diversification?
  • What, if any, modifications to plan investment policies and guidelines should plans consider when utilizing "hard to value assets?"
  • As fiduciaries, what do you deem to be or what do you expect to be "hard to value assets?"
  • Who can the fiduciary rely upon when ascertaining the value of "hard to value assets" when the fiduciary is incapable of valuing, in order to fulfill their fiduciary responsibility to plan participants?
  • What valuation policies and procedures should a fiduciary adopt when holding "hard to value" assets?
  • What disclosures and education measures are required or suggested for participants and fiduciaries with respect to plans which invest in "hard to value" assets?

Given the recent tumult in the global financial markets, it seems as if an eternity has passed since the September 11 hearing date. Valuation continues to be a hugely important topic. I hope that my comments are informative and helpful to readers. Let me know what you think. Click here to read "Testimonial Remarks Presented by Dr. Susan Mangiero." 

New Accounting Rules for Public Pension Funds

According to "Government Rule Makers Looking at Pensions," New York Times reporter Mary Walsh (July 11, 2008) describes a new initiative, sure to create headaches for troubled state and city pension plan auditors. Announced at its July 10, 2008 public meeting, the Government Accounting Standards Board plans to "force state and local governments to issue better numbers and reveal the true cost of their pension promises." Walsh describes a GASB report that is frightening at best. (I am trying to get a copy of the report to upload to this blog.) Questionable practices include:

  • Award of retroactive employee benefits without recognizing the incremental costs
  • Use of "skim funds" which diverts some investment income dollars away from the pension plan for other uses
  • Amortization of expenses over 50 or 100 years (versus the customary 30 years)
  • Use of a 30-year amortization period with an annual reset back to Year 1.

Additionally, on June 30, 2008, GASB issued Statement No. 53, Accounting and Financial Reporting for Derivative Instruments in order to promote transparency about the use of derivatives by public entities. In its news release, GASB describes the need to determine "whether a derivative instrument results in an effective hedge." Unclear is whether GASB 53 applies to public pensions that employ derivative instruments for hedging, return enhancement or a variety of other applications. Also unclear is whether embedded derivatives must be accounted for. (I am researching these questions.)

Having been on the front lines of FAS 133 implementation (the corporate equivalent of GASB 53), challenges await auditors and pension finance managers alike. Click to read "FAS 133 Effectiveness Assessment Issues" by Dr. Susan Mangiero (GT News, June 15, 2001) or "Is correlation coefficient the standard for FAS 133 hedge effectiveness?" by Dr. Susan Mangiero and Dr. George Mangiero  (GARP Risk Review, May 2001).

Notably, a survey soon to be released by Pension Governance, LLC and the Society of Actuaries suggests that public and corporate pension plans worry about accounting representation. A large pool of U.S. and Canadian respondents rank compliance with new accounting rules as their number one concern. The survey, entitled "Pension Risk Management: Derivatives, Fiduciary Duty and Process" is tentatively scheduled for release during the week of July 21, 2008.

Editor's Notes:

  • You may have to register in order to read articles online by New York Times reporters.
  • Check out "The $3 Trillion Challenge" by Katherine Barrett and Richard Greene (Governing, October 2007) and the related "Q&As With the Experts" - Gary Findlay, Susan Mangiero and Richard Koppes.

CSX Battles Hedge Funds - A Cautionary Tale for Pensions?

In case you missed it, possible trend-setting legal parries are commanding attention from New York jurists, institutional investors and proxy specialists. According to corporate governance expert Jay Brown, "The CSX case is the first decision to find that shareholders must sometimes disclose the shares acquired by investors as part of equity swap transactions. This holding makes it harder for activist shareholders - trying to acquire or influence control of a public company - to keep their holdings secret." Brown should know. As a securities law professor (University of Denver Sturm College of Law) and lead contributor to The Race to the Bottom (a widely read legal blog), he and colleagues have penned no fewer than 16 posts about the ongoing litigation between CSX Corporation ("CSX") and several CSX investors - 3G Capital Partners ("3G" or "3G Capital") and The Children's Investment Master Fund ("TCI").

By way of background (and this is a summary only), a letter was sent to CSX by TCI on February 7, 2008, stating its intentions to acquire effective control. In response, CSX filed a lawsuit against the two funds. The Q1-2008 quarterly SEC filing for CSX states:

<< On March 17, 2008, the Company filed a lawsuit against The Children’s Investment Master Fund (together with certain of its affiliates, “TCI”), 3G Capital Partners Ltd. (together with certain of its affiliates, “3G”) and certain of their affiliates (collectively, the “TCI Group”) in the United States District Court for the Southern District of New York alleging violations of federal securities laws, including violations of Sections 13(d) and 14(a) of the Securities Exchange Act of 1934. The lawsuit alleges, among other things, that TCI and 3G have undisclosed plans with respect of CSX. The lawsuit further alleges that TCI and 3G have employed swap agreements in order to evade the filing requirements of Section 13(d) and that their Section 14(a) and Section 13(d) filings concerning their collective 12.3 percent swap position in CSX shares are materially misleading. The lawsuit further alleges that TCI’s and 3G’s disclosures in their Section 14(a) and Section 13(d) filings concerning their formation of a Section 13(d) group are false and misleading. >>

Click to access the CSX 10-Q, filed on 4/16/08. Click to read the complaint for "CSX Corporation v. The Children's Investment Management (UK) LLP et al," filed with the U.S. District Court, Southern District of New York.

Following various motions (in limine, opposition and so on), the two funds (owning about 20 percent in direct form and via equity derivative contracts) sent a letter to other CSX shareholders on June 20, 2008 in which they explain why five nominees should be elected to the CSX board. Citing support for their slate from RiskMetrics Group - ISS Governance Services, they write:

<< If you believe CSX cannot afford to rest on its laurels in favorable pricing and market environments, if you believe that CSX should strive to achieve its full operating potential, if you believe that CSX can and should be the best railroad in America and, finally, if you believe the board of CSX will benefit from the railroad experience of our nominees, along with the perspectives of large shareholders who are engaged because they have made a significant investment in CSX stock using their own money, we urge you to join with us in electing our five nominees to the board of directors of CSX by voting on the BLUE TCI/3G proxy card today. >>

On June 20, 2008, Judges Hall, Livingston and McMahon opine that TCI and 3G Capital Partners can vote their shares, additionally setting up a briefing schedule to include a July 25, 2008 date by which reply briefs in each appeal must be filed. Click to read the ruling.

The "TCI and 3G Comment on Circuit Court Ruling" (dated June 20, 2008) is short and sweet, expressing confidence in the then future June 25, 2008 vote to elect "five highly qualified director nominees." Following that vote, CSX declares the June 25, 2008 board vote "too close to call." In its June 25, 2008 press release, CSX states that the "annual meeting will reconvene at 10 am ET on Friday, July 25, 2008.

Courtesy of Knowledge Mosaic, we know that many large pension funds likewise invest in CSX (at least as of the end of Q1-2008). Regardless of the election results, the corporate governance impact is real. A partial list of funds is included below.

  • CALIFORNIA PUBLIC EMPLOYEES RETIREMENT SYSTEM
  • CALIFORNIA STATE TEACHERS RETIREMENT SYSTEM
  • CANADA PENSION PLAN INVESTMENT BOARD
  • ELCA BOARD OF PENSIONS
  • EMPLOYEES RETIREMENT SYSTEM OF TEXAS
  • IBM RETIREMENT FUND
  • NEW MEXICO EDUCATIONAL RETIREMENT BOARD
  • NEW YORK STATE COMMON RETIREMENT FUND
  • NEW YORK STATE TEACHERS RETIREMENT SYSTEM
  • ONTARIO TEACHERS PENSION PLAN BOARD
  • PUBLIC EMPLOYEES RETIREMENT ASSOCIATION OF COLORADO
  • PUBLIC EMPLOYEES RETIREMENT SYSTEM OF OHIO
  • PUBLIC SECTOR PENSION INVESTMENT BOARD
  • STATE BOARD OF ADMINISTRATION OF FLORIDA RETIREMENT SYSTEM
  • TEACHER RETIREMENT SYSTEM OF TEXAS
  • VIRGINIA RETIREMENT SYSTEMS ET AL

Not being an attorney, this case caught my eye because of the numerous and complex investment and governance implications, including the concept of"beneficial ownership" and use of financial derivative instruments. Several things come to mind.

  • When a defined benefit invests in a particular stock (or selects such stock for its defined contribution plan participants), are plan fiduciaries doing sufficient homework with respect to identifying "large" ownership stakes and assessing possible corporate governance implications?
  • For those defined benefit plans allocating monies to activist hedge funds, are investment fiduciaries taking into account a potential diversification "offset" that could occur if the plan invests directly in the same stock that represents a concentrated hedge fund position? (This is predicated on the notion that many pensions invest in alternatives for portfolio diversification reasons.)
  • Are pensions (endowments and foundations too) asking enough questions about their external money managers' use of derivatives? Always a critical exercise, this case illustrates that equity exposure can be material through both direct buys and indirect trades, i.e. equity swaps. Though not germane to this case, equity futures or options facilitate exposure to an individual stock and/or a particular sector of the equity markets. Will their use connote "beneficial ownership" and is the exposure deemed significant? (Note that in their June 2, 2008 amici curiae brief, the International Swaps and Derivatives Association, Inc. and Securities Industry and Financial Markets Association argue against the notion that equity swaps evidence "beneficial ownership," adding that to conclude otherwise would disrupt derivative market activity.  In an unrelated case, "Securities and Exchange Commission v. Larry P. Langford et al" (filed with the U.S. District Court for the Northern District of Alabama, Southern Division, on April 30, 2008), the issue as to whether swaps (interest rate) are securities appears again. See "SEC Plan for Swaps 'Securities' Gets Alabama Rebuff" by Bloomberg reporter Joe Mysak (July 3, 2008).
  • In the event that a fund manager is known to use equity derivatives (because the pension fund or consultant inquires), should plan fiduciaries be carefully tracking whether the derivatives represent a hedge, a cross-hedge or an anticipatory price/volatility trade? In the case of a hedge, yet another question goes to how best to measure effectiveness.

The CSX case is sure to be the beginning of a lively debate among financial market participants and corporate issuers.

Editor's Note: Go to www.corpgov.net for a great collection of corporate governance sites. Directors and Boards is another valuable resource.

Not Everyone Agrees What Liability-Driven Investing Means

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.

Lowballing LIBOR May Cost Pensions Plenty

According to Wall Street Journal reporter Carrick Mollenkamp ("Libor Surges After Scrutiny Does, Too - April 18, 2008), the British Bankers' Association is moving ahead to investigate the veracity of self-reported cost-of-funds numbers. The fear is that banks are paying more to borrow in the short run than they want to admit. If peers discover the truth, bank borrowers may find themselves at a competitive disadvantage. Non-borrowers will feel the pinch too as will swap and over-the-counter fixed income option counterparties and those trading the Eurodollar futures contract. The London Interbank Offer Rate ("LIBOR") is a common base rate for most short-term loans and derivative instrument contracts.

American regulators are worried too as market pundits predict that U.S. dollar LIBOR rates are likely to spiral. Just last week, three-month LIBOR loan rates rose to 2.8175% per annum, up from 2.7335%, "the biggest increase since the three-month rate rose 0.12 percentage point on August 9" when BNP Paribas prevented investors from withdrawing money from several of their funds. The current level is reported at "its highest" since March 13 when news came out about Bear Stearns.

A rising LIBOR makes swap-driven Liability-Driven Investing ("LDI") strategies more expensive for Fixed Rate Receivors - Floating Rate Payors. In addition, if quarterly checks indeed differ from estimated projections, pensions may eschew LDI strategies as too difficult to evaluate for accounting or risk management purposes.

Interestingly, quotation problems seem to be contained to U.S. dollar LIBOR situations and not other currencies such as the Euro.

FASB Releases New Pension Accounting Rules for Comment

In an effort to unlock the mystery about pension investment risk-taking (something we've discussed at length in previous posts), the Financial Accounting Standards Board recently released FASB Staff Position FAS 132r-a (Employers' Disclosures about Postretirement Benefit Plan Assets) for public comment. This author is preparing a response on behalf of Pension Governance, LLC (having also been invited to informally speak with FASB last summer about risk metrics and disclosure pitfalls). If adopted, it will combine elements of FASB Statement No. 157, Fair Value Measurements, and FAS 133/161, the latter being focused on accounting for derivative instruments. 

Critics are already sharpening the proverbial knives, asserting that the proposed rule addresses the asset side only, leaving interested parties in the dark with respect to the economic impact of integrated asset-liability management strategies. Others suggest that a requirement for plan sponsors to separately disclose the fair value of each "significant" category of plan assets will be lots of work with limited benefit to financial statement users. Having worked with FAS 133 compliance (sometimes referred to as the "consultants' full employment act"), I believe that FAS 132r will encourage plan sponsors to hire outsiders to assist with fair valuation and valuation process checks. (We offer this service as do others.) For some plans, the cost of engaging an independent third party might be cost-prohibitive, putting fiduciaries in a difficult spot as to what to do instead, especially if staff members are ill-equipped to do the work on their own. On the positive side, a comprehensive review (if done properly) can aid plan sponsors by pointing out compliance and economic gaps.

Click to read the draft of the FASB proposed pension accounting rules. Public comments will be accepted until May 2, 2008.

FASB Unveils Proposal to Require More Pension Disclosure

In what should be seen as a giant step forward for anyone interested in pension fund financial health, the Financial Accounting Standards Board (FASB) just approved a proposal that could force additional disclosures about investments. The rationale should be obvious. Defined benefit plans are allocating billions of dollars to alternative investments. When these capital pools invest in "hard to value" assets, trying to gauge pension risk is like catching jello. It's a near impossible task.

According to the Board Meeting Handout for February 13, 2008, few plan sponsors have gone beyond what is required of them by FAS 132(R), essentially reporting asset class categories "without further disaggregation." Additionally, the Board decided in November 2007 that FASB Statement No. 157 (fair value rule) would not apply to pension plans. In the absence of other mandates and voluntary disclosure (something free market economists favor, myself included), retirees and shareholders are nearly clueless when trying to gauge potential fallout from "risky" investing. If approved as an amendment of Statement 132(R), the new rule would "include a principle for disaggration of plan assets and a list of required asset categories" and "require further disclosure of categories or subcategories for concentratons of risk."

This blog's author has written ad nauseum about the critical information void with respect to pension investment risk. In fact, I literally just submitted a provocative piece on this topic for CFA Magazine. It will be part of the March/April 2008 issue.

Here are some initial thoughts. (I could write a book on this topic of pension risk disclosure.)

  • Could disaggregation veil true risk exposure in much the same way that single asset performance is not the same as portfolio performance?
  • Will there be a universal consensus about how to properly measure risk?
  • Will certain risk metrics be accepted as superior for a particular asset class (an approach I advocate)?
  • Will increased disclosures discourage some plan sponsors from dipping their toes into alternative investment waters?
  • Will pensions be encouraged to hire Chief Risk Officers as pension risk management takes its rightful place on stage?
  • Will some instruments such as derivatives be decomposed as standalone versus embedded?
  • Will alternative managers push back from pension clients when asked to open their trading books to more scrutiny? (Remember the response when several endowments asked alternative fund managers for more information as part of the Freedom of Information Act a few years back? They were  shut out of deals.)

The U.S. Government Accountability Office is soon to release its study about pension fund investments in hedge funds. It will be interesting to compare their recommendations with those from the folks in Norwalk, home of FASB.

AIG Auditors 1, Traders 0 - Round 1



February 11 was a bit of an equity rollercoaster. Reports of another big price gap were to blame. According to Reuters, PricewaterhouseCoopers LLP, external auditors for AIG, "concluded that the company had a material weakness in its internal control over financial reporting relating to the fair valuation of credit default swap portfolio obligations of AIG Financial Products Corp." Those in the know estimate the unrealized valuation loss relating to credit default swaps as being close to $5 billion, much bigger than originally believed. The stock closed down 12 percent lower. (Click to read "AIG discloses hole in derivatives valuation" by Lilla Zuill.)

Several questions come to mind, not the least of which is whether internal auditors came to the same conclusion at the same time and by the same route. How did the outside auditors decide on the adjustment? What models did they use? (AIG's Form 8-K, filed with the SEC as of February 11, 2008, mentions the Binomial Expansion Technique and Monte Carlo Simulation.) How often did auditors and traders kick the proverbial tires? On the business development front, how will this news impact organizations on the other side of AIG trades? Will they ask for more collateral? Will trade size fall to reflect a reappraisal of default risk?

To be sure, AIG is not the only name in the headlines. Irrespective of any particular company, and as we've mentioned many times before, pension funds are duly exposed when they transact derivatives, buy financial company stock or bonds or allocate money to multi-purpose behemoths. Now is not the time to be shy about asking tough questions as regards risk management and valuation policies and procedures of firms such as AIG. This holds true even when a consultant is engaged. Legal experts remind. Fiduciary oversight remains.

Awhile ago, this blogger authored "Asset Valuation: Not a Trivial Pursuit" for the Institute of Internal Auditors. Topics discussed include model risk, model validation and the internal auditor's role. Also check out "The Role of the Financial Expert in Valuation of Derivative Instruments." Yes Virginia, there is lots of litigation as a result of markdowns, disclosure questions and risk management process (or lack thereof). 

On March 5, 2008 (in case you missed our earlier announcement), Pension Governance, LLC is proud to sponsor a webinar entitled "Fiduciary Risk, Trading Controls and External Asset Manager Selection." Persons who attend this 75-minute webinar will learn the following:

  • 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 and Lessons Learned About What to Avoid.

We hope to have you join us!

Derivatives and Greed

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!

4P's - Pensions, Private Equity, Performance and Placement

As 2008 rolls in, uncertainty is on the minds of many. Will there be a recession? Will market volatility persist? Will asset prices continue to converge, making it more difficult to diversify? One question in particular is oft-discussed, notably the issue of strategic asset allocation for defined benefit plans. In a December 17, 2007 news release, the California Public Employees’ Retirement System Board of Administration announced its intent to invest nearly 70 percent of its $250 billion under management to stocks. Private equity will account for 10 percent, up from 6 percent. According to Charles P. Valdes, Investment Committee Chair, “These revised allocation markers reflect the promise of our private equity, real estate, and asset-linked investment classes."

In stark contrast, the Pension Benefit Guaranty Corporation went in the opposite direction a few years ago, now bearing the burden of a positive equity risk premium. In a December 20, 2007 article entitled "The $4 billion trade-off: PBGC misses out by eschewing stocks in favor of LDI," Financial Week reporter Doug Halonen points out the perils of allocating a high percentage of assets to fixed income. He rightly points out "the irony" that numerous companies are seriously investigating the economics of adopting a liability-driven investing strategy which almost always entails a shift away from stocks to bonds and/or interest rate derivatives.

Importantly, the decision to invest in alternatives, including private equity, must reflect a careful analysis of the likely risk-return tradeoff, mapped to the objectives and constraints of a particular pension plan. A short-term focus could create upset for those exposed to holdings that more logically lend themselves to a long-term commitment. In today's "Wall St. Way: Smart People Seeking Dumb Money," New York Times reporter Eric Dash writes that investors in Ohio Public Employees Retirement System and Fidelity Investors "would have made more money this year investing in an old-fashioned index fund that tracks the S&P 500-stock index" rather than plunking down money for the IPO of "private equity powerhouse" Blackstone Group. Perhaps that's true but does it matter if their respective goals are to realize capital gain over the next five to seven years? (Note that this blog's author has no knowledge of the intent of either investor.)

Allowing for upside potential (and statistics do validate a big move into private equity by pensions, endowments and foundations), lack of liquidity and valuation difficulties are harsh realities. However, barriers are starting to soften. Barry Silbert, CEO of Restricted Stock Partners, operates the Restricted Securities Trading Network, a mechanism for trading insider stock options, convertible bonds and private investments in public equity. A recent venture capital injection is arguably a validation of this attempt to enhance fungibility of otherwise "infrequently traded" instruments. The PORTAL Alliance, brings together the Nasdaq Stock Market and leading securities firms to "create an open, industry-standard facility for the private offering, trading, shareholder tracking and settlement of unregistered equity securities sold to qualified institutional buyers ("QIBs")." If successful in allowing for ready buys and sells, institutions may be more open to kicking the private equity tires.

For further reading, these websites (a few of many) may be of interest:

Missing Collateral = More Risk for Hedge Funds and Pension Plans

Some investors may be getting coal for Christmas. According to a December 20, 2007 Financial Times article ("Hedge funds assess exposure to banks"), reporter Saskia Scholtes describes a role reversal with respect to risk. Whereas banks worried about hedge fund losses in the aftermath of the 1998 collapse of Long Term Capital Management, hedge funds now tally their exposure to credit-challenged banks. Noteworthy is an observation by attorney Lauren Tiegland-Hunt that one-way derivatives-related collateral agreements expose hedge funds to risk of bank failure. She adds that, even if an agreement was bilateral, banks sometimes amended terms to "prevent hedge funds from calling for collateral before a bank’s losses on the trade reached a certain threshold, with the bank’s threshold marked as 'infinity'."

Kudos to this managing  partner of law firm Tiegland-Hunt for calling attention to an important risk factor. As this blog has pointed out several times, the posting of fungible assets such as U.S. treasury bills is one way to mitigate counterparty risk. A thorough assessment of the credit worthiness of the counterparty, consideration of the expected risk associated with a particular derivative instrument and/or strategy and analysis of overall exposure to a given name are similarly important.

For those pension funds sending money to hedge fund land, make collateral assessment part of your due diligence. Derivative instruments, used properly, can sometimes offer a bevy of advantages over investing in the underlying "cash" asset. However, as Nobel prize-winning economist Milton Friedman oft-declared, "there is no free lunch." Once a derivative instrument is created, its fair value (zero at inception) changes. Unfortunately, gains can only be realized by the winner in this zero sum game if the loser does not default.

Editor's Note: To learn more about collateral issues as relates to derivative trading, check out the 2005 ISDA Collateral Guidelines. (ISDA stands for International Swaps and Derivatives Association, Inc.)

Bank Risk Managers - Missing in Action?

In a recent interview on the John Batchelor show, Globalprivatequity.com, Inc. CEO Doug Miles described the current credit crisis as a "black swan" event. This summer, Miles predicted the valuation fallout associated with complex derivative instruments. Adding that banks can't know the extent of their problems anytime soon, an uncertain interest rate environment, new valuation accounting rules such as FAS 157 and infrequent trading in instruments such as Collateralized Debt Obligations make life very uncomfortable. Click here to listen to the November 11, 2007 interview with John Batchelor and Doug Miles.

In his bestselling book, The Black Swan: The Impact of the Highly Improbable, essayist Nassim Nicholas Taleb assigns three attributes to a black swan event in business. "First, it is an outlier, as it lies outside the realm of regular expectations, because nothing in the past can convincingly point to its possibility. Second, it carries an extreme impact. Third, in spite of its outlier status, human nature makes us concoct explanations for its occurrence after the fact, making it explainable and predictable." Click here to read the first chapter, as reprinted by the New York Times on April 22, 2007. In his video interview entitled "Learning to Expect the Unexpected," Taleb describes the human brain as "designed to retain, for efficient storage, past information that fits into a compressed narrative." He adds that "this distortion, called the hindsight bias" makes it difficult to learn from past mistakes.

If true that the sub-prime situation is a black swan as Miles asserts, and taking a page from Taleb, we embrace the notion that we are blind to randomness, what then is the proper role of risk management? According to Financial Week reporter Matthew Quinn, inquiring minds are asking "Where were the risk managers?" He avers that some pundits debate whether technology can keep up with product innovation or adequately assess leverage. He suggests that, even if rocket scientists raise their hand, warnings may go unheeded, especially given banks' dependence on proprietary trading. See "Risk managers return (belatedly) to Street: Chastened banks, brokerages get religion on minimizing exposure to hidden bombs. Coulda, woulda, shoulda?" (Financial Week, November 19, 2007). 

In an article I wrote in mid 2003, I commented that the life of a risk manager is challenging to say the least. In addition to a plethora of data analysis skills, a Chief Risk Officer ("CRO") or someone with similar functional duties must be a diplomat, a motivator and a keen student of human behavior. Most people don't want to hear bad news since it usually means more work for them, not to mention the added stress and the potential damage to one's career of being tainted with a problem. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" (AFP Exchange, July/August 2003).

Unfortunately, for retirement plan decision-makers, risk management is going to be impossible to ignore. Pension funds that include allocations to bank stocks or equity in bank-like financial organizations are already feeling the pinch. Plan sponsors who hired bank asset managers or hedge funds/mutual funds that invested in banks are going to be asked tough questions about the due diligence they performed. Did they sufficiently kick the tires with respect to understanding how the banks managed risk? Fiduciaries of banks' 401(k) plans who recommended company stock are getting sued for allegedly having done too little to assess the attendant risks. Just last week, a complaint was filed against the Federal Home Loan Mortgage Corporation ("Freddie Mac"), citing poor controls that encouraged the acceptance of "risky" loans and inappropriate appraisals of those loans. Click here to read the class action complaint against Freddie Mac.

Black swan or not, the current credit crisis is going to get nastier. Expect many more litigation complaints in the ensuing months.

FAS 157 and FAS 159 - Day of Reckoning for Pension Investors?

In case you missed it a few weeks ago, the Financial Accounting Standards Board voted 4-3 in favor of implementing FAS 157 on time. Ignoring early adopters, FAS 157 takes effect as of November 15, 2007. A company reporting at year-end (or any time after mid November) will be obliged to consider FAS 157. Its companion, FAS 159, allows organizations to "choose to measure many financial instruments and certain other items at fair value."

While "employers’ and plans’ obligations (or assets representing net overfunded positions) for pension benefits, other postretirement benefits (including health care and life insurance benefits)" are excluded from the list of eligible items that can be measured at fair value, plan sponsors are nevertheless impacted by both FAS 157 and FAS 159. 

  • If an employer issues stocks or bonds or transacts in other eligible assets and liabilities, FAS 157 and 159 will apply and could, at the enterprise level, indirectly impact pension plan economics.
  • If a plan invests in a wide variety of stocks and bonds issued by other reporting entities, fiduciaries will need to fully understand the gap between economic risk and the accounting representation.
  • In selecting external money managers, defined benefit and defined contribution plan fiduciaries alike will need to add FAS 157 and FAS 159 questions to their RFPs. Focus on  valuation model selection and testing, choice of inputs and appropriate "level" of three possible categories are a few of the many items to vet.

How FAS 157 relates to existing standards is not known with certainty at this time though FAS 133 accounting for derivative instruments is one affected area. While FAS 133 does not directly apply to a pension plan that trades derivative instruments, as investor, that plan must be savvy enough to access how issuer risk is impacted by new rules.  Consider a hypothetical scenario.

A defined benefit pension plan (Pension Plan Y) hires Bank X as a value-oriented equity portfolio manager. Bank X is a significant user of derivatives and has existing derivative instrument contracts with five different counterparties such a Bank Z, Corporation A and so on. Under FAS 157, Bank X must reflect counterparty risk in assessing fair value. Conceivably, this could result in a FAS 157 fair value for any or all of the five positions held by Bank X that is different enough from the fair value of the "hedged item." The result would be a nullification of favorable hedge accounting treatment for Bank X and reported post FAS 157 earnings that are more volatile. How does Pension Plan Y respond? Do they stop doing work with Bank X because their financial statements make them a higher risk? 

Reporting entities and investors alike are going to have to roll up their shirt sleeves and get to work. It doesn't take a rocket scientist to see the obvious. An incomplete understanding of FAS 157 and 159 lends itself to bad decision-making on the part of plan sponsors. 

Here we go...

Editor's Note: There are many ways to determine FAS 133 hedge effectiveness. If you want copies of selected articles on the topic, click here to send an email. Please include your name and company.) Click here to visit the FASB website to learn more about FAS 157 and 159.

Is Disclosure Really That Hard?


Investment risk disclosure continues to take center stage. In "Clearing the Financial Fog - Emily Barrett ponders the virtues of transparency" (Wall Street Journal, MarketBeat Blog, September 14, 2007, posted by Tim Annett), the point is made that full disclosure is fraught with problems.

"The trouble with transparency is, there’s just something terribly obscure about it."

"In some ways, banks are already engaged in the clarification process, as more are forced to take back on their books funds previously buried out of regulators’ reach. This includes loans lying around in banks’ warehouses waiting to be chopped up and sold to raise money for private-equity takeovers. A number of bank sponsors of hedge funds have also been forced either to cut credit lines, or, as in the case of Bear Stearns Asset Management, to commit financing to shore them up. But there are limits to how clear banks can be. The complexity of structured finance, which deals in layered bundles of debt, doesn’t lend itself to easy analysis."

“The problem is exposures get buried in different structures,” said Jim Caron, rates strategist at Morgan Stanley. “I don’t think it’s a lack of willingness to get things out to regulators, there’s just a natural lack of transparency in these structures.”

Click here to read the aforementioned post in full.

To be sure, deciding on what and how to provide information is not an easy task. Nevertheless, access to sufficient and meaninful information is vital to good decision-making on the part of institutional investors such as pension funds. Here is the comment I posted.

<< As I’ve written many times (www.pensionriskmatters.com), pension fiduciaries have an obligation to make informed investing decisions. Whether pensions are counterparties to a derivative-related trade (mostly with banks on the other side) or they invest in funds (mutual/hedge/etc) that invest in derivatives, the information they currently get from their trading partners is limited at best. A plan sponsor must understand enough about risk controls and risk drivers for a particular investment/counterparty/asset manager so the investment committee can answer a fundamental question - Are we likely assuming too much risk for the expected payout if we transact with this bank/asset manager? In my view, financial institutions have a golden opportunity to disclose meaningful information about their risk exposures with institutional investor clients, going beyond mandatory requirements. Besides building goodwill, they may be able to attract (and retain) additional assets to manage by fully acknowledging the pension plan’s pain points (need for solid risk information). This does not necessarily translate into providing more information but rather providing “better” information that directly addresses economic risk-taking, and related controls. A joint interview with the portfolio manager and risk manager is one option. Providing the pension plan investor with the bank or asset manager’s risk management policy or statement of risk-taking is another positive gesture. Working with an independent third party to vet risk management process on behalf of the pension plan investor is another possibility. Comment by Susan M. Mangiero - September 18, 2007 at 1:10 pm >>

LDI Costs Go Up for Plan Sponsors as LIBOR Soars

While seen by some as a new-fangled name for an old concept ("keep your eye on the liability ball"), liability-driven investing ("LDI") is taking the defined benefit world by storm. Thought by some as a panacea for mismatched assets and liabilities, one type of LDI strategy entails the use of an interest rate swap (or a portfolio of swaps) whereby a plan sponsor receives a cash amount tied to a fixed rate (usually a specified treasury yield plus X basis points). Its obligation as a Floating Rate Payor is determined by the set level of a variable rate benchmark such as the six-month London Interbank Offered Rate ("LIBOR"). Like anything else, there is no free lunch. Besides the collateral a plan sponsor must pledge to the counterparty (such as a major bank), yield curve changes are another factor. Moreover, as LIBOR rises, the plan sponsor must pay more when swap settlement occurs. (This assumes the absence of an interest rate cap that could otherwise create a ceiling as short-term rates climb.) This is exactly what has been happening of late.

According to the Wall Street Journal, ("Libor Pops Up," September 6, 2007), LIBOR has steadily risen over the last few weeks. Even more troubling, its parallel moves with the Fed Funds Rate have been shattered by credit market turmoil. "In normal market conditions, Libor tracks the Federal Funds rate pretty closely, and as recently as July the two were just 13 basis points, or hundredths of a percent, apart. As of Wednesday's close, that gap had grown to nearly 50 basis points, or half a percent. With exposure to the U.S. mortgage market cropping up in seemingly unlikely places, such as banks around Europe, banks that lend at Libor are expressing concern, through the rising rates, that borrowers who appear safe may prove to have something ugly hiding on their balance sheets."

While the British Bankers' Association suggests stability as of September 7, 2007 (due to central bank intervention), one wonders if this can be sustained. After Friday's disappointing jobs number in the U.S. and statements from money folks worldwide ("The credit crunch is only just beginning."), plan sponsors may find themselves exchanging one problem (pension gap) for another (rising short-term rates that drive up swap floating obligations). 

Add market volatility and new regulatory mandates for disclosure to the mix and it's seat belt time for pension fiduciaries with financial decisions to make. Moreover, in "Why Libor Defies Gravity: Divergence of a Key Global Rate Points to Strain" (September 5, 2007), Wall Street Journal reporters Ian McDonald and Alistair MacDonald note that many other short-term rates are actually falling even as LIBOR and related financial instruments struggle. That's cold comfort if a corporate plan sponsor issues commercial paper or borrows via a short-term facility tied to LIBOR.

More to come about an increasingly important topic - LDI and pension financial management.

Editor's Note:

1. Click here to access LIBOR rates from the British Bankers' Association.

2. Click here to access H15 Selected Interest Rates from the Federal Reserve.

3. Click here to read derivative instrument FAQs, courtesy of the International Swaps and Derivatives Association, Inc.

 

Model Risk - Great Unknown for Pension Plans

In "How Street Rode The Risk Ledge And Fell Over," Wall Street Journal reporter Justin Lahart writes that "many lenders, funds and brokerages were following statistical models that grossly underestimated how risky the market environment had become." Warnings about model error or "model risk" are not new. In "Model Risk and Valuation" (Valuation Strategies - March/April 2003), Dr. Susan M. Mangiero, CFA and Accredited Valuation Analyst, suggests possible red flags, adding that the consequences of a poor, inaccurate or incomplete model (or problems with data) can be dire. She adds that what constitutes a "good" model is likewise important to assess. This is sometimes made more difficult when inputs themselves must be modeled. For example, in the case of derivatives related to credit risk or mortgage loans (dominating headlines of late), estimating variables such as prepayment or recovery rates is an important precursor to any valuation of the derivative instrument itself. Email us if you would like articles about model risk and valuation.

Pension Risk Management Course

The RiskMetrics Group and Susan Mangiero, author of Risk Management for Pensions, Endowments and Foundations, are pleased to present an introductory course on Investment Risk Management for Pension Funds. The two and a half day workshop addresses investment risk measurement and valuation fundamentals, along with an overview of new pension rules and regulations as they relate to procedural prudence. Combining lectures, cases and lab work, plan sponsors will learn about risk management standards, how to apply various risk assessment techniques and what to avoid in creating and implementing a risk management plan.

Who should attend: chief investment officers, portfolio managers, corporate governance officers, chief risk officers, trustees, risk analysts and board members

Instructor: Dr. Susan Mangiero, CFA, AIFA, AVA, and FRM, President and CEO Pension Governance, LLC.

Dates:
Wednesday- Friday, September 12-14, 2007

Time:
September 12-13 - 9:00 am - 5:00 pm
September 14 - 9:00 am - 12 noon

Location:
RiskMetrics office
1 Chase Manhattan Plaza
44th Floor
NY, NY 10005

Email education@riskmetrics.com to register for the course or to obtain additional information about cost or content. 

Space is limited so, please reserve your space today.

Long, Hot Summer for Pension Investors Exposed to Credit Woes

Summertime and the livin' may be easy for Porgy and Bess. If you're an investor caught in the middle of a scorching hot credit meltdown, things are far from tranquil. Besides the fact that many deals are being put on hold (thereby reducing the universe of available stocks and bonds), more than a few asset managers are reporting giant write-downs. If you haven't seen it, the Wall Street Journal's list of affected deals and organizations is sobering. Click here to read "Scorecard: Debt Dilemmas - How Credit-Market Tremors Have Affected Junk Bonds, LBOs and Hedge Funds."

Jittery traders are starting to wonder how quickly sub-prime loan problems will spread to other market sectors, ultimately impacting the ability of corporations and individuals to borrow and spend. In "Strategies correlate after credit market crunch hits," Financial Times reporters Peter Garnham and Paul J. Davies describe changing patterns across markets and strategies. What does this mean for institutional investors? Quite simply, a lot.

Hedge funds and private equity managers who tout absolute return (based on uncorrelated return patterns) are going to have a tough challenge ahead if convergence occurs. Defined benefit plan sponsors are going to have no less a difficult time.

Strategic asset allocations are going to be directly (and arguably materially) impacted by the notion that "the investment world is getting smaller." To read an earlier post about contagion, click here to access "Pension Contagion - Should We Worry?"

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.

Pension Governance, LLC Offers Webinars for Pension Fiduciaries about Hedge Fund Risk Management

Hedge funds are increasingly being used as part of a pension’s liability-driven investing (“LDI”) strategy or to potentially diversify a portfolio. At the same time, several recent hedge fund blow-ups, along with their prominent presence in corporate boardrooms via activist investing, has regulators and institutional investors more than a little concerned. Pension fiduciaries must demonstrate a rigorous due diligence in their selection process or risk breach of duty allegations. 

In an effort to assist plan sponsors, Pension Governance, LLC continues its Hedge Fund ToolboxSM series with two more online events this week. Join pension decision-makers for an engaging and timely discussion about the use of leverage, derivatives and financial risk controls (July 10, 2007) and operational risk (July 12, 2007).

According to series creator, Dr. Susan M. Mangiero, CFA, Accredited Valuation Analyst, Financial Risk Manager and Accredited Investment Fiduciary Analyst, "There is a sea change underway with respect to the use of hedge funds by pension plans. While increased monies to alternative fund managers may make perfect sense in some situations, a lack of understanding about financial and trading risks could spell disaster for retirement plans. We help plan sponsors interview a hedge fund’s risk manager as a more complete gauge of potential problems. If that function does not exist, that could be a red flag. However, the existence of a risk management function in and of itself does not mean that it is an effective safeguard against runaway losses. Personal and professional fiduciary liability exposure, duty to oversee and an increasingly complex investment landscape makes this a particularly challenging time for plan sponsors.” President of Pension Governance, LLC, Mangiero adds that "Our goal is to help fiduciaries with research, process checks and training to thwart trouble and help to promote best practices."

For more information, click here. Recordings of all six webinars are available for a modest fee to non-subscribers. To order past webinars, click here.

Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs. Each program qualifies for 1.5 PD credits.

About Pension Governance, LLC:
Pension Governance, LLC (www.pensiongovernance.com) is an independent research, analysis, training and publishing company, emphasizing investment fiduciary risk management. Covered topics include fee structure, liability-driven investing, controls, valuation, alternatives and fiduciary best practices for board members, CFOs, treasurers and their attorneys, consultants and banks.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village, Hedgeco.net, Lipper Hedge World, and the National Association of Certified Valuation Analysts as media sponsors.

Tulip Craze Redux and What Models Mean to Pensions

Since the mid 1600's, tulips have come to symbolize economic bubbles. Excess demand for the floral beauties led Dutchmen to pay a hefty price, resulting in the tulip mania of the early 17th century.

One wonders if a June 24 article by New York Times reporter Gretchen Morgenson hadn't been inspired by this tale of yore. Entitled "When Models Misbehave," this prize-winning business columnist describes the challenges of assessing securities that trade in relatively illiquid markets. In the absence of ready buyers and sellers, traders mark to model, making assumptions about the future behavior of inputs such as interest rates. Unfortunately, problems may arise if the underlying assumptions make no sense. Consider the notion that past is prologue. Referring to the sub-prime debacle currently plaguing several large financial institutions, Morgenson describes 2006 and 2007 lending practices as overly generous and likely to tighten. Correctly recognizing that future supply-demand conditions for credit might change leads to an altogether different model outcome.

Lack of independence or "the fantasy that a firm's principals prefer" is another concern. Blind acceptance of model-generated outputs as gospel could mean a subsequent, and arguably tainted, outlay of serious money to other trades.

Morgenson has a good point.

It's easy to be lulled into false security with computer-generated numbers. Unfortunately, bad values beget bad economics. A computational flaw, unstable or inappropriate model and/or low-integrity data could end up costing investors millions of dollars. Trading decisions based on garbage are expensive mistakes.

Good model-building is a start. Validating, testing, revising and testing anew should follow. Heady stuff but anything else might be considered remiss. Importantly, it's up to investors to query asset managers about what's inside the black box.

Anecdotally, I'm not sure there is enough of this rigorous oversight happening right now. As an accredited appraiser, I'm disturbed by the laxity of investigation about valuation and the related process of risk management.

With new accounting rules on their way, we'll talk much more about models and model risk in future posts. In the meantime, click here if you'd like us to send you information about valuation and modeling.

Pensions and Hedge Funds and Private Equity - Assessing Risks

In case you missed it, here is the link to a video of my appearance on CNBC's Morning Call.  While I concede that it's impossible to have an in-depth conversation in only a few minutes, several things are worth mentioning as a result of the May 17 chat with host Mr. Mark Haines.

1. Not all institutional investors have a large staff to vet different investment ideas. Moreover, large does not always mean better. Witness Fannie Mae and Amaranth Advisors. "Thorough" is the watch word.

2. If considering a hedge fund, ask if the fund has a functional risk manager who monitors, tests and reviews policies for financial and operational trouble spots. Does that person have independence and authority to effect meaningful change?

3. I believe the other speaker in this segment said that private equity avoids having to deal with the daily volatility of being invested in public equities. Caution - The absence of a ready trading market does not necessarily mean that there is less risk. Some could easily assert the opposite. Private equity deals, because they are private, entail valuation challenges, difficulty in liquidating ownership interests and so on.

4. The use of correlation (a measure of linear association) to gauge diversification benefits depends on having good data for all relevant time periods. If using an inappropriately long calendar period (example: last ten years), output may reflect a smoothing out effect which therefore underestimates "true" volatility.

5. There is much more to say on the topics of risk management and valuation!

Hedge Fund Toolbox - Webinars for Pension Fiduciaries

At a time when pension funds explore new ways to buoy funding, billions of dollars are being allocated to hedge funds and fund of funds. Either direct or part of a portable alpha strategy, alternative investments offer potential benefits but often bring new challenges in the form of multi-tiered fees, valuation, leverage, transparency, short-selling, illiquidity and operational risk. Add to the mix the mandates of the Pension Protection Act of 2006 and one thing is clear. Pension fiduciaries are on the hook to demonstrate a solid understanding of the structural and financial characteristics of hedge funds and fund of funds and what could potentially cause problems if left unchecked.

To help pension decision-makers better understand this important area, Pension Governance, LLC has created the Hedge Fund ToolboxSM – a series of six webinars that focus on hedge fund economics, operations and legal considerations. Webinars are scheduled as follows:

•Hedge Fund Fees, Performance and Transparency (June 14, 2007)
•Hedge Fund Documentation, Background Checks, Enforcement and Litigation (June 19, 2007)
•Role of Consultants and Financial Advisors in Selecting Hedge Funds (June 26, 2007)
•Hedge Fund Valuation, Use of Side Pockets and New Accounting Rules (June 28, 2007)
•Hedge Fund Leverage, Use of Derivatives and Risk Management (July 10, 2007)
•Hedge Fund Operational Risk (July 12, 2007)

Register to attend the entire series or individual webinars. If you miss an event, recordings will be available for a modest fee for non-subscribers. Webinars are free to all Pension Governance subscribers. For more information, go to http://www.pensiongovernance.com/webinars.php?PageId=58&PageSubId=59.

About Pension Governance, LLC:
Pension Governance, LLC (www.pensiongovernance.com) is an independent research and analysis company that focuses on benefit plan related investment risk, corporate strategy, valuation and accounting issues, with the fiduciary perspective in mind. Pension Governance, LLC is registered with CFA Institute as an Approved Provider of professional development programs.

Media Sponsors:
Pension Governance, LLC is proud to have Albourne Village (www.albournevillage.com), Hedgeco.net (www.hedgeco.net) and the National Association of Certified Valuation Analysts (www.nacva.com) as media sponsors.

Contacts:
Pension Governance, LLC
Susan M. Mangiero, 203-261-5519
Ph.D., CFA, AIFA, AVA, FRM
PG-Info@pensiongovernance.com

Can Warren Buffet Be Wrong About Derivatives?



According to various press reports, in his conversation with Berkshire Hathaway shareholders, CEO Warren Buffett reiterated his concern about the use of derivatives, "saying that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocation in the financial markets. In fielding a question Saturday about derivatives, which he once referred to as "financial weapons of mass destruction," Mr. Buffett told shareholders that he expects derivatives and borrowing, or leverage, would inevitably end in huge losses for many financial participants." He further added that "The introduction of derivatives has totally made any regulation of margin requirements a joke." (See "World According to Buffett: How Media, Oil -- Among Others -- Matter" by Karen Richardson, Wall Street Journal," May 7, 2007.)

We've written about derivatives many times and will continue to do so. (I've even written an entire book on the topic.)

Derivatives are everywhere in pension land. Defined benefit plans consider liability-driven investing and portable alpha strategies (often entailing the use of derivatives). On the DC side, qualified default investment alternatives sometimes involve futures, options and/or swaps. Hedging company stock in 401(k) plans might rely on the use of derivatives. Many external money managers employ derivatives and pension fiduciaries are responsible for vetting their risk process and procedures.

So the pivotal question is whether derivatives are a hindrance or a help. Certainly a market that topples $400 trillion in global size reflects widespread popularity. Like anything else, however, fiduciaries who don't understand the incremental risks are putting themselves in harm's way.

Much more to come!

Pension Investors, Corporate Governance and Financial Reporting



According to the New York Stock Exchange Fact Book, pension ownership now accounts for nearly twenty-five cents of every equity dollar. No surprise then that the governance movement is alive and well and ensuring that forthcoming talks about proxy reform receive wide attention.

Part of the SEC's roundtable discussions about voting reform, various institutional investors, attorneys and governance experts will meet on May 7 to talk about topics such as shareholder rights under state law, whether investors should be able to exert more influence over corporate management and the role of the SEC in overseeing the proxy process. Click here to access the full agenda and list (and bios) of speakers. Subsequent meetings will take place later this month.

At a time when large shareholders crave more power over issues such as executive pay, corporate social responsibility and proper financial disclosure, a meaningful conversation is welcome.

On a related note, the PCAOB (Public Company Accounting Oversight Board) concluded its first International Auditor Regulatory Institute on May 4, 2007. With representatives from over forty countries assembling to discuss how the PCAOB handles Sarbanes-Oxley Act of 2002 compliance, chairman Mark Olson extols the notion of global oversight.

Also in the news, BDO Seidman's "Financial Reporting" letter (dated May 2007) is replete with question lists for shareholders. Organized by topic such as board composition, audit committees, preparation of financial statements, management's strategic plans and business ethics, the publication is easy to understand and serves as a useful guide.  The sub-list on risk management emphasizes company-wide issues, including, but not limited to, topics such as the role of the board in developing a risk management system and the choice of risk management techniques to evaluate "the adequacy and cost effectiveness of insured risks." Questions related to derivatives and financial risk are shown below (excerpted verbatim from the BDO document). Click here for the full text publication.

1. Does the company use enterprise risk management?
2. What is the company's attitude towards financial risk?
3. Were there any significant foreign currency exchange gains or losses in 2006 and in interim 2007 operations?
4. What is the company doing to minimize the impact of changes in foreign currency rates?
5. Does the company hedge its foreign currency exposures?
6. What types of financial instruments and derivatives does the company use?
7. What are the major risks from the company's use of financial instruments or derivatives (e.g. options, futures, forwards, caps, collars, interest rate swaps)?
8. Does the company have written guidelines and policies on the use of financial instruments and derivative instruments?
9. Who formulated those policies?
10. Did the board of directors approve those policies?
11. Do management and the board of directors monitor the company's financial instruments and derivatives exposures?
12. Is there a limit system in place (i.e. a system that sets the maximum amount of loss the company would tolerate before liquidating a position)?

PG Editor's Note: We are (and will continue to) address many of these issues online. Visit www.pensiongovernance.com. Also watch for our soon-to-be published newsletter about the use of derivatives, investment fiduciary risk, financial statement analysis and so much more. Pension Risk AlertSM will examine risk and valuation issues from a "how-to" perspective. Email us if you want to be notified about the availability of this informative newsletter.

Derivatives, Mutual Funds and Pensions



Continuing to exhibit meteoric growth, the global derivatives market is now estimated at around $400 trillion. That's a lot of zeros - $400,000,000,000,000. In contrast, the CIA World Fact Book estimates 2006 Gross World Product at $65 trillion. Said another way, aggregate economic production for the entire world has an approximate dollar value of only 1/6th the estimated market size for futures, options, swaps and various combinations.

Is it any wonder then that regulators  are asking questions about who does what in the world of derivatives? One false move and the intricate web of financial institutions which dominate derivatives trading could fall apart. Increased volatility for the market as a whole or an exogenous shock to a particular sector potentially spells trouble.

In her April 4, 2007 article, Wall Street Journal reporter Eleanor Laise writes that "automated trading of derivatives and increased use by fast-growing hedge funds have helped make the market more accessible to mutual funds" and that "mutual funds aim to stand out in a crowded field." She further points out that identifying the use of derivatives by portfolio managers requires a hard look at the fund's prospectus. I'd emphatically add that reading what is available is seldom sufficient. To the contrary, a pension fiduciary needs to ask a myriad of questions of and about the mutual fund manager. Here are a few suggestions from a long list. (Email me if you want additional information.)

1. Who determines the type of permitted derivative instruments and strategies, and on what basis?

2. Does the fund or family of funds have a risk manager? If so, does he or she have the authority to make meaningful decisions about risk controls? Who does that person report to?

3. How are mutual fund traders compensated with respect to return, risk and risk-adjusted return?

4. Is there a risk management policy (and related procedures) that can be reviewed before investing? If considered proprietary, is it possible to meet with the portfolio manager and/or risk manager to discuss?

5. What types of risk metrics are employed by the mutual fund?

6. Who authorizes derivatives-related trading limits, and on what basis?

7. Are the fund's auditors comfortable with how the derivative instruments are marked-to-market?

8. Does the portfolio manager rely on an external system to analyze and monitor risk? If a proprietary system is used instead, is there an independent party who validates the models and integrity of the data feed?

9. How is liquidity measured? What is the portfolio manager's plan for liquidating various positions if necessary?

10. Does the portfolio manager have the latitude to switch gears with respect to derivatives-related trading and not have to fully disclose to investors? (In other words, is there a chance that the mutual fund's use of derivatives in a risk-return sense could differ materially from the stated scope?)

American author Mark Twain once said - “There are two times in a man's life when he should not speculate: when he can't afford it, and when he can.” While clever, the fact remains. Financial engineering and derivatives are here to stay. Any pension fiduciary not yet familiar with the D-word needs to remedy that situation right away.

Risk Lessons from the Financial Services Industry

                                                  
Regulation of financial service companies has long been a catalyst for pro-active risk management. Banks, for example, are obliged to address risk controls and measurement of risk as they ready themselves for Basel II compliance and related capital charge calculations. (The Bank for International Settlements describes the Basel II Framework as a "more comprehensive measure and minimum standard for capital adequacy that national supervisory authorities are now working to implement through domestic rule-making and adoption procedures.")

So results from a recent Deloitte survey of global financial institutions are surprising and a bit worrisome. Interviewing Chief Risk Officers at more than 130 global financial institutions, the "Accelerating Risk Management Practices" report finds that only 47 percent of respondents describe their institution as "extremely or very effective in managing risks associated with business continuity/information technology (IT) security, 43 percent each for operational and vendor risk, and 35 percent for geopolitical risk." This is in contrast to more than 70 percent who report good standing in the areas of market, credit and liquidity risk. The survey results also suggest a need for additional work in the area of credit products and commodity derivatives, including energy.

Noteworthy is the migration of risk issues to the board level, something we think makes sense for pension plans as well. While the Deloitte survey finds that 84 percent of reporting institutions have a Chief Risk Officer in place, little information is available about this role at plan sponsors. (The just released survey, co-sponsored by Pension Governance, LLC and the Society of Actuaries, asks about the existence and responsibilities of a Chief Risk Officer.)

Surveys like this are good reminders that a risk manager's work is never done!

Editor's Notes:

1. Click here to read the March 26, 2007 press release issued by Deloitte.

2. Click here to read an article about the job of Chief Risk Officer entitled "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Susan M. Mangiero



Constructing the Real Estate Derivatives Market



Our March 9, 2007 post about real estate derivatives created a buzz, at a time when the financial industry grapples with the usual fits and starts of developing a new product. This post looks at where things stand. Expect more news in the aftermath of the upcoming March 28-29 conference of the Pension Real Estate Association (PREA) in Boston.

Creating a new market for any financial instrument requires sufficient interest. People have to be willing to buy and sell in large enough numbers to keep the bid-ask spread somewhat "low". Otherwise, participants will likely struggle to unwind a position. Additionally, too few actors result in excessively "high" costs that could destroy the economic rationale for trading in the first place. The burgeoning market for commercial property derivatives is no exception. According to Jim Clayton, PREA's Director of Research, there are two types of swaps being developed. The total return swap takes a LIBOR versus real estate index structure. The second version is a swap of total returns on two respective NCREIF (National Council of Real Estate Investment Fiduciaries) property sectors. Carter adds that "index return swaps allow investors to adjust exposure to real estate without buying or selling properties, thereby creating flexibility for portfolio management while eliminating the required physical delivery of the asset."

While true that more than a few pension funds now invest in commercial properties outright, obstacles remain. Valuation challenges, relatively high transaction costs, long lead times, difficulties in selling short and oft-encountered illiquidity are a few factors that influence the asset allocation decision. For a review of market development activities in the UK and US, click here to read "Commercial Real Estate Derivatives: They're Here ... Well, Almost" by Jim Clayton (PREA Quarterly, Winter 2007, pages 28-31).


Continue Reading...

New Pension Risk Management Survey Launched

News ReleaseContact:Kim McKeown
For Immediate ReleaseMarketing/PR Program Manager
March 22, 2007847-706-3528 (kmckeown@soa.org)

New Survey Looks at Pension Risk Management and Impact on Funding Gap

Pension Governance, LLC and the Society of Actuaries (SOA) are proud to join forces to research current pension risk management practices. In what is believed to be a unique large-scale assessment of this critical topic area since research was done in 1998, the jointly developed survey investigates the use of derivatives and related risk and valuation policies by pension funds and their external money managers. Questions address other topics such as the role of the pension consultant, involvement of the plan actuary, new pension rules and regulations and an increased emphasis on enterprise risk management.

Global growth in futures, options and swaps dwarfs all other financial markets. According to the Bank for International Settlements, over-the-counter and exchange-traded derivatives market activity in 2006 grew to more than $400 trillion. Public and private pension plans, a second giant force, control over $10 trillion in assets. Their risk management decisions affect millions of people around the world, compelling the need to understand pension risk management as never before.

Different than even a few years ago, markets are now more volatile, increased longevity is worsening the funding gap and pension fiduciaries seek higher returns in the form of hedge funds, private equity investments and portable alpha strategies, all of which frequently involve derivative instruments. Derivatives show up in countless liability-driven investing strategies as well, making it impossible to ignore their economic impact.

Adding to the complexity of the investment decision-making process, board members, policy-makers, taxpayers, shareholders, actuaries, fiduciary liability underwriters, debt rating analysts and plan participants need and want to understand what fiduciaries are doing in the area of pension risk management. Unfortunately, a dearth of information about plan sponsors and their money managers makes it extremely difficult to head off trouble before it starts. The primary goal of this survey is to make it easier for relevant parties to identify existing risk control practices and, by extension, encourage a long overdue discussion about best practices. While this survey emphasizes defined benefit plans, risk management applies to defined contribution plans as well. When financial controls are absent or implemented poorly, fiduciaries are unable to select appropriate 401(k) investments and evaluate service providers’ fees, possibly leaving themselves exposed to lawsuits.

Author of Risk Management for Pensions, Endowments and Foundations, Dr. Susan M. Mangiero, CFA, FRM, Accredited Valuation Analyst, Accredited Investment Fiduciary Analyst and her team are responsible for survey design and statistical analysis with ongoing input from an oversight group of pension professionals assembled by the SOA. According to SOA Research Actuary Steve Siegel, "we are all very excited about the prospect of providing our members invaluable insight about this important area.”

Invitations have been sent to nearly 6,000 pension fiduciaries in the United States and Canada. Interested plan sponsors who have not received an invitation are encouraged to participate by contacting either Dr. Susan M. Mangiero at 203-261-5519 or PG-Info@pensiongovernance.com or Steve Siegel at 847-706-3578 or ssiegel@soa.org.

Participation is limited to plan sponsors only. Preliminary results will be released to attendees of the SOA's Investment Symposium in New York, April 18-20.

Are Pensions Ready for Property Derivatives?

David Oakley reports the imminent launch of a U.S. commercial property derivatives market trading platform as early as this week. (See "Property derivatives poised for US launch", Financial Times, March 5, 2007.) Estimated at $26 trillion in value, Oakley writes that "property is one of the few major asset classes without a developed derivatives market in the U.S."

Four banks have signed with the National Council of Real Estate Investment Fiduciaries to license their index data for three years - Bank of America, Credit Suisse, Goldman Sachs, and Merrill Lynch. Click here to read the NCREIF press release.

This type of financial instrument has already taken hold in the UK with a property derivatives market that has grown to nearly $10 billion in the two years since inception. No surprise then that US banks will plan to follow suit, especially with respect to the use of good data (cited as a driving factor behind the UK experience).

Note that the NCREIF Property Index (NPI) is self-described as "a unique property valuation and performance metric. It is the largest, oldest, and most recognized measure of institutional quality, privately owned commercial real estate in the U.S. The benchmark represents (as of Fourth Quarter 2006) marked-to-market valuations on 5333 U.S. properties reported quarterly by a large number of institutional owners and fiduciaries. It has a total market value of $247 billion. The NPI includes sub-indices by property type, and location."

Structured as a type of interest rate swap, one counterparty receives a cash flow tied to real estate market performance. A second counterparty receives a variable rate-driven cash flow every few months, tied to LIBOR (London Interbank Offered Rate).

For a pension fund unable to buy property and/or allocate monies to a real estate investment trust or real estate private equity fund, this new derivative may be a good workaround. Suitability will depend of course on many factors such as terms specific to the derivative instrument contract, what the plan is seeking to achieve and whether exposure to real estate makes sense.

The Baltimore Sun reports continued good performance as recently as two months ago. (See "Commercial real estate funds continue to thrive" by Andrew Leckey, originally published January 7, 2007.) On the other hand, valuation and liquidity must be taken into account. Future expected risk-adjusted returns and correlation patterns with other assets are similarly important.

Can Pension Funds Forgive Hedge Fund Failures?

According to David Hammerstein of Yanni Partners, ("Fewer Second Chances For Failed Fundies" - Hedge Fund Daily, February 27, 2007), "There is an extra standard of caution and care that has to be demonstrated among institutional investors" when it comes to giving failed hedge funds another chance. Noting the significant amount of pension dollars going into alternatives, Hammerstein emphasizes the need to assess risk controls.

He's not alone. Next week, I will join other speakers at the 23rd Annual Risk Management Conference to wax and wane about all sorts of investment-related risks. Hosted by the Chicago Board Options Exchange, Chicago Board of Trade, Chicago Mercantile Exchange and OneChicago LLC, the conference brings together a variety of researchers, investors and consultants.

My presentation is entitled "What Every Institutional Investor Fiduciary Must Know About Derivatives" and will cover investment fiduciary practices related to risk control. (Click here to view the agenda.

Can the risk lion be tamed?

Absolutely - but only if one is willing to open the cage door and acknowledge its presence!

ERISA and Derivatives

During a September 26, 2006 panel discussion about the use of derivatives by pensions, mention was made of a U.S. Department of Labor letter. Several people asked for more information. (The Pensions & Investments conference focused on liability-driven investing.)

Click here to read the letter. Excerpts are provided below. Several items are noteworthy, especially since liability-driven investing strategies often rely on the use of derivatives.

1. There is a clear focus on process.

2. Regulators cite the need to identify operational and legal risks.

3. Passing the baton to a money manager does not absolve plan decision-makers of oversight duties with respect to the use of derivatives by outside firms.

4. Methods used to assess market risk should be appropriate and could include stress testing and simulation.

<< Investments in derivatives are subject to the fiduciary responsibility rules in the same manner as are any other plan investments. Thus, plan fiduciaries must determine that an investment in derivatives is, among other things, prudent and made solely in the interest of the plan's participants and beneficiaries.

In determining whether to invest in a particular derivative, plan fiduciaries are required to engage in the same general procedures and undertake the same type of analysis that they would in making any other investment decision. This would include, but not be limited to, a consideration of how the investment fits within the plan's investment policy, what role the particular derivative plays in the plan's portfolio, and the plan's potential exposure to losses. While derivatives may be a useful tool for managing a variety of risks and for broadening investment alternatives in a plan's portfolio, investments in certain derivatives, such as structured notes and collateralized mortgage obligations, may require a higher degree of sophistication and understanding on the part of plan fiduciaries than other investments. Characteristics of such derivatives may include extreme price volatility, a high degree of leverage, limited testing by markets, and difficulty in determining the market value of the derivative due to illiquid market conditions.

As with any investment made by a plan, plan fiduciaries with the authority for investing in derivatives are responsible for securing sufficient information to understand the investment prior to making the investment. For example, plan fiduciaries should secure from dealers and other sellers of derivatives, among other things, sufficient information to allow an independent analysis of the credit risk and market risk being undertaken by the plan in making the investment in the particular derivative. The market risks presented by the derivatives purchased by the plan should be understood and evaluated in terms of the effects that they will have on the relevant segments of the plan's portfolio as well as the portfolio's overall risk.

Plan fiduciaries have a duty to determine the appropriate methodology used to evaluate market risk and the information which must be collected to do so. Among other things, this would include, where appropriate, stress simulation models showing the projected performance of the derivatives and of the plan's portfolio under various market conditions. Stress simulations are particularly important because assumptions which may be valid for normal markets may not be valid in abnormal markets, resulting in significant losses. To the extent that there may be little pricing information available with respect to some derivatives, reliable price comparisons may be necessary. After entering into an investment, a plan fiduciary should be able to obtain timely information from the derivatives dealer regarding the plan's credit exposure and the current market value of its derivatives positions, and, where appropriate, should obtain such information from third parties to determine the current market value of the plan's derivatives positions, with a frequency that is appropriate to the nature and extent of these positions.

If the plan is investing in a pooled fund which is managed by a party other than the plan fiduciary who has chosen the fund, then that plan fiduciary should obtain, among other things, sufficient information to determine the pooled fund's strategy with respect to use of derivatives in its portfolio, the extent of investment by the fund in derivatives, and such other information as would be appropriate under the circumstances.

As part of its evaluation of the investment, a fiduciary must analyze the operational risks being undertaken in making the investment. Among other things, the fiduciary should determine whether it possesses the requisite expertise, knowledge, and information to understand and analyze the nature of the risks and potential returns involved in a particular derivative investment. In particular, the fiduciary must determine whether the plan has adequate information and risk management systems in place given the nature, size and complexity of the plan's derivatives activity, and whether the plan fiduciary has personnel who are competent to manage these systems. If the investments are made by outside investment managers hired by the plan fiduciary, that fiduciary should consider whether the investment managers have such personnel and controls and whether the plan fiduciary has personnel who are competent to monitor the derivatives activities of the investment managers.

Plan fiduciaries have a duty to evaluate the legal risk related to the investment. This would include assuring proper documentation of the derivative transaction and, where the transaction is pursuant to a contract, assuring written documentation of the contract before entering into the contract.Also, as with any other investment, plan fiduciaries have a duty to properly monitor their investments in derivatives to determine whether they are still appropriately fulfilling their role in the portfolio. The frequency and degree of the monitoring will, of course, depend on the nature of such investments and their role in the plan's portfolio. >>

Pensions and Derivatives, the "D" Word



Are derivative instruments a recipe for disaster, an integral part of effective investment management or something in between? As explained in "Derivatives: The $270 Trillion Gorilla", meteoric growth around the world speaks volumes. At the same time, the incremental risks are real and cannot be dismissed.

Financial News reporter Renee Schultes writes that few fund managers "have the operational infrastructure and expertise to trade outside the listed and less-liquid listed derivatives market." (See "Managers struggle with OTC derivatives trading", Financial News, September 25, 2006.) Financial Times journalists Paul J. Davies, Gillian Tett and Saskia Scholtes chronicle efforts to address operational issues related to derivatives. (See "Derivatives dealers' tough match", Financial Times, September 25, 2006.)

New accounting rules and regulations encourage a paradigm shift that emphasizes risk analysis. Liability-driven investing is the new "it" topic and, by extension, derivatives are getting a serious look by public and ERISA pension fiduciaries alike. Money managers use derivative instruments as well for a variety of reasons such as transforming cash flows, leveraging exposure to a particular asset class or hedging. The Towers Group, a research and consulting firm, reports that "buy-side derivatives usage" is expected to "explode, bolstered by the shift to electronic trading, search for alpha, and more accommodating regulations (such as changes to ERISA and the adoption of the Prudent Investor Rule), which allows derivatives usage in pension funds and institutional money management." (See "Growth in Derivatives to Have Profound Impact on Wall Street Firms", September 18, 2006.)

The ultimate question is whether the expected benefits outweigh the costs. I wrote an entire book on this topic. Written for fiduciaries and related parties, Risk Management for Pension Funds, Endowments, and Foundations is a primer about the risks and benefits of derivatives and, more broadly, risk identification, measurement and control. I could easily write a second book about the topic. There is so much to say.

That is why subsequent posts will address the topic of derivatives, and the fiduciary implications of their use.

For those who want to read more, here are links to earlier blog posts and some articles I've written about risk management.

1. "Derivatives Get the Blame"

2. "Operational Risk and Derivatives"

3. "Derivatives Valuation: One Size Does Not Fit All"

4. "Pension Risk Management: What We Don't Know Can Hurt"

5. "Five Keys to Risk and Risk Management"

You can find lots more by going to our online library. You may also be interested in receiving our complimentary ezine about risk and valuation. Click here to sign up. (A link to our privacy policy is at the same URL.)

Derivatives Get the Blame



In a recent Washington Times article entitled "Derivatives: Global roulette wheel", editor-at-large Arnaud de Borchgrave describes a global market now topping $300 trillion as reason to "fasten your seat belt". It's not clear what precipitated his dire warnings about systemic risk and classification of risk management talk as "gobbledygook to the layman". (Take a look at our March 2006 posting about derivatives.)

It's true that the use of derivatives introduces incremental risk such as the possibility of counterparty non-performance or problems with settlement. (Arguably netting and collateralization help to reduce some of the transaction-specific risk.) At the same time, derivatives used properly (and this is an important qualifier) can mitigate financial risk, transform cash flows, transfer risk, enhance asset performance or otherwise synthesize exposure to a particular risk-return position. How else could the market have grown to its giant size had it not been for a large number of participants who were (and are) willing to trade with each other?

At the risk of dating myself, I did an analysis about fifteen years ago that showed that derivatives-related losses were a fraction of disappearing dollars due to fixed income security defaults for the time period in question. It would be interesting to update the analysis and gauge whether derivatives are indeed the equivalent of a financial hurricane, wreaking damage far and wide.

One key issue (among many) is the measurement of risk. Consider a fixed-to-floating interest rate swap with a $20 million notional principal amount or "face value". Depending on the particular counterparties and deal structure, this popular size measure fails to convey meaningful information about potential loss. The incremental exposure for a counterparty that hedges its short-term commercial paper costs by entering into a swap as a fixed rate payor is not the same as a counterparty that receives floating in anticipation of higher rates.

Derivatives are not necessarily for the faint of heart nor should they be shunned as the proverbial bad boy of finance.

Derivatives and Hedge Funds


Derivatives have long been the proverbial "black sheep" of finance. A few highly publicized losses and it's off to the races with bad headlines galore. Don't get me wrong. I'm neither an advocate nor a critic. Like many others, I believe that the decision to use derivative instruments (type, strategy, application) depends on a multitude of factors, starting with an organization's objectives and constraints.

There is no perfect investment or financial technique. Something that works for one company or government may be wholly inappropriate for another. That's why a recent article about hedge funds and derivatives has me puzzled. While I agree that more and better disclosure is paramount, I'm not sure anyone is better off by being scared in the absence of evidence.

Here are a few things to ponder.

1. A $270 trillion derivatives market did not grow by leaps and bounds because these instruments are considered dangerous by all market participants. Someone has to think there are benefits associated with their use.

2. It's possible to create examples that show how the identical derivative instrument and/or strategy can reduce risk in one situation while inducing risk in a second situation. Context is everything.

3. Not all hedge funds hedge. Indeed, some of them employ derivatives in a speculative fashion as a way to try to enhance return. Others use derivatives to reduce interest rate, currency, equity and/or commodity risk.

4. Investors should not plunk down hard-earned money without doing their homework. This applies to institutional investors as well. Pension funds commit billions of dollars to hedge funds every year. Beneficiaries and regulators want to assure themselves that pension investment fiduciaries are doing what is needed to make a well-informed decision about hedge funds, whether they use derivatives or not.

5. Fraud is a tragic reality. Both buyers and sellers need to work together to preserve financial market integrity and make it as hard as possible for bad players to ruin things for everyone else. If this were easy, it would have been done by now. Industry associations and providers of fiduciary education can help.

Derivatives: The $270 Trillion Gorilla


The just released pension fund asset management guidelines, courtesy of OECD (Organisation for Economic Co-operation and Development), state that "legal provisions should address the use of derivatives and other similar commitments, taking into account both their utility and the risks of their inappropriate use".

I will devote considerable time to the topic of derivatives and pensions in this blog. For now, I will make a few introductory comments to hopefully whet your appetite.

1. Derivatives can be used in a variety of ways to manage assets and/or liabilities and for both defined contribution and defined benefit plans (though there are significant differences with respect to strategy, risk assessment, accounting treatment and so on). I have written a lot about this topic, including a book and countless articles, and there is still much more to say. Identifying, measuring and managing risk is a cornerstone of being a good investment fiduciary.

2. The derivatives market is huge. According to the Bank for International Settlements, outstanding over-the-counter derivatives contracts (in terms of notional amounts) exceeded $270 trillion when estimated in June 2005. Think about it. In comparision, the U.S. national debt tally is approximately $8.36 trillion. Estimated 2005 gross world product is $59.38 trillion. The global derivatives market is the proverbial 200 pound gorilla of the financial world. It is worthwhile understanding why this market continues to grow. (Stay tuned!)

3. Derivatives are contracts that "derive" their value from the value of an underlying security, commodity, index or other type of instrument. For example, the value of a gold derivatives contract depends on the price of cash gold. (Derivatives valuation is a broad topic and will be addressed in other postings.)

4. The term "financial risk management" typically refers to the use of derivatives in some fashion (though this is not always the case).

5. Pension fiduciaries who ignore derivatives, especially if the Investment Policy Statement restricts their use, may want to rethink their stance. They should know that financial performance is impacted by the price behavior of derivative instruments if they have allocated monies to: (a) hedge funds or mutual funds that employ derivatives (b) asset-backed securities such as mortgage-backed bonds or collateral default obligations (c) convertible bonds (d) callable bonds (e) currency sharing agreements (f) private equity with warrant arrangements (g) contingencies of any type and the list goes on.

6. Derivatives, used improperly, can wreak havoc. Much more will be said about the identification and measurement of risk, how to determine appropriate use and a host of other critical MUST KNOW elements of the decision-making process.

7. The issue of a fiduciary duty to hedge is an ongoing and interesting legal question.

8. Financial engineering opens the door wide to a variety of new investment opportunities for pension funds. Fiduciaries must know (or learn) how to evaluate each opportunity. Outsourcing does not eliminate the fiduciary's duty to monitor.

9. Using derivatives is seldom a one-time event but instead requires a commitment to evaluate economic efficacy on an ongoing basis.

10. Creating a risk management process is just the beginning. I will address the Five C Approach(SM) as a way to assist fiduciaries.