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

On April 7, 2008, this blogger wrote about unhappy pension campers, seeking to rid troubled companies of certain board members. (See "Three Public Pension Plans Say No Thanks.") At the time, the general consensus seemed to be "good luck but don't count on being able to oust anyone" in part because experts suggest that boards may be limited in their oversight capabilities. In what appears to be a win for protesting pensions, director Mary Pugh has resigned from Washington Mutual. According to The Street.com, CtW Investment Group had asked shareholders to draw support for Pugh (chairwoman of the bank's finance committee) and a second director, James Stever (chairman of the human resources committee). In a slide presentation and on its website, CtW blames this duo for failing "to recognize and act in a timely manner on the risks to shareholder value presented by the housing bubble" and for not reducing executive bonuses as a result of "this risk management failure." Note that she was re-elected with "50.4 percent of the shareholder vote" according to the Associated Press ("WaMu directors narrowly re-elected in shareholder vote, April 16, 2007), notwithstanding a Q1-2008 reported loss of $1.1 billion.

Click to read "WaMu Director Resigns Under Pressure" by Laurie Kulikowski (TheStreet.com, April 15, 2008).

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In "Morgan Stanley reviews position of risk officer over writedowns" (December 22, 2007), Financial Times reporter Henny Sender describes the hostile environment in which some risk management gurus live. Declaring that critics now accuse the Morgan Stanley Chief Risk Officer of being late in "sounding the alarm about the dangers stemming from the bank's exposure to sub-prime related trades" or having used "language that was too technical or obscure," advocates counter that his warnings were ignored. Not surprisingly, other banks are "overhauling their risk management function after announcing multi-billion dollar losses on subprime-related trades. (Morgan Stanley reported an approximate $10 billion loss.) 

The article adds that Morgan Stanley's risk guru "was very vocal in saying that there were no proper pricing models for such trades, that positions were not being properly measured, and that the history traders used in their models was not a reliable guide." A further investigation will ultimately shed light on whether Mr. Risk at Morgan Stanley had the authority to effect significant change or was instead unaware of mounting exposures until it was too late.

The lessons to be learned here are far from trivial. Spending significant money to hire a risk wizard or team of pundits is a waste unless (a) the risk control function is recognized as essential to core operating activity and (b) these individuals are empowered to work independently of line managers. A new study suggests that the tide is turning though there is room for improvement.

According to "Beyond Compliance: The Maturation of CROs and Other Senior Executives" (GARP Risk Review, November/December 2007), researchers Annette Mikes and David Townsend describe the way Chief Risk Officers are encouraged to participate in "capital allocation and group-level budgeting and planning." At the same time, more than two-thirds of surveyed bank CROs expressed frustration at not being able to convince top management to improve risk disclosures included in public financial statements. Over reliance on risk models was cited as a concern of CROs, especially when credit allocation decisions are based on "automated model responses, with little oversight from humans." The article concludes that "the ultimate test remains the ability of risk managers to influence risk-taking behavior in the business lines."

As this blog's author wrote several years ago, Chief Risk Officers are part diplomat and part rocket scientist. Ultimately, their contributions are constrained by whether a risk culture exists within an organization. One can be technically competent but lack the organizational wherewithal to put out a fire. Read "Life in Financial Risk Management: Shrinking Violets Need Not Apply" by Dr. Susan Mangiero, Accredited Valuation Analyst, CFA and certified Financial Risk Manager.

Should pension and 401(k) plan sponsors care about bank risk management? Absolutely.

Since many retirement plans hire banks to manage assets or recommend bank funds to defined contribution plan participants, fiduciaries MUST include risk controls as part of their due diligence process when selecting, monitoring and perhaps firing money managers.

Some plan sponsors create and implement risk management policies that are separate from their formal Investment Policy Statement. Elsewhere, ERISA and public plans are hiring risk management professionals to go in-house. For example, the Ohio Public Employee Retirement System (OPERS) seeks a risk analyst who can perform tasks such as those shown below.

<< 1. Develops a comprehensive risk management program to identify, assess, manage and report investment related risks.

2. Oversees in coordination with the appropriate parties, the management of market, credit/counterparty, operations, reputation and other investment related risks.

3. Develops and participates in processes and procedures of reviewing, discussing and prioritizing risks in each major category.

4. Develops and reports risk metrics to monitor market, credit/counterparty, operations and other related risks.

5. Prepares periodic reports for senior management and OPERS Board to review investment related risks and makes recommendations, as appropriate.

6. Assesses risk management tools and capabilities, recommends improvements and implements approved solutions.

7. Reviews, monitors and oversees derivatives activities and capabilities for internal operations and for external managers in coordination with appropriate staff.

8. Performs on-site manager due diligence reviews from a risk assessment, management and monitoring perspective.

9. Leads and/or participates in various risk management committees.

10. Establishes and maintains a customer service focus work policy through example and clear, timely delineation of expectations. >>

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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.)

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In his November 11, 2007 blog entry, New York Times reporter Floyd Norris describes an interesting tidbit of information, tucked inside the just filed 10-Q by Wachovia Corporation. On page 27, it reads "In the third quarter of 2007, we purchased and placed in our available for sale portfolion $1.1 billion of asset-backed commercial paper from Evergreen money market funds, which we manage. We recorded a $40 million valuation loss on this purchase, which is included in our market disruption-related losses." As Norris explains, while the regulatory filing adds that Wachovia is "not required by contract to purchase these or any other assets from the Evergreen funds" they manage, a loss of that magnitude would "break the buck." When the $1 Net Asset Value typically associated with a money market fund no longer prevails, Wachovia or any other financial institution in a similar position is arguably obliged to stem the financial tide or risk loss of investors or worse. Click here to access the 10Q report.

In today's article entitled "SEI, Rival Money Funds Go on Offense to Avoid 'Breaking the Buck'," Wall Street Journal reporters Diya Gullapalli and Tom Lauricella write that money manager SEI Investments has said "it would provide financial guarantees for some of the funds' holdings of SIVs." CEO Alfred West explains the rationale for voluntarily providing credit support, in the aftermath of a threatened downgrade of SIV Cheyne Finance, LLC paper. Held by several SEI funds, "managed for SEI by Columbia Management, the money-management arm of Bank of America Corp," the funds' rating could likewise be compromised. Click here to listen to the recorded November 12, 2007 presentation to SEI investors. 

A recent IMF presentation, entitled "Regional Economic Outlook - Europe" stresses the importance of improving "risk assessment models, market and liquidity risk management, due diligence, and transparency regarding the loan origination process and counterparty risk exposure."

Color me confused. Haven't many banks held themselves out to be leaders in the area of risk control? What about the fact that banks are highly regulated? Doesn't that contribute to good oversight? What is the role of Basel II, looming right around the corner and meant to reflect robust risk management activities on the part of banks in the U.S. and abroad?

For those banks with pension clients, what is the process in place to vet all recommended money market funds, including their own? Is the process conflict-free? Conversely, are pension funds directly (or through pension consultants) asking sufficient questions about the safety of recommended short-term capital pools?

As the mysteries unfold, don't be surprised what we learn about the importance of good fund selection and risk review process.

Note: Wikipedia defines a structured investment vehicle as "an evergreen credit arbitrage fund, similar to a CDO or Conduit. They are usually from around $1bn to $30bn in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. An SIV is formed to make profits from the difference between the short term borrowing rate and long term returns." Click here for more information.

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In a November 5, 2007 statement, Citi announced that current CEO Charles Prince will step down. Robert E. Rubin will become Chairman of the Board and a search for a new leader will begin immediately. In a related story, Wall Street Journal reporters Carrick Mollenkamp and David Reilly describe Citigroup's struggles to estimate trading losses, in large part due to the fact that internal quantitative models relied heavily on credit ratings assigned to securities that were used in structuring Collateralized Debt Obligations (CDOs). With recent downgrades (to arguably better reflect risk levels), the value of Citi's sub-prime holdings similarly sank. Credit fears dampened already limited trading interest, forcing a heavy reliance on a mark-to-model approach.

As this blog's author has stated many times before, model risk is real. Bad or inappropriately used models lead to imprecise outputs. Decisions based on poor information can only lead to trouble. According to "Why Citi Struggles to Tally Losses Swelling Write-Downs Show Just How Fallible Pricing Models Can Be" (Wall Street Journal, November 5, 2007), modelers projected future expected payments for then high-rated sub-prime backed CDOs on the basis of how similar credit rated corporate bonds were trading. By not recognizing that default experience for corporate versus sub-primed backed securities differed dramatically, Citi's rocket scientists painted too rosy a valuation picture.

In a related article ("Where Did the Buck Stop at Merrill? November 4, 2007), New York Times reporters Graham Bowley and Jenny Anderson describe oversight problems at Merrill Lynch. Following a $8.4 billion charge and the recent resignation of CEO O'Neal, questions have arisen about whether board members should be more aware of daily operations, especially those areas that are likely to present problems if things go awry. Quoting Meredith Whitney, CIBC World Markets financial analyst, the point is made that Merrill had no one with sub-prime experience to serve on any of the committees charged with risk oversight and auditing. Despite creating a post for Chief Risk Officer in early September 2007, other experts cited in the article decry the lack of board/oversight committee independence from senior management, at the same time that large trading books were "hard to value."

By extension, this notion of oversight applies to pension fiduciaries. As this blog's author has repeatedly emphasized, plan sponsors MUST do a thorough job of vetting service providers (including banks) with respect to their "red flag" controls. How many pension fiduciaries ask about the existence of a Chief Risk Officer (or lack thereof)? How much detail do pension fiduciaries demand to know about each bank's risk management function, certainly for key parts of trading operations? Do pension fiduciaries ask to speak to members of the valuation team and/or those responsible for collateral management? Have pension fiduciaries asked banks about their progress with respect to preparing for Basel II and related model requirements? (Click here to read the November 2, 2007 press release from the Federal Reserve Board which describes their approval of new risk-based capital rules.) The list of other "must know" queries is long but nevertheless essential to proper due diligence.

Will clever attorneys make a case for poor process if pension fiduciaries have allocated monies to any or all of the banks now making headlines, citing breach if they failed to dig deep about risk and valuation policies and procedures?

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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.

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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.

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Wall Street Journal journalists Kate Kelly, Serena Ng and Michael Hudson report that two once-large hedge funds are barely worth the paper that documents their existence. According to a letter to investors, parent Bear Stearns has already committed $1.6 billion in a "collateralized repo line to the High-Grade Fund" but cautions that prices are dropping fast. At the heart of the matter is the challenge to "place values on assets tied to subprime home loans" that are not actively bought and sold. (See "Subprime Uncertainty Fans Out - Bear's Hedge Funds Are Basically Worthless; More Bond Fire Sales," Wall Street Journal, July 18, 2007.) 

As an accredited appraiser, I'm here to say that there is an entire industry of valuation professionals who eat, live and breathe process, standards and methodologies. In fact, following the U.S. savings and loan debacle in the early 1980's and the 1989 enactment of the Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA"), Congress essentially sanctioned the work of several entities - Appraiser Qualifications Board and the Appraisal Standards Board. For more information about the Appraisal Foundation and its history, click here.

So the hullabaloo about valuation problems (likely the tip of the iceberg) is extremely important but ignores a critical point.

In general (and not necessarily germane to this particular pair of hedge funds), a failure of institutional investors to oversee who renders value numbers, how, and on what basis, opens the door to "anything goes." Independent assessments of models and processes are arguably more important than ever before. If plan sponsors feel uncomfortable with the rigors of valuation and risk management, hire experts to help. Make sure that they know what they are doing. Ask whether they have specialized credentials and experience.

Why is valuation so important? Numbers drive nearly EVERYTHING financial,  from performance reporting to risk management to determination of fees and asset allocation decisions. GIGO - Garbage in, garbage out - could be very hard to explain as an acceptable basis for good decision-making.

If you are interested in reading a June 4, 2007 interview I gave to Securities Industry News about hedge fund valuation, click here.

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