Sunday, June 29, 2014

Brief Hiautus

Meditations on Money Management will return the week of July 14th.

Friday, June 27, 2014

It’s Not Getting Any Better: The Treasurer’s Bill Moves Forward

It’s Not Getting Any Better:  The Treasurer’s Bill Moves Forward

The House Committee on Personnel recently amended and approved H. 1209, the “Retirement Investment Accountability” Act.  The bill contains specific requirements for auditing and analyzing the investment performance of the North Carolina pension plans.  As I’ve previously written, most of the bill’s requirements shouldn’t be put into the statute.  See “Reasonable Goals in a Poorly Constructed Bill:  Unnecessary Requirements (June 17, 2014).  I’m not surprised that the bill is moving forward because the Treasurer’s bill allows the General Assembly to go into areas where it doesn’t belong and where it can’t possibly have the necessary expertise.

The House Personnel Committee appears to have made one substantive change.  Instead of hiding investment-related documents for ten years after an investment fund is terminated, the revised legislation allows disclosure five years after termination.  Is this “compromise” a step toward greater transparency?  Hardly.  Instead of permitting disclosure twenty to twenty-five years after an initial investment, the revised bill makes that disclosure possible fifteen to twenty years after the investment.  The current State Treasurer, her successors, and generations of money managers will be able to hide their financial arrangements with the public pension plan for generations to come.  See “Reasonable Goals in a Poorly Constructed Bill:  Burying Public Records (June 16, 2014) for a more detailed discussion of this provision of H. 1209.

North Carolina is supposed to be one of the few states where a sole fiduciary manages the investments of the state’s public pensions.  In reality, we don’t have a sole fiduciary.  The State Treasurer has already conceded her authority to one hundred twenty representatives and fifty senators.  The General Assembly has been put into the business of determining how much will be invested in each investment category and precisely how performance will be reported.  They also seem to be backing the idea that money managers are very privileged people whose documents should be protected until the papers are irrelevant.

Unfortunately, the beneficiaries of the North Carolina pension plans don’t have any credible advocates.  The State Employees’ Association of North Carolina (SEANC) has lost its credibility by underwriting the Benchmark Financial report.   Instead of investing their members’ fees in studies to counterbalance bad policy proposals, they decided to commission a study that makes wild claims of fraud and abuse.  I can understand why the General Assembly is paying little attention to SEANC on this matter.  Meanwhile, the State Treasurer, who has real knowledge about pension investments, is ceding her power to 170 legislators and creating a lock-box for documents that deserve public scrutiny.

Thursday, June 26, 2014

Is Bank Risk Rising or Are Risk Managers Reining It In?

Is Bank Risk Rising or Are Risk Managers Reining It In?

Today the Wall Street Journal is carrying two stories that seem to contradict one another.  The headline of the first story says, “After Crisis, Risk Officers Gain More Clout at Banks, U.S. Banking Industry Bends to Pressure to Make Operations Safer and Simpler.”[1]  The second story says, “Lenders Are Warned on Risk Regulator, Urges Caution by Banks About Looser Standards in Pursuit of Profits”[2]

The first story features the chief risk officer from Wells Fargo and describes how he nixed a home equity credit product.  The article details the rising number of risk officers and bank examiners.  The reporter, James Sterngold, mentions the OCC report but doesn’t seem to appreciate the irony of reporting that the clout of risk officers is rising as the OCC reports that bank risk is rising.

The second article is a summary of the Office of the Comptroller of the Currency’s (OCC) semi-annual report[3], which makes the following assessments among others. 

  •       Intense competition in a slow-growth, low-interest-rate environment is continuing to fuel riskier lending by banks
  •      Two areas in particular where banks took on more risk in pursuit of profits: high-yielding loans issued to more speculative borrowers and indirect auto loans, in which banks provide financing through a car dealer. Banks also are easing lending standards in commercial loans.
  •       Lower market volatility may be understating trading risk.

The following chart from the OCC report illustrates one of the risks that has re-emerged since the credit crisis.  Covenant-lite loans have blossomed in recent years at substantially higher levels than in the run up to the credit crisis.  Typically these are loans made on highly leverage companies.  In a normal loan, the borrower is required to meet a series of financial tests (covenants) in order to protect the bank.  These tests are disappearing in the drive for banks to capture more business

While I’m not suggesting that we’re on the verge of another credit crisis, I am wondering where the risk managers are when these loans are being made.  While the OCC report also concludes that a number of measures of risk have improved, it appears to me that Dodd-Frank and the Fed’s low interest policy may be responsible for these developments. 

Every time we have a financial crisis, compliance and risk budgets are increased.  In the aftermath, organizational charts are rejiggered to place the naysayers higher up in the bank. Strictly speaking, the two Wall Street Journal articles aren’t contradictory.  The visibility of risk managers is rising.  Risk is rising.  The clout of risk managers, however, is about the same as it always has been.  In the end, short-term profit always trumps long-term prudence. 


Wednesday, June 25, 2014

When A Win Is A Loss: Fifth Third Bank versus Dudenhoeffer

When A Win Is A Loss:  Fifth Third Bank versus Dudenhoeffer

A group of employees of Fifth Third Bancorp sued the bank for failing to reduce the bank’s employee stock ownership plan (ESOP) in the face of the bank’s weakening financial condition and the subsequent plunge in its stock price.  The plaintiffs argued that the bank had violated its fiduciary responsibility under the Employee Retirement Investment Security Act (ERISA).  The lower court had rules that the bank enjoyed a “special presumption of prudence,” since an, by definition, it isn’t investing in a diversified portfolio.  In a unanimous decision[1], the court reversed the lower court ruling and said that there is no special presumption.  The trustees are subject to the same standard of prudence as with any other investment.  If you stopped reading at this point, you’d think that the employees won the case as AP concluded: “Supreme Court sides with bank employees in dispute over retirement investments.”[2]

However, the Supreme Court went on discuss the grounds under which the employees might be able to state a cause of action, which seems to have led Reuters to conclude: U.S. top court rules for bank over class action case.”[3]   In my view, the employees lost their case in the second half of the opinion when the court turned to the question of whether the plaintiffs could come up with a cause of action. 

The employees argued that the senior bank employees who oversaw the ESOP had to know that the bank had significant financial issues because they were privy to inside information.  The bank argued that it couldn’t act on inside information without violating federal securities laws.  The Supreme Court agreed with the bank, and said that ERISA does not require a fiduciary to use inside information in discharging its duty.  Thus the failure to act upon inside information cannot be the basis for a claim.

Alternatively, the plaintiffs argued that the defendant should have taken action to reduce the ESOP’s exposure to Fifth Third’s stock based on publicly available information.  The court ruled that this argument was insufficient to state a cause of action, because the stock price is supposed to reasonably reflect all public information (good or bad).  The court ruled that plaintiffs have to come up with some “alternative action that the defendant could have taken, that would have been legal, and that a prudent fiduciary in the same circumstances would not have viewed as more likely to harm the fund than help it.”

Perhaps plaintiff’s lawyers are more creative than me and can come up with an alternative action defendant’s could have taken.  I doubt it.  Even though the trustees of Fifth Third’s ESOP are subject to the fiduciary standard of ERISA, there is probably no way to bring a cause of action against them.

I will be devoting part of a future New & Observer column to the question of investing your retirement net egg in your company’s stock.  Hint: it’s a bad idea.


Silly Statistics From the Private Equity Growth Council

Silly Statistics

The Private Equity Growth Council issued a report touting the $443 billion PE firms invested in the United States.[1]  The figures are broken out by states and by congressional districts as if the money had actually flowed into these jurisdictions.  Texas is listed as the big winner with 282 deals and $87.4 billion in capital.  The PEGC wants us to know that the districts of the following five Congressmen received the greatest amount of investment: John Carter (TX-31)-$24.9 billion -Mike Doyle (PA-14)-$24.8 billion -John Culberson (TX-7)-$14.6 billion -Carolyn Maloney (NY-12)-$13.7 billion -Henry Waxman (CA-33)- $10.7 billion. 

The private equity industry is trying to position itself as an economic engine that is stimulating key areas of the country.  This data is making its way into local newspapers and will be talking points for Senators and Congressman as they defend the PE industry.  For example, The Sacramento Bee carried the following headline: “California trails Texas in private equity investment dollars.”[2]   The Journal Sentinel of Milwaukee positioned the report as if the state had done something to draw capital, “Wisconsin attracted $5.9 billion in private equity investments in 2013.”[3]  It’s pretty much meaningless.

PE investments aren’t like government contracts that bring actual money into states or districts.  When a PE firm buys a company, most of the proceeds go to the selling investors, who are probably not in the same state or district even if the company is headquartered there.  To the extent some of the capital is invested in businesses, the plants, distribution centers, or retail outlets may be located just about anywhere, including overseas.  In other words, the figures are very misleading.

For arguments sake, let’s assume that all the capital actually went into a particular state or district.  We still wouldn’t have a complete picture.  By its very nature, PE firms buy and sell companies.  The PEGC’s report only captures the purchases.  If they were to report the sales and treat them as a divestiture of capital, private equities net impact would be rather small.

PE managers always prefer to talk about performance before fees (gross), rather than performance after fees and expenses (net).    They also prefer that we focus on their winning investments and ignore the losers.   The same principals are at play when it comes to industry marketing.  The data may be meaningless, but the marketing is getting traction.