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Breaking the Buck

Reeling and Writhing, of course, to begin with, and then the different branches of arithmetic -- Ambition, Distraction, Uglification, and Derision.

  - “Alice in Wonderland”

Andrew Donohue, Director of the SEC Division of Investment Management, addressed the Practising Law Institute this month.  Points of interest from his talk include the statistic that “The mutual fund industry…” with over 8000 funds, “is one that approximately 92 million investors have entrusted over 9 trillion dollars to.”  Donohue acknowledged the broad diversity of strategies and objectives, yet found it “surprising” that the divergences of performance have been so wide within sectors.

“For example, in the bond fund area, while the average high yield bond fund lost 26 percent on average, the range of performance was plus 7 percent to minus 78 percent. Similarly, with national tax-exempt bond funds, while the average fund lost almost 7 percent, the range in performance was from plus 6 percent to minus 49 percent.”

Sounds like the return from a mutual fund might be no more reliable than what you have been getting from your stockbroker, or from (gasp!) Jim Cramer.  “What”, asks Donohue, “is the value proposition in taking on the risk for this variance in performance?”


Interviewed in this Sunday’s New York Times Business section (“He Doesn’t Let Money Managers Off The Hook”), John C. Bogle – founder of the Vanguard Group and the Yoda of the managed funds industry – raises the issue of just how irresponsibly the mutual funds industry has discharged its fiduciary duty to the – did you read that number? – ninety-two million investors who collectively have entrusted them with over nine trillion dollars.  America, these are seriously big numbers.

The SEC has so far escaped criticism in the area of proxy voting, but that may change.  Donohue may not be aware of how large a mess has been swept under his Division’s carpet.  But he lifted the corner of the rug in his PLI address, so he is now Fair Game.

Hedge fund and mutual fund managers devote many pages of their compliance manuals to the procedures for proxy voting, and an entire industry has grown up to handle the proxy process for professional investors.  There is a small subset of managers who engage directly with the managements of companies in which they invest.  They are called “activist” managers, and there is something gamey, rough-and-tumble and perhaps not quite White Shoe associated with the moniker.  They hire lawyers and say nasty things at shareholder meetings and launch proxy fights.  Many managers state simply that they simply divest themselves of holdings in companies whose managements they are not prepared to back.

In fact, as reported in the Financial Times (6 April, “Mutual Fund Votes Helped To Boost Pay”) mutual fund managers have been major contributors to excessive executive pay in public companies.  According to the FT piece, “AllianceBernstein, Barclays Global Investors, Ameriprise, and Bank of America’s Columbia Management were the most consistent backers of management proposals to increase executive pay…”  The article reports that “In 2008, the 26 mutual fund groups included in the study voted in favour of management compensation proposals 84 percent of the time…”  One should not require the benefit of 20/20 hindsight to observe that this is an unconscionable record in an abysmal year.

If you are “professional” investor, and you do not engage with the management of the companies in your portfolio, then in what does your professionalism consist?  Are the thousands of managers running the thousands of mutual funds nothing more than a legion of Educated Guessers armed with such fearsome weapons from the arsenal of Modern Portfolio Theory as the Capital Asset Pricing Model and the Dividend Discount Model?  Indeed, they have led their investors lemming-like in a charge across the Efficient Frontier and into a never-never land of smoke and mirrors wealth. 

The President of the United States steps up as Mutual Fund manager-In-Chief and fires the CEO of a company in which he has taken a major stake with his clients’ money.  Should we demand any less from those Harvard MBAs and MIT PhDs to whom we have entrusted our trillions?

Donohue next said “the review of the money market fund model and its regulatory regime is one of our top priorities in the Division of Investment Management this year.”  Noting that there is some $4 trillion invested in money market funds, Donohue said the standard money market model has come under stress in the past 18 months, and investor protection concerns warranted a fresh look. 

Using a graphic real-life example, Donohue questioned whether the notion of a $1 net asset value (NAV) should be reviewed and suggested that a $10 NAV or a floating NAV may address some of the problems associated with the current model. Donohue showed how, under current rules, an investor may be paying one dollar a share for shares whose actual NAV is $.9960 – taking an immediate unrecorded loss on their investment.

This effect is exacerbated by professionals who understand the money market funds’ regulatory structure.  The rules permit a 50 basis point (one half of one percent) fluctuation in NAV before the fund has to declare a NAV change.  In Donohue’s example, the big players withdraw 25% of the cash in a money market fund in a single day.  It is all paid out at the stated NAV of one dollar, when the actual NAV is $.9960.  The resulting imbalance, after the 25% drawdown, leaves the NAV at $99.47.  Under the current rules – did you guess right? – the fund must now Break the Buck and state its NAV at 99 cents. 

Fifty basis point tolerance.  Above half a cent, round up to the dollar.  Below half a cent, round down to $.99.  Thanks for playing.

For most retail investors, the real news is that money market funds are not banks.  They are investments, and they entail risk.  This is why the regulatory agencies require individuals who recommend money markets to investors be Series 7 Registered Representatives.  As with so much else that has emerged in the recent collapse of the global financial system, the big surprise came at the margin, with the once-in-a-century meltdown.  Your dollar is not guaranteed to stay at a dollar.  Who would have thought?  So in Whom do we trust? 

Donohue mentioned the idea of having money market funds state NAV at ten dollars per share.  Keeping the half-cent tolerance, this would make fluctuations in share value much smaller.  In the world of equities we call this a Reverse Split, and it ends badly.  Call us simple stock jockeys, but Donohue’s trial balloon looks to us like simple inflation.  It says that there is so much money in the system that we can no longer denominate our dollars in dollars.  Welcome to the Weimar Fund, where NAV is stated in wheelbarrows full of hundreds.

While we recognize the desire to address this situation, merely applying an orders-of-magnitude upwards ratcheting still leaves the fundamental issue unaddressed: investors always thought their money market fund dollars were going to be worth a dollar.  Moving the NAV marker up tenfold seems to buy time, without creating fundamental change.

Another matter Donohue touched on was leveraged ETFs that are marketed to investors as professional-style tools for capitalizing on moves in market sectors.  Anyone who bothers to apply basic arithmetic will quickly spot the risks, but most people, guided by their investment professionals, do not bother to add, subtract, multiply and divide before they invest.

A fund that promises 200% of the upside of a market index will use leverage to obtain that return.  When the sector goes down, the leverage exacerbates the downward move of the fund, which then must work orders of magnitude harder to recover.  It’s simple arithmetic.  A 25% down move requires a 33% upwards move to recover back to even.  Down 50% requires up 100%.  And so on.  When your investment is leveraged – and driven by the compounding factor of daily pricing – one quickly gets so far behind that, even with the indexes charging ahead, recovery is well nigh impossible.  Donohue referenced an instance of an index being up fifty percent, while the accelerator fund that tracked it, because of negative returns during the fund’s early stages, was down 21% during that same period.

In a snip of a story that, apparently, no one thinks is related, the SEC Division of Trading and Markets has permitted Legg Mason to stop sending monthly account statements to customers whose “only” transactions were reinvestment of dividends in money market funds underwritten by Legg Mason itself.  The reasoning is that, since the specifics of the funds are available on the internet, it is no longer necessary to send out a piece of paper.

Do we mistrust Legg Mason? Not in the slightest, though we have a less sanguine opinion of the SEC.  The bias towards Disclosure By Availability, and away from making the investor engage, feeds into the continued domination of the markets by those who create and sell product, and away from beefed-up protection for those who consume product.

Until investors are forced to face the reality of the marketplace, regulators will remain ineffective.  Who benefits from the write-up of money fund assets?  Is it the investor?  Or is it the fund managers, who will not have to adjust the way they manage risk?  It looks to us like the regulators’ approach to increased risk in the marketplace is to give market operators more latitude, when what they should really be doing is giving investors more education.  The simple solution?  Make any broker who wishes to sell products to investors take an investor-safety course.  Better yet, make the customers take it.

Motive, Means And Opportunity
European insurance companies…

- Sir Alan Greenspan

Lloyd Blankfein, CEO of Goldman Sachs, held the floor on the global stage last week for the very best possible reason: because he could.  For all the cynicism – those who believe he was giving mere lip service to corporate responsibility – it is clear that Goldman has top-drawer risk management.   One need not be a die-hard cynic to recognize that true risk management consists, not in making risks vanish, but in getting someone else to take them on.

Thus, on the occasion of his knighthood, Alan Greenspan was able to smile serenely as he told his hosts that the European insurers had taken the beating on the implosion of derivatives, synthetic securities, and plain old common stocks that had come in the wake of the “dotcom” bust.

Thus, on the eve of floating a public offering that will finance their paying back the TARP funds (you didn’t think they were going to use their own money?) Blankfein has one of the few legitimate claims to the title of Last Man Standing.

We recommend that all our readers replay Blankfein’s speech.  Forget the big pink banner (no, fellow journalists, Blankfein was not “upstaged” by the giant pink banner reading “we want our $$$ back”).  The philosophical takeaway fits with what we perceive as President Obama’s view on market regulation.  By retooling compensation across the board, Blankfein is suggesting a significant duration shift in Wall Street’s outlook.  The change from instant gratification, to long-term greed, is likely a very healthy notion, and certainly one whose time has come.  It used to be the way of the world, until technology partnered up with greed and allowed local petty thieves to morph into Robber Barons.

The Obama Administration appears to be pushing for longer-term perspective in the marketplace, and the regulatory structures they are putting forward are part of this outlook.  SEC Chairman Schapiro’s proposed reforms are generational changes, in that they will not truly take hold until much of the existing Old Guard has been flushed out of the system.  We think the industry is also being pressured to change its outlook.  Goldman Sachs is driven by the profit motive, while regulatory agencies are driven largely by the desire of vast armies of ineffectual employees to keep their jobs and pensions.  We take it as no coincidence that Blankfein’s perspective dovetails with much that emanates from the new Administration. 

Look to Wall Street to take the lead with major changes in the marketplace.  It is the only player that can, and it has every reason to do so.  Where Goldman Sachs leads, the SEC will, perforce, follow.

iShared, iSaw, iConquered
The hurrieder I go, the behinder I get.

We admit to being conspiracy theorists, and we like very few things as well as a juicy story that connects the dots and emerges with a sinister global cabal. 

Our latest offering is a two-way cabal: it has a major market player perpetrating an apparent fraud on the world markets, and the fraudster itself stands to be dealt a crippling blow by a counter-fraud that lurks like a depth charge in its path.

Barclays Plc has given the markets two things they have been hungering for: a Really Big Loan from a Really Big Bank, as well as a Really Big Profit Number for a Really Big Company.

This week, Barclays announced that CVC is the winner of the bid for its iShares operation.  The purchase is being funded with one billion dollars in equity, and a $3.1 billion loan, issued by none other than Barclays itself.  This will be a relatively simple transaction.  From a logistical point of view, Barclays will simply convert the loan into a revenue number.  In anticipation of the profit it stands to book, Barclays shares rose significantly in last week’s trading.

The details – where the devil is said to lurk – include half a billion dollars to be paid later, based on a projected high level of profitability of the operation for its new owners.  (We think the wording is “if, and only if…”)  Also, for some reason that is perceived as boosting the credibility of the deal, Barclays has undertaken to hold the loan on its own books.  Some have speculated that the loan might be difficult to syndicate, while others – more cynical? – posit the reason is that Barclays will have to make some rather ugly concessions, as the iShares business is not as profitable for its new owners as it was for the Bank.  We add to this the notion that, as the business starts to unravel under the stewardship of CVC, no one wants to see a troubled $3.1 billion loan spawn an untraceable daisy chain of CDS betting against it.

But wait.  What’s this? 

Chinese company LIMMT Economic and Trade Company Ltd., was sanctioned in 2006 by the U.S. Department of the Treasury for providing material support for Iran’s missile program.  Now Manhattan District Attorney Robert Morgenthau has announced a 118-count indictment against the company, alleging the LIMMT sent and received dozens of illegal payments through U.S. banks in the two years after the OFAC sanctions were imposed. 

These payments, made through alias accounts and shell companies, were facilitated by some of the biggest names in global banking.  Prominent among them are Lloyds TSB Bank Plc, Credit Suisse, and Barclays.  These banks were themselves said to have illegally – and possibly knowingly – structured payments from Iran in such a way that the US counterparty banks could not tell their true point of origin. 

Dozens of illegal transactions were allegedly processed through Bank of New York Mellon, JP Morgan Chase, Wachovia, American Express, and Citigroup.  Our experience in the world of anti money laundering compliance is enough to tell us that US domestic entities have the right to rely on other financial institutions, if those counterparties are, themselves, subject to a recognized AML regime.  Thus, while we suspect the story is far from over, the U.S. banks have so far not been charged with wrongdoing.  Bloomberg.com (7 April, “Chinese Firm Indicted For Misusing Banks, Aiding Iran”), quoted Morgenthau as saying “Our banks have high standards and sophisticated systems to stop these transactions, but this conduct was specifically designed to defeat their systems.”

Morgenthau achieved a $350 million settlement with Lloyds TSB Bank, announced in January.  Credit Suisse and Barclays have both said they are cooperating with Morgenthau’s probe.

And if they don’t?

We wonder what part this deceit played in the US’ recent attack on Swiss bank secrecy.  We think the US Government would consider it wholly appropriate to strong-arm the government of Switzerland to open up its banking sector to scrutiny, once the Iran / China connection came to light.

We have been watching developments in the ETF markets, and we still believe there will be a regulatory comeuppance for their issuers.  The Senate has not finished with efforts to rein in speculation in the commodities markets, where much of the ETFs are based, and legislative attempts to place similar restrictions on the equities markets may be in the offing.  Remember, SEC Investment Company Division Head Donohue just spoke to the PLI about the broad disparity in ETF performance.  Could he be testing the waters for new regulation?  Have you ever known a regulator to show up on the rubber chicken circuit for anything else?

Last week, we theorized that the iShares transaction might be a way for the US to exert pressure on Luxembourg to prevent tax fraud, bringing them in from the cold.  This week, the picture gets bigger, better, and more connected. 

Barclays may simply be raising a bundle of cash the best way it knows how, in anticipation of writing a very large check to Mr. Morgenthau.  But there is a rub – indeed, more than one.

First, there is always the likelihood that the deal collapses on its own.  We detect a note of panic in the fine print surrounding how, and on what basis, Barclays actually gets its money and is able to get rid of the gigantic loan it has self-guaranteed.

Failing that, we are left with the following scenario: a major global bank which defrauded the US banking system has put up $3 billion of its own money in a self-guaranteed loan to a private firm in a country suspected of being a haven for tax fraud.  The bank has done this in order to book a quick profit – which it can report, but not spend, as it is still far from being actual money – in hopes that it will not have to dig deeper into its own pocket to bail out the buyer when serious regulatory problems blow up in their face.

Just speculating, folks.  But remember: you read it here.

Moshe Silver

Chief Compliance Officer