“Playing with fire”: AFTRA fund trustee David Browde defends failed speculative investment

I received an email today from David Browde, a trustee of the AFTRA Health and Retirement Funds. It is posted below.

The email is in response to my blogging here that the AFTRA fund put its assets at risk by participating in a securities lending program with JPMorgan Chase. Such a program provides AFTRA fund shares to short sellers who are engaged in highly leveraged and speculative bets against the future value of American businesses. Browde confirms this was the case but he attempts to blame the decision to invest in the program on a third party investment manager hired by the AFTRA fund. He ignores the fact that it was the two co-chairs of the AFTRA fund who signed the contract with JPMorgan Chase setting up the lending program.

If you take Browde at his word, pension fund trustees, elected by union members, are really not much more than bumps on a log when it comes to overseeing the deployment of the funds’ assets. Do we really want labor trustees to take a “see no evil, hear no evil” approach to labor retirement and health care assets?

He also attempts to defend the decision by saying that the investment strategy probably did not lose money over time. That ignores the policy question which I think should be a matter of concern to American unions of whether it is appropriate for union members’ retirement assets to be lent to speculators betting against American businesses.

Browde says such speculation can “provide value” to union members. But at what cost? At the cost of potentially destroying the jobs of members of other unions in other sectors of the economy? That is possible because short sellers can cause runs on the value of a company’s stock that can lead to financial distress for a company. It has been reported in the press that the AFTRA fund has now ended its participation in securities lending. Let’s hope so.

Now once the securities lending program was in place JPMorgan Chase, in turn, invested the funds generated from those loans in Sigma, an offshore tax haven entity known as a “structured investment vehicle” or SIV managed by a British hedge fund called Gordian Knot. Gordian Knot had some $57 billion under management. The SIV, headquartered in the Cayman Islands, invested its funds in mortgage and other asset backed securities that then lost billions of dollars when credit crisis hit, including millions of AFTRA’s funds.

The AFTRA fund is now suing JPMorgan, perhaps with justification, because the bank also lent money to Sigma when it was in real trouble but it received collateral that AFTRA did not receive. Browde appears to be suggesting that the AFTRA fund was unaware of the decision by JPMorgan to invest in Sigma. But he does not confirm that.

The public record, however, makes clear that the AFTRA fund did give explicit approval to JPMorgan to invest in “medium term notes” – an instrument that Browde does not appear to be familiar with, along with numerous other complex and risky financial instruments. It would be interesting to know, for example, how much the AFTRA fund co-chairs who approved the investment in MTN’s understood about them in advance of that commitment.

MTN’s are inherently complicated (if you don’t believe me, read here and time yourself before your eyes glaze over) and even more so when invested in an offshore tax haven run by a $57 billion hedge fund in London that in turn is investing those funds in asset backed securities. The critical issue about MTNs is that they are typically “unsecured” meaning there is no collateral backing up the investment. They pay a higher interest rate than secured debt but you are taking on more risk. And you are also taking on the risk that the issuer will raise other more senior debt that IS collateralized.

And that is what appears to have happened at Sigma – JPMorgan invested in Sigma through “repo” financing which did have collateral. The AFTRA lawsuit claims that one side of the bank essentially ran ahead of its other clients, jumping the line to get at the secured debt of Sigma, knowing it would collapse and thus allowing the bank to take over the collateral. There may be something to this but of course the bank will argue it was lending money to Sigma because it needed the money to survive and that that would have, in ordinary times, helped the SIV to stabilize rather than collapse.

Now, to suggest that this transaction was not “complicated” or is not, in Browde’s words, “playing with fire,” beggars belief.

There is very little disclosure available to the public about this transaction (one reason that these kinds of deals are done off shore). But had AFTRA trustees asked they could have learned whatever they wanted to know about these instruments. They have sufficient bargaining power to do so. They could also have easily placed limits on how JPMorgan could invest union members’ assets such as not putting any assets into speculative short selling or into offshore tax havens.

It appears that Browde’s argument is that if the trustees personally did not engage in due diligence to understand the risks it was because the losses sustained were “non-material.” Well let’s be grateful the amounts were relatively small but are they really not material? If not material, then why is the AFTRA fund spending more member money trying this lawsuit? And if they now want to blame their investment managers for the decision, why not sue them, too? In any case, it would certainly seem material to a fund’s beneficiaries to learn whether or not the fund was engaged in speculative, complicated and inherently risky transactions apparently without adequate oversight

The AFTRA lawsuit is innovative and interesting and they may prevail but that has nothing to do with whether it was sensible to 1) try to make money supporting short sellers speculating against American companies; and 2) invest in un-collateralized financial instruments that were in turn invested in an offshore tax haven run by a British hedge fund.

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Prof. Diamond:

While you’re certainly entitled to express an opinion regarding the wisdom (or lack thereof) of a pension fund participating in a securities lending program, your postings regarding the AFTRA H&R Funds appear to be lacking in factual underpinning. Thus, this e-mail, based on information provided to me by the H&R Funds staff.

The AFTRA H&R Funds first participated in the JP Morgan Securities Lending program in December 2005. The participation was not expected to yield huge returns, rather, it was designed to offset the cost of the custodial services JP Morgan provided the Funds. The risk factor was seen as commensurate with the return offered: relatively low on both sides of the equation, but potentially providing value to the members by offsetting a not insubstantial cost.

While we’d certainly have hoped for more in terms of yield, even with the loss related to the Sigma vehicle the program, over its life the Securities Lending program is within $100,000 of a break even, something not at all material in a fund of this size. Final totals aren’t yet available, as, though AFTRA’s Trustees have voted to terminate the program, it still is not completely unwound.

To your other points, relating to the “complicated” nature of the transaction(s) and the “offshore tax haven” – you appear not to understand the decision making process within a Pension Fund. The 22 Trustees do not meet to decide whether we’re going to invest in GE or Apple stock. Nor do we pass on individual – or even aggregate – transactions. Our decision making process starts with the hiring of an Investment Advisor – in our case a company called Meketa Investment Group, which also advises several other entertainment industry funds.

With Meketa we review the funding requirement provided by our actuarial consultants. The question to be answered is, “What is the most prudent allocation model to meet the cash requirements the Funds foresee?” In other words – how much do we need to make on our investments in order to both pay current pensions and continue to grow the fund to have money to pay for those pensions that will accrue in the future.

Using that requirement – and projecting 30 years into the future – we attempt to come up with the most risk averse investment allocation model that is predicted to yield the desired return. Typically – and on the very broadest level – this involves an allocation with a certain percentage to stocks, a certain percentage to bonds and a certain percentage to “other,” or alternative investments. Within the three categories are subcategories. For stocks, those include domestic large cap, domestic mid cap, domestic small cap, and foreign. Large cap is further subdivided into Core, Value and Growth. Alternative investments include infrastructure, real estate, private equity and a variety of others…

We hire individual companies as what you might call “sub-managers” in each of the subcategories – large, well known firms that are both top performers in their fields and ERISA fiduciaries. The performance of these firms is measured at least quarterly on an absolute return basis, relative to benchmarks and relative to their peers.

Before hiring the firms are screened by the Investment Advisor and by legal, and detailed contracts are negotiated. Within their areas of permitted operation the submanagers have autonomy to make investments, subject only to the terms and limitations of their contracts with the H&R Funds. This is the only practical way for unions to manage their funds – the Trustees are not investment professionals – half of us are union members or staff, the other half are management representatives who tend to be career executives in Labor Relations. We can’t sit and make buy/sell decisions on billions of dollars in investments – that’s neither prudent nor practical.

While they have broad autonomy, none of the investment firms are permitted to be their own custodians – thus a Madoff scam can not take place…but, therefore, a custodian is necessary, and that custodian charges a fee to hold the securities in our portfolio. That custodial cost can be substantial, even if not material in terms of the overall fund. It is that cost that the Trustees back in 2005 sought to offset by income from Securities Lending – something that but for the Sigma issue would have worked out quite nicely, and, even with Sigma, it was far from a “play with fire” scenario, and certainly did not result in our members getting burned.

The non-materiality of the loss to the AFTRA Funds from Sigma notwithstanding, it is my view (shared, I suspect, by the other Trustees who voted to participate in the litigation) that it is our responsibility to take all prudent steps to recover sums on behalf of the participants in the Fund. Without the litigation there is no likelihood of recovery of any of the Sigma related moneys. With the litigation we expend some staff time, but little more. The risk/reward ratio of participating as one of three lead plaintiffs in a class action suit, therefore, seems reasonable.

Of course you’re free to disagree.

David Browde
Trustee, AFTRA H&R Funds

Disclaimer: Though the above is based upon information provided me by the H&R Funds staff as a Trustee it should not be taken as a position or official statement of the Funds or of AFTRA, of which I am a member of the National and New York Boards of Directors.

3 thoughts on ““Playing with fire”: AFTRA fund trustee David Browde defends failed speculative investment”

  1. Mr. Hughes:

    Thanks for the suggestion. However, here’s the result of a little research into the two main Domini funds:

    DOMIX – the foreign fund – has losses since inception in Dec. 2006 of about 6%.
    DSEFX -the domestic fund – has losses since 2000 and is down over 20% since Dec. 2006. Since inception in about June 1991 it trails the S&P by a substantial increment.

    http://finance.yahoo.com/echarts?s=DOMIX#chart4:symbol=domix;range=my;compare=dsefx;indicator=volume;charttype=line;crosshair=on;ohlcvalues=0;logscale=on;source=undefined

    The expense ratios (1.25% for DSFEX, 1.6% for DOMIX) are also out of line with our investment profile, perhaps because the Dominici funds are small, geared to individual investors putting in $1500-2500, not to pension funds.

    In my view, while the stated goals of the funds may be laudable, neither the results nor the expense ratios make the funds attractive for a pension fund that seeks an annual return of 8%.

  2. David Browde writes that “… there certainly would not be universal agreement that forgoing return in exchange for some hypothetical ‘socially conscious’ investment policy would not conflict with the fiduciary duty to seek optimum returns for the members”.

    Nonetheless, ‘socially conscious’ investment policies exist with real profitability in the real world.

    Employing socially conscious investment criteria in the management of an investment pool favors investments in enterprises that practice good governance, contribute to a clean, healthy environment, treat people fairly, embrace equal opportunity, produce safe and useful products, and support efforts to promote world peace.

    Nonetheless, the performance of any investment pool being managed using socially conscious investment criteria is expected to be competitive with non-screened investments with similar risk characteristics.

    Taking the discussion of long-term vs. short-term speculative investments to a socially conscious level, socially conscious investing looks at long-term vs. short-term corporate focus

    In comparison to countless corporations taking advantage of natural assets and exploiting human labor for short-term profits, a socially responsible stock drives under long-term natural sustainability.

    Chevron and Exxon Mobil have experienced exponential expansion in the last numerous years.

    Nonetheless, in ten or twenty years the oil rigs will be pumped dry and consumers will have switched over to hydrogen-fuel cars.

    In stark contrast, socially conscious investing stresses the long-term sustainability of corporate social responsibility on the environment, society, and monetary well-being.

    Socially conscious investing analyzes whether a company’s business practices are sustainable in the long term. If the business operations negatively impact the environment, economy, communities, or human welfare, then it is not considered sustainable investing for long term profitability.

    Thus socially conscious investing analyzes a company’s policies regarding employees, community, investors, stakeholders, and the environment .

    Social screening reduces the economic risk of the individual corporate holding.

    By not choosing to invest in tobacco, socially responsible investors shield their portfolios from the negative performance factors of lawsuits.

    By selecting companies that have good relations with their employees, the socially responsible investment portfolio does not suffer the negative financial impact of strikes.

    Socially responsible stock portfolios include international holdings.

    Socially conscious investing analyzes foreign governments’ actions, either on an individual country case-by-case basis, or based upon an international mandate, such as a ban by the UN or NATO.

    It has been well demonstrated that socially conscious investing can be done quite profitably.

    In fact, in some market conditions, socially responsible funds outperform their market counterparts.

    The Domini 400 Social Index (DS 400), the socially responsible investing industry benchmark, has outperformed the S&P 500 since its inception in 1990.

    Domini Social Investments announced just a week ago that the Domini Social Equity Fund (Nasdaq: DSEFX) ranked in the top 10% of its peer group for the 1-year and 3-year periods ended March 31, 2011.

    The Domini Social Equity Fund works to bring universal human dignity to those who lack it and ecological sustainability to our planet.

    “We are proud to contribute to investors’ triple bottom line: people, the planet, and profit.”

    The DS 400 screens its index for socially responsible stocks based upon environmental, governance, and social filters, and within its index, there are 250 S&P 500 represented companies, 100 companies not on the S&P 500, and another 50 socially responsible stocks that have demonstrated significant strength in social investing filters.

    Socially conscious investment policies would not “conflict with the fiduciary duty (of the AFTRA Pension Fund Trustees) to seek optimum returns for the members”.

    There is nothing “hypothetical” about socially conscious investing.

    Socially conscious investing can match or outperform its market counterparts –dispelling the myth that a socially responsible investor must kill performance for social consciousness.

  3. While I appreciate your posting of my e-mail, your characterization of what I wrote defies both logic and my specific words.

    Far from suggesting that Trustees on either the labor or management side are “bumps on a log” or in a “hear no evil” posture – we do what we were elected/selected to do. We set policy and make sure it is being followed. On those rare occasions when it isn’t being followed we take corrective action.

    We are not operational managers and do not make individual investment decisions, any more than the Board of Overseers of a University makes individual decisions as to its specific endowment holdings or, for that matter, a decision on whether an individual professor gets a raise.

    They hire people who specialize in those functions. So do Pension Fund Trustees, whether in the union world or in corporate plans.

    That is not an abrogation of due diligence, nor a suggestion that we or others do not perform it. Our due diligence, however, is at a different level.

    For you to suggest otherwise is disingenuous in the extreme. It is also absurd for you to attempt to characterize any individual or group of Trustees’ knowledge as to any investment vehicle, as it is for you to generically suggest something inappropriate about an investment in “medium term notes,” especially based upon an e-mail that made no mention of them.

    Is that seriously your suggestion? That medium term notes are inappropriate investment vehicles for a pension fund? Or that the Trustees of a multi-billion dollar fund should meet and decide whether to buy or sell specific stocks or bonds? Which union members or management representatives would you suggest should handle those tasks? When?

    I have made and am making no statement of any kind as to the specifics of the litigation related to Sigma, for obvious reasons. If you want that kind of comment, you should contact the attorneys handling the case.

    What I offered was specific detail as to the nature of the investment, how the decision to invest was made and what the result of that decision was – a securities lending program that instead of making a relatively small amount of money ends up approximately at a break even point. So much for your claim of the members getting burned.

    There may be a legitimate debate as to whether union pension funds (or others) should limit their investments to some social standard. However, one person’s social standard may not be another’s…and there certainly would not be universal agreement that forgoing return in exchange for some hypothetical “socially conscious” investment policy would not conflict with the fiduciary duty to seek optimum returns for the members.

    Ultimately, if you follow that line of reasoning to its logical conclusion no union fund could ever hold the stock of a company which has union workers, since obviously corporate owners seek to limit union pay. Not investing in companies with union workers is an obviously contradictory and ultimately unsustainable investment policy.

    But perhaps most surprising is your criticism that “the AFTRA fund put its assets at risk…” Every investment involves risk. One gets paid for taking that risk in the form of returns.

    If you don’t understand that premise you shouldn’t invest in anything more complicated than a Treasury bill – but, of course, as we’ve seen, those T-bills have an increasing risk premium too.

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