By Lowell Flanders*
In his book “The Devil’s Derivatives,” (Harvard Business Review Press, 2011) Nicholas Dunbar explains that in the early 1980’s the US and the UK produced most of their wealth from manufacturing actual products. A decade later the financial services industry was dominant in both countries. “The value of the financial assets held by banks, hedge funds, and other institutions” far exceeded, “the actual producing power,” of both economies and could be “measured in multiples of GDP.” The enormous wealth these people “generated and pocketed, fundamentally and irrevocably changed the world’s financial system, and very nearly destroyed it,” through the misuse of financial derivatives and other non-traditional investment strategies.
Warren Buffet, the “Oracle of Omaha,” one of the world’s wealthiest investors, was more direct. In the 2002, he called "Derivatives … financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." In his 2008 annual letter, Buffet said: "Derivatives are dangerous. They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks."
We witnessed the mass destruction caused when the market for mortgage derivatives exploded in 2008. The crisis was the worst U.S. economic disaster since the Great Depression. In the United States, the stock market tanked, wiping out nearly $8 trillion in value between late 2007 and 2009. Unemployment climbed, peaking at 10 percent in October 2009. Americans, alone, lost $9.8 trillion in wealth as their home values plummeted and their retirement accounts vaporized.
In all, the Great Recession led to a loss of more than $2 trillion in global economic growth, or a drop of nearly 4 percent, between the pre-recession peak in the second quarter of 2008 and the low hit in the first quarter of 2009, according to Moody’s Analytics.
But what are derivatives and why should UN Pension Fund participants and beneficiaries care about these obscure and little understood (at least by most of us) financial instruments? First the why and then the what.
Why Should UN Pension Fund Participants and Beneficiaries Care about Derivatives?
Why should we care? Because, derivatives and other “alternative” financial instruments are coming to a Pension Fund near you. The Secretary-General of the UN, who has fiduciary responsibility for investments of UNJSPF, in his report to the 75th Session of the General Assembly, called “Investments of the United Nations Joint Staff Pension Fund and measures undertaken to increase the diversification of the Fund,” (A/C.5/75/2) endorses a series of measures that will significantly alter the risk profile of the UN Joint Staff Pension Fund. Based on the Fund’s updated investment policy statement of August 2019, the SG indicates “that the Investment Management Division, may use exchange-traded futures, swaps and foreign exchange forwards (all derivatives) for the purposes of increasing the efficiency and lowering the transaction cost of implementing various investment strategies, as well as for risk management and hedging purposes.” In addition, “the Office may establish securities lending programmes and enter into repurchase transactions.” It is noted however that, “the use of such instruments would require the Fund to conduct margin trading,” or leveraging which requires borrowed money.
The Secretary-General then goes on to ask the GA for authority “to engage in borrowing for the limited purpose of performing such transactions and to the extent that such borrowing is required as an adjunct to the securities and instruments otherwise traded or used by the Fund and only for the Fund itself. In that regard, please note that any exposure of the Fund resulting from such borrowing would be adequately covered and collateralized by the assets of the Fund.” Please also note that any losses caused by this type of borrowing would be charged off to the assets held as collateral for the loans, meaning direct loss to the participants and beneficiaries of the Pension Fund.
The GA in its resolution 75/246. “United Nations pension system,” took note of “proposal of the Pension Board “to engage, for the first time, in a range of derivative instruments available to the Fund, to effectively manage the Fund’s investments and address the increasing complexity of the global capital markets environment, and in this context requests the Secretary-General to submit more detailed proposals to the General Assembly at its seventy-sixth session, including information on the use of derivative instruments, engagement in margin trading and participation in securities lending, as well as compliance measures, with a view to ensuring strict adherence to the existing policies and accountability framework and a cost-effective investment strategy, and authorizes the Secretary-General to conduct margin trading for the limited purpose set out in paragraphs 43 and 44 of his report on a trial basis for two years.”
The GA also requested “the Secretary-General to report on the use of these expanded investment strategies, including … their impact on the diversification of the Fund, in the context of his next report on the investments of the Fund, and to review the use of these expanded investment strategies and to report thereon to the General Assembly at its seventy-seventh session in order to determine whether to continue these strategies.”
From Trial Period to Foot in The Door?
While the GA approved the use of derivatives and other risky financial instruments on a trial basis, what starts as a trial often ends up as a foot in the door for more widespread use of these dicey financial instruments. In the past, UN investments have been based of a very conservative policy that includes consideration of 4 elements:
(1) Safety - ensuring adequate asset class, geographic, currency, sector and industry diversification, by careful due diligence and documentation of investment recommendations, and by constant review of the portfolio in order to position it optimally in light of economic and geopolitical trends, and resulting financial market movements.
(2) Profitability - requiring that each investment at the time of purchase be expected to earn a positive total return, taking into account potential risks such as market risk and credit risk which may be mitigated but cannot be eliminated by diversification.
(3) Convertibility - the ability to readily convert investments into liquid currencies. Due to the US dollar-based market valuation of the Fund, and the US dollar based appraisal of its actuarial soundness, all investments, at the time they are made, should be readily and fully convertible into US dollars.
(4)Liquidity - ready marketability of the assets in recognized sound, stable and competitive exchanges or markets.
It is not clear that the range of derivatives and borrowing being proposed, meets any of these criteria. Something might be claimed on profitability, but whatever the small upside profit to be made is greatly out-weighed by the risk of large, unforeseen losses. As we have seen from past experience, derivatives have the potential to bring down financial giants, even those who believed they were in complete control of the process.
The OECD and the International Organization of Pension Supervisors (IOPS) in its 2011 report, “Good Practices on Pension Funds’ Use of Alternative Investments and Derivatives,” recognized, “that riskier strategies are often inherent in alternative investments, given that some were initially designed for high-net worth individuals (with a high tolerance for risk). Such investments may be complex, illiquid or opaque, and therefore require careful scrutiny and analysis, and in many cases, more rigorous review and monitoring than most traditional products (particularly in times of volatility when correlations and other assessments may change). They also tend to be more expensive to manage than traditional investments. For smaller pension funds, or more generally funds that do not have well-developed internal investment and risk management teams, delving into alternatives often requires the use of fund of funds which, although they may provide a higher degree of diversification, adds another layer of cost. Exposure to alternative investments is therefore still limited for pension funds in some jurisdictions.” Why is the UN Pension Fund going in this direction at this time?
Why is the UN Pension Fund switching to these Risky Investments at this time?
So far, Pension Fund members have received no cogent and transparent explanation from the Secretary-General sharing the real motives behind this move. In his report to the GA, he provides some boiler plate about the aim being “to expand the range of instruments available to the Fund to more effectively manage its investments and address the increasing complexity of the global capital markets environment in a phased approach over the medium term.” But there is no explanation for the increased risk, participants and beneficiaries are being requested to bear.
Are we to take it only on faith that the Office of Investment Management (OIM) is capable of handling these financial instruments when, even high-level investment banks and hedge funds have failed. Moreover, we may also question the progress made by OIM in meeting the detailed proposals for managerial improvement outlined in OIOS Report A/75/215 of 21 July 2020, “Audit of governance mechanisms and related processes in the Office of Investment Management of the United Nations Joint Staff Pension Fund.”
The OIOS report describes an office environment rife with “divisiveness among staff and a culture that many staff described as “toxic”. … In addition to the perceived micromanagement by certain senior managers, the attitude and approach adopted by them in response to dissenting views and criticism were perceived as intolerant and even retaliatory.” OIOS said, “Such conditions pointed to the lack of an appropriate tone at the top with regard to the highest ethical standards of behaviour that are expected of officials entrusted with fiduciary responsibilities.” Doesn’t sound like the right environment to take on risky and complex derivatives when collective analytical skills and consensus are needed.
There have been some back corridor mumblings that this change of approach is due to poor financial results from some of our assets and generally weaker market returns all round. According to this, we are failing to achieve our overall "Long-Term Investment Objective,” or policy benchmark, which is to meet or exceed a 3.5% real rate of return (net of inflation, as measured by the US Consumer Price Index) in US dollar terms annualized over the long-term (15 years and longer). The GA in its annual reports regularly “Stresses the importance of continuing to achieve the necessary 3.5 per cent annual real rate of return on a long-term basis for the future solvency of the Fund.”
But how much of the fund’s assets are we willing to risk to meet the benchmark every year? Also, the future solvency of the Fund, doesn’t just depend on rates of return, although important. One other problem the Fund faces is having a sufficient complement of new and continuing staff (participants) to support retired staff or those about to retire.
The most troubling issue is the lack of real consultation with those who will be directly affected by this new investment strategy, including why it is necessary to diverge from the safe and conservative path the Fund has always followed in the past. This conservative approach got us through the 2008 financial crisis relatively unscathed, compared to many other institutional investors who were heavily committed to derivatives and other alternative investments. It is incumbent on all of us to tell our Pension Board representatives (in AFICS and FAFICS) and the Secretary-General to get off this slippery slope before financial disaster strikes.
What are Derivatives?
Derivates are complicated financial instruments that derive their value from an underlying asset or index. In and of themselves, they have zero intrinsic value. A good example is the mortgage derivative that caused such havoc in the 2008 financial crisis. Derivatives are often used to transfer financial risk to someone else, or to hedge investment risk. For example, this is what happened in the mortgage crisis of 2008. Local banks would grant loans (mortgages) to local people wanting to buy homes. The local bank would then sell their mortgages to larger banks or to the Federal Home Loan Mortgage Corporation (Freddie Mac), which is a government-backed agency that buys mortgage loans from lenders. They bundle those loans into mortgage-backed securities (MBS) (a derivative whose value is based on the underlying value of the combined mortgages) and sell them to investors in the secondary real estate market.
This all went bad starting in 2006/2007, when the Federal Reserve began raising interest rates. Many of those who took out mortgages had accepted adjustable-rate loans, because smaller down payments were required. When interest rates started to rise, adjustable-rate mortgage interest also rose, in some cases dramatically. Home owners started defaulting on their loans. But with so many mortgages rolled into mortgage-backed securities it was impossible to separate out the good loans from the bad. And since no one really understood what was in a package of mortgage-based securities, no one knew what their true value was. “This uncertainty led to a shut-down of the secondary market. Banks and hedge funds had lots of derivatives that were both declining in value and, which … they couldn't sell. Soon, banks stopped lending to each other altogether. They were afraid of receiving more defaulting derivatives as collateral. When this happened, they started hoarding cash to pay for their day-to-day operations.”[1] This ultimately led to the nationalization of Fannie Mae and Freddie Mac, the bailout of insurance giant AIG and the bankruptcy of Lehman Brothers Investment Bank, setting off a global panic towards the end of 2008.
Derivatives Come in Various Flavors
Mortgage-backed securities are only one type of derivative. There are many others, including: (1) Future contracts, or simply “futures,” an agreement between two parties for the purchase and delivery of an asset at an agreed upon price at a future date; (2) Forward contracts - known simply as forwards—are similar to futures, but do not trade on an exchange, only over-the-counter;[2] (3) Swaps - often used to exchange one kind of cash flow with another; (4) Options- similar to a futures contract being an agreement between two parties to buy or sell an asset at a predetermined future date for a specific price.
Pros and Cons of Derivatives
In a recent conversation someone suggested that derivatives can be like a football helmet to protect against the risks of rough play because they provide a way to lock in prices, hedge against negative interest rate movements, and mitigate risks—often at a limited cost. Derivatives are very often purchased on margin—that is, with borrowed funds—which makes them less expensive. But buying financial instruments on the margin or on credit, what is called leveraging makes investment in derivatives even more risky and questionable. Leverage in the 1920s stock market played a big role in the 1929 Stock Market Crash, just as leveraging in the housing market did in 2008.
Rather than a protective helmet, derivatives are more analogous to the Takata airbags in your car. You think they are keeping you safe, until they blow up unexpectedly in your face. Derivatives are complex instruments, which even Wall Street hot shots find difficult to manage and come out on the upside. Derivatives are also difficult to value because they are based on the price of another asset. The risks for OTC derivatives include counter-party risks[3] that are difficult to predict or value as well. Most derivatives are also sensitive to changes in the amount of time to expiration, the cost of holding the underlying asset, and interest rates. These variables make it difficult to perfectly match the value of a derivative with the underlying asset.[4] There is also the problem of potential scams. Bernie Madoff built his Ponzi scheme on derivatives. Fraud is apparently rampant in the derivatives market because the Commodity Futures Trading Center (CFTC) maintains a whole advisory list of the latest scams in commodities futures.
*Lowell Flanders joined the UN in 1970 and served in various capacities until his retirement in 2002. He served with the UN Relief Operation in Bangladesh, as Assistant Resident Representative with UNDP in Venezuela and with the Commission on Sustainable Development. He was active in staff affairs as President of the UN Staff Union for two terms.
[1] https://www.thebalance.com/role-of-derivatives-in-creating-mortgage-crisis-3970477
[2] Over-the-counter trading, or OTC trading, refers to a trade that is not made on a formal exchange. Instead, most OTC trades will be between two parties, and are often handled via a dealer network. OTC trading is less regulated.
[3] “Varying degrees of counterparty risk exists in all financial transactions. Counterparty risk is also known as default risk. Default risk is the chance that companies or individuals will be unable to make the required payments on their debt obligations. Lenders and investors are exposed to default risk in virtually all forms of credit extensions.”
[4] https://www.investopedia.com/terms/d/derivative.asp#real-world-example-of-derivatives
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