Fund Directors Oversight of Derivatives. Mark Perlow Mutual Fund Directors Forum San Francisco Chapter Meeting April 2, 2008

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1 Fund Directors Oversight of Derivatives Mark Perlow Mutual Fund Directors Forum San Francisco Chapter Meeting April 2, 2008

2 Overview Investment issues: Complicated and legitimate reasons to use derivatives in many funds portfolios Intricate and fast-changing economic risks associated with the use of derivatives Regulatory, legal and operational issues: Detailed and opaque regulatory and tax structure applying to derivatives requires great expertise Derivatives impact all aspects of fund operations and accounting Roles of Fund Manager and Directors: Management company should have day-to-day responsibilities for implementing, monitoring, testing policies and procedures Directors should discuss issues, policies and procedures with manager, and monitor and oversee their implementation

3 Overview The SEC staff has stated that fund boards have the responsibility to ask questions about: The reasons a fund uses derivatives The risks of using derivatives The effectiveness of internal controls regarding: Risk monitoring Compliance with investment guidelines Compliance with regulatory requirements

4 Derivative is not a dirty word Reasons to use derivatives Flexibility to implement investment and hedging strategies across markets Access to broader set of investment opportunities Ability to implement investment views with minimal portfolio disruption Avoid or hedge against involuntary risks Transact for less or minimal cost v. cash instrument Optimize capital usage through minimal upfront cash outlay

5 Typical Uses of Derivatives in Fund Portfolios Interest rate futures used to manage duration and yield curve exposure Interest rate futures more liquid, easier to sell short, more anonymous than cash instruments Allow for flexibility in implementing security selection decisions while minimizing risks in term/duration structure of portfolio Interest rate swaps more easily tailored than interest rate futures, used to implement sovereign relative value positions, swap spread trades Index credit default swaps used to manage sector over/underweights against benchmark Single name credit default swaps used to implement issuer long or short strategies or to calibrate issuer risk

6 Typical Uses of Derivatives in Fund Portfolios Currency forwards used to express FX views or hedge non- USD exposure, e.g., enter into currency forward in the same principal amount as non-usd investment Total return swaps and credit-linked notes to gain synthetic exposure to foreign markets Local settlement can be difficult and costly, e.g., underdeveloped infrastructure, taxes and tariffs, regulatory registration and requirements Asset-backed securities such as MBS, CDOs, CLOs, CMOs used to gain additional yield in exchange for greater but supposedly manageable risks Needless to say, this view has changed, but it was based on once-plausible assumptions about diversification and noncorrelation of risk in underlying assets

7 Recent Problems with Derivatives ABS CDOs: Higher than expected default rates in underlying debt Credit rating downgrades Results: illiquidity, valuation problems ABCP/SIVs: Illiquidity in underlying asset-backed collateral CP can t be paid on schedule Results: forced renegotiation of terms, money market fund sponsors buying out/guaranteeing downgraded instruments Problems in ABS/MBS/CDOs are particular to securitized debt structures and their derivatives, e.g., ABX instruments

8 Recent Issues with Derivatives Credit Default Swaps Buffett: Weapons of mass financial destruction Bill Gross: used by a shadow banking system to dodge reserve requirements, a pyramid scheme of leverage leading to a more thinly capitalized banking system. But: The liquidity and mechanics of the deep CDS market have held up well, although spreads have widened. Critique speaks more to systemic vulnerabilities

9 Recent Issues with Derivatives Explosion of litigation related to subprime mortgages and mortgage-backed securitizations Securities fraud suits against underwriters and mortgage originators alleging failures to disclose exposures/losses to shareholders and risks of underlying mortgages to ABS investors, aiding and abetting hedge fund collapses, misconduct of bankrupt mortgage originators Fraud suits against credit ratings agencies alleging failures to disclose flaws in ratings ERISA fiduciary suits against investment managers alleging reckless investments in high-leverage, high-risk mortgagebacked securities

10 General Risks Associated with Derivatives Market risk: that the market value of the derivative will decrease as a result of market factors or conditions; amplified by leverage, which is sometimes embedded in the instrument rather than explicit Basis risk: that the value of the derivative does not react as expected to the value of the reference instrument Credit risk: the fund s exposure to a default by the counterparty Legal risk: that the underlying documentation is unenforceable or does not capture the parties agreement Operational risk: that systems and/or personnel are not capable of managing a derivative and its accounting Tax risk: that tax treatment of a derivative is mishandled, uncertain, or changes unexpectedly Regulatory risk: that the fund will not comply with the myriad of regulatory requirements for investments in derivatives

11 General Risks Associated with Derivatives Market risks can include the following: Interest rate risk Market level risk Currency risk Commodity risk Reinvestment risk

12 Regulatory Issues with Derivatives Valuation Rule 22c-1 requires daily valuation of portfolio and securities at market prices if readily available and, if not, good faith fair valuation by board or under boardapproved procedures and methodologies. Exchange-trade futures and options: look to price quotes on relevant exchanges OTC derivatives: dealer quotes, frequently delivered by pricing services

13 Regulatory Issues with Derivatives Problems with dealer quotes: If the instrument is customized or exotic, valuation will be more difficult: there may not be market comparables, or the dealer may rely on an internal model. Dealers sometimes provide accommodation quotes high quotes that both parties understand that the dealer will not honor to avoid offending large customers Dealer models present a conflict of interest and are less reliable than market-based prices. Tips: The manager should document its understanding with the dealer as to the model and its inputs The fund should have procedures to check or verify the quotes

14 Regulatory Issues with Derivatives Recent Valuation Issues with ABS/CDOs/ABCP As underlying default rates have increased, credit ratings have been cut, and buyers have retreated from opaque structures, issues have become illiquid: No readily available market prices Dealer pricing has dried up or low-balled Spillover effects into non-subprime markets In response, fund managers have: Used internal models Engaged third-party pricing consultants FAS 157 gives some guidance: Whether an active market exists Conditions and disclosure around use of models, especially Tier III models involving unobservable inputs

15 Regulatory Issues with Derivatives Testing dealer quotes and model-generated values Validate documented model inputs and assumptions and use of observable proxies Occasionally ask the dealer to execute at the quote check against accommodation quotes test of the dealer s model Back-test against later market sales, disposition prices Obtain portfolio managers feedback on prices

16 Regulatory Issues with Derivatives Liquidity: 85% of portfolio must be liquid can be sold at approximate value on fund s books within seven days. Liquid derivatives include: Interest rate futures Exchange-traded options and futures Currency forwards and futures (can be closed with offsetting transaction) Credit default swaps (can be closed with offsetting transaction) Illiquid derivatives include: Interest rate swaps Now, most ABS, CDOs, SIVs. Not true one year ago.

17 Regulatory Issues with Derivatives Senior Securities and Leverage Section 18(f) prohibits funds from investing in senior securities, which the SEC interprets to include derivatives that create both leverage and a special claim on fund assets, e.g. forwards and swaps. The SEC will not treat derivatives as senior securities if a fund: covers its obligations with a position fully offsetting the exposure, e.g., writing a covered call, or segregates or earmarks liquid securities equal in value to the fund s obligation under the instrument, e.g., full purchase obligation in delivery-settled futures, or net obligation in cash-settled futures No SEC guidance on coverage for many derivatives, esp. swaps SEC has warned directors that significant levels of segregation can impair fund management/strategies and thus should be monitored and/or limited

18 Regulatory Issues with Derivatives Compliance with Investment Guidelines Prospectus/SAI disclosure regarding objectives and policies, limitations and diversification Limits on investments in illiquid securities: 15%, 10% for money market funds Illiquid if cannot be sold in the ordinary course within 7 days at approximately the value used for NAV Many derivatives are illiquid because not freely transferable Rule 12d3-1 limits investments in securities-related business to 10% of issuer s outstanding debt securities, which limits use of counterparties Names rule 35d-1 requires 80% of assets be invested in securities suggested by name of fund How to determine issuer and value of derivative for this purpose?

19 Tax Issues with Derivatives Pass-through tax treatment requires that funds meet 2 tests: Qualifying Income : at least 90% of fund s gross income must derive from investment-related income Not always clear if income from a derivative qualifies. E.g., recent IRS ruling that income from swaps based on commodities indices are not qualifying, but that from commodities-linked notes is. Asset Diversification : two prongs At least 50% of the fund s assets cannot be invested in securities in which the fund has invested more than 5% of its assets or of which the funds owns more than 10% No more than 25% of the fund s assets may be invested in one issuer or two related, controlled issuers, or PTPs Not clear: if a derivative is a security, how to value the derivative or determine the identity of the issuer for purpose of this test Sound procedures and sophisticated personnel are essential

20 Operational Risks Associated with Derivatives Accounting and internal controls. Derivatives present distinct issues: The return on many instruments is linked to many factors and may not be apparent to inexperienced fund accounting personnel Many derivatives do not settle in cash; internal controls tied to cash settlement may not detect the closing of a position E.g., currency forwards, interest rate and credit default swaps Exchange-traded futures require posting initial and variation margin Accounting treatment for some instruments is unsettled and can change unexpectedly, e.g., change of tax-exempt inverse floaters from sales to secured borrowing treatment Internal controls should be specific to each type of instrument and implemented by knowledgeable personnel

21 Operational Risks Associated with Derivatives Issues with Legal Documentation: OTC derivatives require complicated documentation, including a master ISDA agreement, separate annexes for collateral and other issues, and a separate confirmation for each transaction No CUSIP, straight-through processing or position reconciliation with the custodian s records. Extra care must be taken in recording position Confirmations are generally manually prepared on paper several days after the trade. Backlog in CDS, equity TRS markets led to industry-wide efforts to standardize confirmations and electronic methods of delivery, including an industry warehouse for conforming swaps Managers still must develop a system to monitor outstanding confirmations for timely and accurate completion Collateral annexes frequently require variation margin. Monitor!

22 Economic Risks Associated with Derivatives Managing market risk: the manager should have well-defined procedures to define, measure and manage the fund s market risk, including derivatives exposure Define and understand the instrument, its embedded leverage and how it reacts to changes in the value of the underlying as well as all relevant market factors. Deconstruct into all unique and separable components. E.g.: Is the leverage or the performance non-linear? Is there basis risk, especially if it is used as a hedge? Does it create a long or short position in volatility? Periodically evaluate the creditworthiness of counterparties VaR, stress-testing and scenario testing. Tested scenarios should include the evaporation of liquidity.

23 Oversight of Use of Derivatives Evolving Practices: Derivative or new instrument committee or staff Membership covers each area of risk, i.e., investment officer, lawyer, compliance personnel, risk manager, accountant Each new instrument, before approval for investment, must have responsible party sign off that relevant risks are addressed and procedures implemented Ongoing monitoring and re-evaluation Can include board presentation and approval Matrix of derivatives, risks presented and procedures addressing Regular board reports by PMs, risk managers, fund accountants, CCO Position limits or monitoring, which must account for the instrument s effect on the overall portfolio

24 Principles of Oversight Don t paint derivatives with a broad brush Some derivatives are liquid, widely used, accomplish goals cheaply Even time-tested derivatives require monitoring Push SAI disclosure of types of derivatives used

25 Principles of Oversight Find out why and whether the adviser should use derivatives Be sure there s a good reason for adding derivatives Ask how the derivative will help the fund meet its objective Determine whether derivatives are suitable for the fund Assess the investment risks of each type of derivative

26 Principles of Oversight Determine the adviser s competence Assess the adviser s and service providers abilities Examine any track record of using derivatives Ask CCO, CRO, auditors about the adviser s due diligence Review error reports Be sure the adviser has a process for evaluating new instruments

27 Principles of Oversight Scrutinize the back office Evaluate its competence in derivatives Interview fund accounting about their procedures Find out if/how internal audit will monitor Review and understand the adviser s tests of controls Ensure the adviser has the proper controls

28 Principles of Oversight Conduct ongoing assessments Continuously monitor the use of derivatives Ask about failures and successes and the reasons for each Be sure of the reporting process for derivatives Make sure you understand the adviser s reports Focus on exceptions and breaches

29 Principles of Oversight Be wary of pricing and valuation difficulties Verify that pricing process are effective Examine sources of pricing; be wary of counterparty sourcing Regard unconfirmed transactions with caution Look at, beyond pricing tolerance checks

30 Principles of Oversight Educate the board Continuing education, internal and external Know enough to ask the right questions

31 Principles of Oversight Understand the tax ramifications Consider tax effects before adding a derivative Ask whether the adviser understands tax effects Ask whether the adviser has discussed tax effects with auditor

32 Principles of Oversight Weigh conflicts and custody considerations Be aware of the conflicts, legal issues arising from derivatives Be sure that legal, compliance, risk functions understand and monitor Scrutinize trade allocation, segregation Monitor adequacy of derivatives disclosures Understand derivatives custody arrangements