The Kresge Foundation knew they had taken the position
before it was published in the [Wall Street]
Journal, and were in Troy, Michigan,
according to Kresge CIO Robert Manilla, on May 15, referring to
the J.P. Morgan announcement a few days earlier of a $2 billion
loss in its London-based hedging unit known as the chief
Losses from the Whale Trade, as it is now known, are
estimated at close to $9 billion.
So with all that extra time to watch the trade unfold, what
do institutional investors think of that loss and its
consequences, both regulatory and reputational?
Manilla was, on that morning, sitting with seven other top
pension, endowment and foundation investors in New York City
for a roundtable discussion after Institutional
Investors Money Masters awards dinner. Joining
Manilla were Donald Lindsey, CIO at George Washington
University; Lawrence Schloss, CIO of the New York City Employee
Retirement System; Douglas Brown, CIO of Exelon Corp.; Conrad
Freund, COO of the LA84 Foundation; Sean Gissal, CIO at
Marquette University; Joshua Gotbaum, director of the Pension
Benefit Guaranty Corp.; and Lee Partridge, CIO at Salient
Partners and CIO of the San Diego County Employees Retirement
Editor Michael Peltz and Senior Writer Frances Denmark
facilitated the two-hour discussion, excerpts of which appear
below. The full roundtable will appear in the July-August issue
of Institutional Investor and, along with some other
timely excerpts, on the website.
Larry Schloss: It is terrible timing.
Robert Manilla: Yes, thats a huge
issue. If youre going to hedge, you have to spend money
to do it, and quite often youre going to waste that
money. We occasionally take views on the market, when we think
things are overbought or oversold, and well hedge it. We
set a hedging budget each year. Were willing to spend up
to almost a percent of the fund on hedging if we think there
are markets that need to be hedged, so thats spending
premium, usually. Hedging is expensive. Ideally, wed
rather just take the cash back and de-risk the asset
allocation, but thats not always an option.
Joshua Gotbaum: Theres another thing
thats going on, which is learning. As financial markets,
financial instruments and the global markets change, all
institutions are simultaneously in the process of taking risks
and learning about the risks theyre taking, and then
putting in place governance and oversight structures to manage
those risks once they understand them. Thats a
never-ending process. The fact that there was a mistake at J.P.
Morgan, and it wasnt caught, doesnt mean that
people shouldnt try to recognize the risks. It is that
they should pay attention and correct afterwards.
Manilla: The issue was the size of the
position relative to the market. Kresge Foundation knew they
had taken the position before it was published in
the [Wall Street] Journal and
were in Troy, Michigan. Every hedge fund in New York City
knew he had the position in the CDS tranche, so certainly there
are execution issues. But if they had lost $2 billion because
they werent hedged on their book, would you have seen any
different fallout? I think what they really lost is political
Lee Partridge: The size of the market
versus the size of their book
its a $2 trillion entity. New
York City is not a $2 trillion entity. I mean, there are things
that you can do and you cant do at different levels. We
took a bet, it went wrong, were moving on; its
de minimis in the grand scheme of things. It was more
that we didnt understand.
Gotbaum: In the context of a debate over
whether institutions can govern themselves, they need an extra
pairs of eyes. Not because they will prevent every mistake from
being caught, but they may increase the rate at which you
learn. This mistake came at a time when the financial services
industry was saying, ignore the last three years, were
okay. If weve learned anything it is that financial
markets are sufficiently interrelated that we need multiple
sets of eyes.
Partridge: I completely agree with that,
and the question is, in this whole pendulum swing from
laissez-faire economics to overregulation, you just had the
king of the financial industry say we need a second set of
eyes. I always wonder about the unintended consequences. What
is our phone book of regulations going to look like moving from
Conrad Freund: It was so poorly handled
subsequent to that, Jamie Dimon saying we were stupid. I
dont think you want to be saying those things. You want
to have a more rational response.
Donald Lindsey: You cant regulate
uncertainty, too. The longer youre in this business and
the more you learn, the more you realize what you dont
know, and thats always going to be the case. The
uncertainty factor has to be accepted. No amount of regulation
is going to prevent that.
Freund: That wasnt the message that
came out afterwards. Instead of taking a reasonable approach by
saying its $2 billion, but out of a bucket of assets
thats this big, were moving on, there were comments
that lead to more making the phone book thick. That was really
Douglas Brown: I think the risk is this one
event has unduly influenced the discussion with the regulators
and the legislature. And in the sound-bite media frenzy
surrounding this event, the risk is that the regulators and the
legislature wont truly take the time to figure out
exactly what happened and how that should influence the
legislation. I think thats the biggest risk.
Manilla: I do think theres one thing
thats clear. Defining the risks in the system is getting
much more difficult to do. Because what weve seen is most
of the bad hedging or the blowups at hedge funds or even
in this case is because its really hard to define
your risk and then find a hedge that cleanly offsets it. So in
trading lingo, its really a dirty hedge. And youve
seen that happen now numerous times where people thought they
were hedged, and their hedge didnt behave opposite their
asset. I think this points to the fact that the system is much
too complicated today to truly understand all of the risks
Partridge: There is a rule of law. The
taxpayer should be the most senior player in this whole capital
structure. Somehow the taxpayer continues to be structurally
subordinated, eating all these losses and bailing out either
debt holders or equity holders.
Lindsey: The issue of transparency is huge.
I think its going to be extremely important going
forward. A lot of us, ten years ago even five years ago
were willing to invest in strategies with limited
amounts of transparency. The hedge fund community has been
pretty much responsible for a lot of the lack of transparency
in other investment strategies. Thats changing. I
remember a time when fund managers would say, even if we gave
you that position, what could you do with it? And maybe ten
years ago that was true, but technology has changed to the
point where having the visibility, knowing whats in your
portfolio at all times, is doable; and the technology can
provide a lot of feedback. Its not going to prevent
mistakes, but its going to raise red flags that you can
question. So I think as institutional investors, transparency
should be demanded more, it should be emphasized
Schloss: Its a very complicated thing
going on with J.P. Morgan in the city and shareholder activism.
Ill tell you my speculation on J.P. Morgan. They knew
exactly what they were doing. It is a $2.5 trillion balance
sheet, but this is the hedging department. Their job is to
hedge, and they screwed up a hedge. Thats all it is.
Its not more complex, nothing nefarious. You could
disclose it all you like. They made the classic Wall Street
mistake of overly believing their people knew what they were
doing because they made them a lot of money in the past.
But its exactly what everybody would want. Youd
want some group to assimilate all the risks in the firm in one
über risk sensor, so its not in little pockets,
right? Its disclosed as transparent. This is our risk
management department, and were putting on the overlay.
Thats what they did, and they got it wrong. You
cant regulate to be right. They made a mistake.