Principles Newsletter Q2 2008
I. A Financial Markets Perspective
So far in 2008, the global credit crunch has continued to broaden far beyond its initial manifestation in U.S. subprime mortgage securitizations. Investors have been bombarded almost weekly by news of escalating financial turmoil. And the stock market’s sharp rallies on successive Federal Reserve interventions have provided only temporary relief from a more persistent downward trend. Stocks are now burdened by a variety of forces, including worsening conditions in the housing and mortgage markets, concerns about loan losses and capital reserves at major investment and commercial banks, a bleaker outlook for global economic growth, and mounting inflationary pressures from sharply rising commodity prices. Four common threads underlie these seemingly disparate events:
The first three are relatively new phenomena, while the fourth is age-old.
The Price of Easy Money
Low short-term rates and a positively sloped yield curve have provided some relief for financial institutions, and have ameliorated the pain felt by income-short homeowners facing adjustable rate mortgage resets. Unfortunately, the same monetary ease and resultant low interest rates inflated overall financial asset values, encouraged high levels of leverage and produced much of the debt at the heart of today’s global credit problems.
The Chicken or the Egg
While low-quality mortgage lending was primarily a U.S. phenomenon, distribution of the resulting subprime securitizations was global. Financial product innovation included other potentially troublesome structures, such as Eastern European mortgages that offered low interest rates linked to currencies such as the Swiss franc and Japanese yen — a situation now beginning to unwind. Moreover, global hedge funds borrowed heavily in these same low-yield currencies to fund highly leveraged speculations in higher yielding Australian or emerging market debt.
On the lending side, greed appeared in the numerous cases of financial institutions brushing aside the traditional wisdom of “never borrow short and lend long”. Commercial bankers have learned this lesson countless times over the years, but Northern Rock in the U.K. and many structured investment vehicles (SIVs) foundered when markets froze and they could not roll over short-term borrowings to fund longer-term lending. The recent problems involving auction rate notes and variable rate notes — which allowed corporations and municipalities to borrow long-term while paying lower short-term rates — share the same root cause. Of course, investors in these products were encouraged by Wall Street, which earned hefty fees from such business.
The Slow Unwind
The ratings agencies have begun the process of downgrading questionable debt. But they seem reluctant to institute the major downgrades that, in some cases, appear to be implied by bond prices. Having already suffered considerable negative press for enabling the growth of the subprime and structured product industry, the agencies may now be loath to further undermine the stressed financial system.
To their credit, the Federal Reserve and Treasury Department have been timely and innovative in calming market panic and working to alleviate systemic financial stress. And there is substantial global capital on the sidelines ready to buy up distressed mortgage and corporate paper once valid pricing has been established, yet it will likely remain there until price uncertainty is removed. The housing sector and related industries probably face a multi-year period of weakness, and it will take time for capital constrained financial firms to repair their battered balance sheets. The establishment of a floor for valuations of troubled debt structures is a prerequisite for recovery of investor confidence.
Portfolio Positioning and Risks
High quality bond exposure has been very effective year-to-date in hedging stock market risk. CBIS expects quality bonds to maintain their value over the near term, whether or not stock market conditions stabilize. However, analyzed on a longer-term basis, the current low yields offered by Treasury debt seem unsupportable, as implied real interest rates are negative and inflation risk appears to be increasing.
In our view, the trade-off between stocks and bonds will tend to favor equities as 2008 progresses. Additionally, the Federal Reserve’s low interest rate policy and foreign investors’ increased discomfort with U.S. debt will likely encourage further international diversification away from the U.S. dollar. We believe that our recent recommendation that participants shift an additional 10% of their domestic equity exposure to international equity exposure remains a prudent one.
A focus on high-quality issues in CBIS bond portfolios has avoided many of the pitfalls in the debt markets. Interest rate spreads on investment-grade corporate and mortgage debt have widened sharply in recent months, and now offer what we believe are attractive opportunities for our sub-advisers to purchase undervalued securities and augment future returns.
Our equity sub-advisers have been sensitive to financial sector risks, and have generally underweighted companies with leveraged balance sheets and direct exposure to mortgage problems. However, strong company fundamentals have not been consistently favored during the stock market’s recent stretch of high volatility — perhaps due to the unwinding of speculative and leveraged positions. Nevertheless, we continue to believe that our sub-advisers’ general focus on strong fundamentals remains the most reasonable approach to identifying intrinsic value in what will likely continue to be a difficult market environment in the months ahead.
II. Frequently Asked Questions
Q: Some institutions have been unable to withdraw their capital from what they believed were liquid, cash-like investments due to the ongoing credit crisis. Is there a risk of this happening in the RCT Flex Cash or Short Bond Funds?
A: Investors’ unwise stretch for yield took many forms during the past several years, as greed overwhelmed prudence as the primary credit market sentiment. In the case of institutional cash products, the investment programs that ran into trouble sought to enhance return by heavily investing in relatively illiquid asset-backed securities, auction rate bonds or commercial paper. As the credit crunch broadened in recent months beyond subprime securitizations, fear returned as the primary market sentiment and buyers for some of these illiquid and relatively complex products disappeared, effectively freezing investor capital.
The RCT funds do not hold any of these problem securities and hold only modest amounts of asset-backed securities (and those have high quality mortgages as collateral). Both RCT funds maintain large positions in highly liquid and safe U.S. Treasury and Agency securities, as well as other secure and liquid short-term issues, in order to provide participants with competitive money market yields on cash investments with maximum safety and liquidity. We believe that participants in the funds will not experience liquidity problems or a principal mark-down due to the impaired credit quality of fund positions.
III. Becoming a Catholic Fiduciary A new CBIS white paper presents a Catholic perspective on fiduciary responsibility.
An important ongoing goal for CBIS is to help participants introduce their fiduciary colleagues to the rich tradition of Catholic teaching that guides our approach to portfolio stewardship. Our new white paper “Becoming a Catholic Fiduciary” reviews the nature and history of fiduciary responsibility, the Catholic thought that inspires our vision of socially responsible investing, and the techniques we use to unify faith with finance in the management of instituitonal assets. We hope this publication can serve as a useful guide and source of ideas when participants and their financial colleagues who oversee portfolio strategy discuss the reasons for our Catholic socially responsible approach to institutional asset management. A serialized, edited version of the publication appears below and will continue in the next two issues of PRINCIPLES. For a PDF version of the complete document, please visit www.cbisonline.com/fiduciary.
“All economic life should be shaped by moral principles.... Workers, owners, managers, stockholders and consumers are moral agents in economic life. By our choices, initiative, creativity and investment, we enhance or diminish economic opportunity, community life and social justice.”
Through these and other writings, the Bishops give voice to a powerful idealized vision of a humane capitalism — one that offers broad-based appeal to individuals of conscience around the world. However, financial fiduciaries at Catholic institutions face a more immediate and pragmatic mandate. They must invest an institution’s assets in a manner that targets the risk-adjusted return necessary to achieve its financial goals and fund its unique mission.
For some fiduciaries, Catholic teachings may appear to conflict with the demands of institutional finance. But the reality is just the opposite. Indeed, the legal framework that governs the interpretation of fiduciary responsibility has evolved in recent years to acknowledge that ethical principles can play a constructive role in investment strategy. Fiduciaries at many religious and secular institutions are integrating environmental, social and corporate governance (ESG) considerations into portfolio management in order align their institution’s values with portfolio selection while using the influence they possess as shareholders to promote corporate policies that advance economic justice.
Moreover, many prominent secular institutional fiduciaries now advocate for a vision of portfolio stewardship similar to that described by the Bishops. As stewards of institutions whose life spans are measured in decades, these investors recognize that economic justice is a crucial underpinning of healthy and growing markets, vibrant global trade, and the strong, sustainable profit growth that drives superior investment returns. And growing numbers of institutions are now incorporating the analysis of ESG factors directly into the stock selection process, firmly believing that this improves their ability to identify companies who will outperform competitors over the long term.
While some fiduciaries concern themselves primarily with short-term portfolio performance, a Catholic fiduciary takes a broader and perhaps a more rewarding view. Becoming a Catholic fiduciary is not difficult; it requires only thought and guidance. We hope this publication inspires the former and offers the latter.
I. The Role of the Fiduciary
An important formal articulation of fiduciary responsibility was coined fairly early in American history. In 1830, the Massachusetts Supreme Court passed the “prudent man rule,” which instructed the stewards of institutional and family assets “to observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested.” Even today, this standard of a “prudent man” remains a widely used benchmark for fiduciary performance.
A contemporary, and more exact, description of fiduciary duty for institutional investors comes from the U.S. Department of Labor, which says that the primary responsibility of retirement plan fiduciaries is “to run the plan solely in the interest of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses. Fiduciaries must act prudently and must diversify the plan's investments in order to minimize the risk of large losses. . . . [and] avoid conflicts of interest.”
These definitions established a conceptual framework for the role of the fiduciary that discouraged speculation with assets and prohibited self-enrichment at the expense of beneficiaries, but that did not specify whether or how ethical considerations could be incorporated into the stewardship of the plan’s investments.
The Growth of Ethical Stewardship
In the 1980s, for example, many religious and public institutional investors divested from their portfolios the stocks of companies with business ties to South Africa as a statement against apartheid. Many believe that apar-theid’s collapse was in no small measure a result of the influence wielded by these institutions, who felt a social responsibility to stand up and demand that American corporations not support such an assault on human dignity.
While religious investors initiated the socially responsible investing (SRI) movement in the United States, its broad appeal to individuals of conscience and its success at effecting change drove it far beyond its religious roots to become one of the fastest-growing segments of the investment management business over the past two decades. SRI now includes a diverse range of religious and secular institutional investors and retail mutual funds and encompasses some $2.3 trillion in assets, or nearly 10 percent of the approximately $25 trillion in total assets under professional management tracked by Nelson Information’s Directory of Investment Managers. But the legal interpretation of fiduciary responsibility took some time to catch up with the growth of SRI.
An Evolving Concept
“. . . it is the view of the Department that the same standards set forth in sections 403 and 404 of ERISA governing a fiduciary’s investment decisions . . . apply to a fiduciary’s selection of a “socially-responsible” mutual fund as a plan investment.... Accordingly, if the above requirements are met, the selection of a “socially responsible” mutual fund as either a plan investment or a designated investment alternative for an ERISA section 404(c) plan would not, in itself, be inconsistent with the fiduciary standards set forth in sections 403(c) and 404(a)(1) of ERISA.”
With this interpretation, the consideration of non-financial criteria in the investing process was officially deemed to be consistent with fiduciary responsibility as applied to retirement plans, as long as it did not conflict with the institution’s overall investment strategy.
In 2001, a group of leading business academics and institutional fiduciaries working under an initiative called The Global Academy sought to evolve an expanded concept of fiduciary responsibility, one that could better promote the interests of both institutional investors and society as a whole. The Global Academy recognized that institutions, by virtue of the scale of their collective investments, have enormous influence over financial markets and global business practices. According to the Global Academy:
“ . . . the integration of prudent financial management practices with principles of environmental stewardship, concern for community, labor and human rights, and corporate accountability to shareholders and stakeholders — which until recently have not been considered relevant to the financial decision-making process — constitute in fact a single bottom line. In order to guarantee long-term sustainability, to minimize long- and short-term financial risk, and to identify investment opportunities, and thereby increase shareholder value, the definition of fiduciary responsibility has to evolve.”
This perspective clearly repositioned the relationship between ethics and investing. Ethical considerations were no longer suspect as potential impediments to investment success, nor were they merely tolerated as neutral counterparts to investing. Instead, they were viewed as essential elements in the search for superior risk-adjusted, long-term performance.
In Q3 2008 PRINCIPLES: “The Business Case for Ethical Stewardship.” Please visit www.cbisonline.com/fiduciary for a PDF version of the complete publication.
IV. Out of Cash Before Payday
Encouraging fair treatment of low-income borrowers by financial service providers is a top priority for CBIS and other SRI investors. We believe that everyone has a fundamental right to access capital in a responsible manner. Yet low-income Americans have historically been excluded from mainstream financial services, leaving them vulnerable to predatory lenders. Lenders who offer appropriate products to this market contribute to the development of more prosperous communities and can build profitable markets for themselves. Lenders must take care, however, to ensure that loan products truly serve borrower’s needs.
Some high interest loans, especially when loan terms are unclear, can place borrowers in a debt trap of costly refinancings, with increasing interest and principal payments and declining ability to repay. These loans weaken borrowers’ financial condition, damaging rather than building the lender’s market over the long term.
CBIS has filed a shareholder resolution with Cash America for the 2008 proxy season on the issue of predatory lending. Cash America’s services include payday lending, pawnshop loans and short-term cash advances, and we are concerned that some of the company’s loan products may be considered predatory.
According to the Cash America website, the annual percentage rate for a typical payday loan exceeds 400%. However, a 2001 study by the Credit Research Center found that nearly half of all payday loan borrowers believed their rate to be under 30%.
The industry also claims that these loans are intended only for occasional short-term cash needs. Yet a 2003 Iowa Banking Division study found the average payday borrower in Iowa received 12 such loans per year, suggesting that many people may be using cash advances to roll over or “flip” earlier payday loans. According to the Coalition for Responsible Lending, the average payday loan borrower spends nearly $800 to repay a $325 loan.
Cash America refused to engage our filing group in dialogue following a single meeting with its CEO more than a year ago. It insists it follows all state guidelines for high interest loans and it says it adheres to the lending best practices advocated by its trade association, the Community Financial Services Association of America (CFSA).
However, some states have no payday lending guidelines at all while those in others are quite lenient, and the CFSA has no mechanism for monitoring member company compliance with its standards. Moreover, as a result of new federal legislation limiting the interest rate charged to U.S. military personnel, the company’s cash advance products are now off-limits to U.S. servicemen and women and their families.
CBIS and our filing group believe Cash America should formally reassess whether it is providing products that truly serve borrowers’ short-term needs without damaging the financial well-being of captive customers and their communities.
Our resolution asks the board of directors to form an independent committee of outside directors to: (1) oversee the amendment of current policies and development of enforcement mechanisms that prevent employees or affiliates from engaging in predatory lending; and (2) provide a report to shareholders that offers assurances about the adequacy of the policy and its enforcement, by May 2009. We also ask that policies be accompanied by thorough internal controls and public reporting that allow shareholders to evaluate the company’s success in complying with its own standards.
V. Security Brief: Signs of Identity Theft
How do you know if you’ve become a victim of identity theft? Many of the signs are obvious — in hindsight. Vigilance can help spot ID theft early when it occurs.
If you become a victim: alert the credit bureaus immediately, notify merchants of fraudulent charges, change all passwords and PINs, report the crime to the police and follow their advice. Keep a log of every conversation, including names, dates, times and phone numbers.
VI. SRI Update: No Penalty for Early Withdrawals
We are pleased to report that we have withdrawn our resolutions at Dillard’s, Lowe’s, Felcor and Ford for the upcoming 2008 proxy voting season after the companies agreed to either engage us in dialogue, strengthen their policies and/or improve their reporting to shareholders on the issues of concern. Our preferred strategy for encouraging better environmental and social performance is a meaningful dialogue with management based on our rights as shareholders. Filing a resolution is one means to encourage such a dialogue.
Lowe’s — We withdrew our resolution at Lowe’s after the company agreed to a dialogue, to include a section in its sustainability report on site selection for new stores, and to report on its community engagement policies that ensure protection of historic sites, the environment and sacred lands when new stores are sited and developed.
Felcor — We withdrew from Felcor after the company, a real estate investment trust (REIT), agreed to a dialogue and to report on its energy efficiency measures and the ways it seeks to reduce greenhouse gas emissions associated with the 100 hotels in its portfolio. The company has also posted on its website for the first time basic information about its environmental and social performance. Shareholders can now use this to encourage other REITS to provide similar information. See: http://www. felcor.com/felcor_sustainabilityreport. html.
Ford — Our group withdrew our resolution after Ford agreed to reduce by at least 30% the greenhouse gas (GHG) emissions from its new vehicle fleet by 2020. This commitment makes Ford the first U.S. auto company to set an emissions reduction target. The company also provided a detailed analysis of its fuel emissions goals showing how the reduction would be achieved. The most any U.S. auto company had previously agreed to on the issue of GHG emissions is enhanced reporting of climate change risks or GHG reduction goals without showing how they could be met.
Still on the Ballot
TimeWarner — The resolution on separation of the positions of board chairperson and CEO will be voted on at the company’s May annual meeting. Due to several shareholder concerns, including excessive executive compensation, discontinuance of stock options for employees, fines paid to the SEC and employee layoffs, our resolution argues that there would be greater accountability to shareholders by separating the two positions.
Abbott Labs — The SEC has required the company to keep on its proxy our resolution asking it to amend its human rights policies to include the right to medicine. The resolution will be put to a vote at the April 25 annual meeting in Chicago. A positive development is the company’s agreement to dialogue with shareholders on the issue of HIV/AIDs for the first time in four years.
Cash America — The SEC has required the company to keep on the ballot our resolution asking it to report on ways it ensures that its loans are not predatory. The resolution will go to a vote at the company’s April 23 annual shareholder meeting in Texas. After one discussion last year, the company has refused to engage with us in dialogue.
We have co-filed resolutions for the 2008 proxy season at Dupont (GMO food), Chevron (climate change), and Exxon Mobil (climate change). Since we have not come to an agreement with these companies, the resolutions will remain on the ballot and go to a vote at each company’s annual meeting this spring. We will release the results as soon as they are available. Our resolution at Cisco (executive pay) will be filed in May.
Please visit the Shareholder Advocacy Directory www.cbisonline.com for the latest status of all resolutions and dialogues.
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