By Robert Whiteford, Bank of America
“Take calculated risks. That is quite different from being rash.” –George Patton
The quote shown above is an odd one considering the source, but I believe that it may be appropriate advice for several groups of participants in the stable value market–the wrap providers and the asset managers. All of us in the stable value business have a strong interest in creating additional wrap capacity. The best way to do so is to demonstrate that the risk that the wrappers undertake is well monitored and controlled. While no one rashly entered into risky wrap agreements prior to the financial crisis, we did discover that wrapper risk was higher than previously thought. The rash action would be to ignore all that we have learned. Wrappers are paid to take risk, but that risk must be calculated as closely as possible and controlled.
Historically, the stable value business was viewed as one in which there was little risk of loss for any of the parties involved. It was very common for consultants, and even some asset managers, to openly express the opinion that the wrappers were being paid for nothing more than an accounting treatment. The perception was that there was no chance that a loss would ever be incurred. The unfortunate events of 2008 disproved this. Market-to-book-value ratios fell to unheard of levels, and true market prices for the underlying portfolios were often difficult to determine. The reality is that there is considerably more risk than was previously thought.
To increase wrap capacity, wrappers need to demonstrate that risk has been successfully and meaningfully reduced. This doesn’t mean that the wrappers are trying to eliminate all risk, but it does mean that the risk must be reduced to the level that makes wrap risk management teams comfortable, while providing the affordable protection that wraps bring to stable value.
The good news is that the wrappers and asset managers have made great progress in reducing risk in a way that should allow the existing wrappers to increase capacity in the future. Successful risk control will also make the wrapper business more enticing to new participants. New investment guidelines have been constructed to more faithfully reflect the mission of stable value funds, which is to produce a good, steady investment return while investing in high quality, liquid investments that can withstand a severe market storm. Additionally, wrap contracts have been revised to better control credit risk and to reduce or eliminate the impact of events that fall outside the benefit-responsive purpose of the wrapper. Finally, reporting required by wrap contracts has been materially improved: this allows the wrappers to better monitor the portfolios that they wrap and to more quickly determine the effect on wrapped portfolios when an asset is downgraded or defaults.
I am extremely pleased with the progress that the participants in the stable value industry have made to find real, substantive solutions. This hasn’t been easy for the asset managers, as each wrapper has its unique set of concerns. There is still more work to be done, but great progress has already been made. We need to keep at it. New capacity to meet the increasing demand by 401(k) plans should follow.
