Expert Witness

Expert Witness

                 Back in 2012 I was recruited as an expert witness by a law firm trying a case about securities lending on behalf of a foreign pension fund.  The suit was against a big bank that acted as the fiduciary for the pension fund.  It was a fascinating case that involved a classically innocent and naive widows and orphan’s operation getting led by the hand down the primrose path of global alternative investments.  I was unusually qualified to act as an expert witness since I was an expert in securities lending, having run one of the biggest such operations and having worked the arena off and on for thirty-six years.  But that’s not all, I was also a pension fund and investment expert having run three separate world-class investment managers in recent years, all of which managed money for large and small pension funds.  I had been a Clinical Professor at Cornell at the graduate level on both topics.  And I had written a soon to be published book on both subjects.  The law firm was happy to have me on their team.

                 The expert witness gigs are done at a set hourly rate and they leave the tactical decisions to the experts, so I was able to set my own schedule and punch my own clock.  The lawyers keep up with your work, but these areas are so esoteric and specialized that they have little choice but to follow your lead.  I had often said that less than one in a hundred Wall Street professionals understand the intricacies of the plumbing of Wall Street, which is what I call securities lending.  The pension space is less esoteric and there are lots of people who know something about the investing side of pensions, but when you combine that with the structural or liability side of pensions, not so much.  For instance, in academia (if that is an appropriate term for the study of finance in the business school realm), there are very few pension academics versus finance or investment specialists.  The areas of pensions and insurance, which are actuarially-driven, are a very different discipline than general finance.  Most schools do not have that pocket of specialization because the laws around it are specific and arcane and the math around it are decidedly different from the heuristic and statistical methods (often called “closed-form” solutions) that one finds in finance and investment math.

                 I do not want to get into the mathematical differences between investment math and actuarial math, both because I would bore the hell out of most of my readers, but also because I would be testing the limits of my mathematical competence.  As they say about pornography, I know it when I see it.  Suffice it to say that they are both very different and very similar in many ways and the specialists who inhabit both areas are quite particular and stay out of each other’s space. These are the characteristics that make for interesting expert witness territory.

                 I want to briefly and simply explain the matter I was involved in since I find it so interesting. Imagine a small foreign pension fund tip-toeing into the scary global investing waters and hiring a big, reputable firm to keep it from drowning.  The most important thing to most pensions is to protect its principle and thus, they use what is called the ring-fence of a trust.  That trust cannot be invaded by any marauders looking to plunder.  It gives the pension managers the ability to sleep well.  So, the big advisory firm sets up the ring-fence to give the pension comfort and then takes it by the hand into the water by investing it into a global index fund.  The water is warm and pleasant.  But index funds are so boring and always feel at times to give away opportunity because they are constrained in using some of the obvious new instruments and using leverage to enhance yields.

                 Leverage and new instruments are the hallmark of those scary investment vehicles called hedge funds.  Little foreign pension funds are rightly scared of hedge funds, the sharks of the investment waters. But with a big tough advisor you worry less about the sharks.  Big tough advisors are always looking for ways to make more money and the thing about sharks is that they look to allow everyone to make lots more money (supposedly for investors, but certainly for intermediaries like advisors).  So, the advisor invents an index fund with a slight tilt that is sort of a hedge fund light vehicle that looks and feels like an index fund but is free to use a very limited amount of leverage and some new instruments.  Seems perfectly sensible and a way to have the best of both worlds.

                 All you must do is get a prime broker involved.  Not to mix fish and foul analogies, but brokers of any kind are more scavenger fish (hyenas, if you will).  You need them if you are going to allow even limited amounts of shorting securities (one of those “new” instruments and the province of securities lending).  Do you remember the old ethics story where you ask a woman if she will sleep with you for a million dollars and she agrees, and then you lower your offer to ten dollars and she says, “What do you think I am?”  Then you answer that you have already established that, you are just haggling over the price.  Well, the same applies to letting a prime broker into your wading pool.  What the poor little pension fund doesn’t realize is that by letting a prime broker into their ring-fence, they have opened themselves to all the sharks of the world.

                 Would it shock you to know that a prime broker can rehypothecate all your securities (that means give them away, for all intents and purposes) in order to let him borrow the securities needed to execute a short sale?  You would say, “I get cash collateral, right?”  and I would say, sure you do, but then that cash collateral gets lent by the broker (something he has been empowered to do and can legally do) to his parent company, who then goes bust.  Oops.  There goes your ring-fence, there go your assets, there goes your pension fund.  All that happened because the plumbing of Wall Street has esoteric rules (do a man on the street request as to what rehypothecation means) that few understand, even investment professionals.  Double oops.

                 I just got contacted again to ask if I would act as an expert witness in several arenas, especially securities lending.  I think I may increase my hourly rate since they are still having a hard time finding people who understand and can stomach this unusual and shadowy realm.