A Silver Lining to the Credit Crisis

For many months following September 15, 2008, the day Lehman filed for bankruptcy, the last thing on my mind was that there would be a silver lining in the black clouds that stretched to the horizon. 2008 was an extremely tumultuous period within the fixed income markets as the credit crisis that began with the meltdown of the sub-prime mortgage market mushroomed into a global liquidity event. During September, the crisis intensified with the collapse and/or bailout of some of the world's largest financial institutions resulting in widespread risk aversion, which constrained the flow of capital and severely depressed asset valuations for most financial products. In the wake of the credit crisis, investors rushed to the safety of Treasuries resulting in historic credit spread widening across all segments of the fixed income market with spreads in several sectors reaching all time wide levels in November.

Immediate pain occurred in wrapped bond portfolios. Lehman debt was written off. WaMu debt was written off. Valuations of corporate and non-agency MBS securities (especially sub-prime, alt-A) dropped like a stone. Even securities that by all measures were "money good" suffered marked to market shocks. Wrap contracts' market to book ratios plummeted. From the wrap issuers' perspective, what had been viewed as a low risk, low margin commodity transformed before their eyes. The capital cost of wrap books rose causing wrap issuers to freeze their wrap books while they reexamined each of the deals that they had wrapped. During this period, stable value funds had very few

options as to where to invest their liquid assets. Cash positions grew as bank short-term investment funds (STIF) rates plummeted causing a drag on stable value fund yields.

Insurance companies were similarly buffeted by the credit crisis. The market and economic environment led to rating agency downgrades as falling asset values pressured earnings and capital positions. Moreover, frozen capital market conditions reduced financial flexibility as new sources of capital to repair balance sheets became extremely scarce. Traditional GIC issuance was not completely frozen but severely curtailed as result of efforts to preserve capital. Some issuers withdrew from issuance; some froze their businesses (some are still on the sidelines) and those few that were still of sufficient quality offered only limited capacity.

The difficulties for stable value and the industry's response to them have led us to the silver lining. During the slow thaw in the credit freeze, wrap and GIC issuers have had the opportunity to shore up their capital, repair balance sheets and thoroughly examine their liabilities. Stable value management has become more difficult: investment capacities are only slowly expanding, every deal is under much closer scrutiny and the terms of deals have been subject to de-risking while wrap fees have risen. The difficulties for managers have led to benefits to plan participants.

The credit quality of funds has improved as wrap and GIC issuers have replenished capital positions at their issuing companies. They have de-risked their own balance sheets and have instituted more rigorous underwriting of their books of business. The duration of bond positions are becoming shorter as the Barclay's Intermediate and shorter duration mandates are replacing many of the Barclay's Aggregate mandates. This bodes well for reducing volatility and capital losses particularly as rates move off of historic low levels. Diversification has improved in one regard as scarce investment capacity forced plans that had long since become 100% synthetic to begin adding insurance company traditional GICs to portfolios as well as insurance company separate account products. And traditional GIC issuance is on the rise as some issuers are reentering the marketplace.

The net result to participants is that they are now in Stable Value funds where the managers and issuers are more carefully scrutinized and constrained. The funds themselves are higher quality, shorter in duration, less risky and more defensively positioned to weather future financial stresses.

In other words, stable value is in better shape to provide what participants are seeking from stable value: preservation of principal, low volatility and returns in excess of money market and short bond funds. Stable value is returning to its roots and participants are reaping the benefits of the Silver Lining.

Finally, it is worth noting what didn't happen during the crisis. With exception of the Chrysler and Lehman Brothers 401(k) plan terminations (where apparently fund managers were not allowed to apply proven techniques to unwind at book value over time) stable value participants did not lose money. Certainly crediting rates declined as a result of depressed market to book ratios, high allocations to cash, and depressed interest rates, but participants realized no principal losses. Despite the crisis, cash flows were neutral to positive for stable value funds. Participants maintained their faith in stable value and their patience is being rewarded as the funds have become less risky and their returns are beginning to rise. In the end, Stable Value proved to be a "safe harbor" that in fact was safe.