Greece Out in Legg Mason Stress Test Drawing Lesson From Lehman

Greece Exits in Legg Mason Stress Test
Legg Mason Inc.'s European contingency task force seeks to prepare for worst case in Europe. Photographer: Andrew Harrer/Bloomberg

It’s 9 a.m. on a Friday in June, and for a drill at Legg Mason Inc.’s Baltimore headquarters, Greece has quit the euro.

Gathered around a conference room table, with team members from offices including London and New York joining by video, 15 employees are given eight hours before markets open in Asia to assess everything from the firm’s investments and whether they can execute trades, to how workers in European offices will be paid.

Almost four years after the bankruptcy of Lehman Brothers Holdings Inc. froze financial markets, asset managers from Legg Mason to State Street Corp. and Vanguard Group Inc. are drawing from lessons learned during that crisis to prepare for a worst-case scenario in Europe. Firms are running drills, forming special teams and testing information technology systems to avoid being blindsided by a disintegration of the euro, however remote the prospect.

“We want to have as much information as possible because we don’t know what’s going to happen, but want to have all the tools to deal with whatever may happen,” said Joe Carrier, director of enterprise risk at Legg Mason. “Post-Lehman we realized that things that you would never imagine would catch you, did catch you.”

Pro-bailout parties in Greece obtained enough votes in national elections Sunday to form a government, easing concern the country will leave the euro currency union. Greece, dependent since 2010 on emergency loans from the European Union and International Monetary Fund, has to meet the creditors’ conditions to keep the aid flowing. Central banks have intensified warnings that Europe’s failure to tame its debt crisis threatens to roil the world’s financial markets.

‘Lot of Lessons’

State Street, which oversees $16.9 trillion in custody assets and manages $1.99 trillion for clients in its investment-management unit, has set up two committees in the past year to prepare for fallout from a potential worsening of the crisis in Europe, said John L. Klinck, head of strategic planning and institutional client relationships. The first focuses on risk management, examining everything from macro-economic conditions to the company-by-company impact of various crisis scenarios.

“There were a lot of lessons learned from 2008, especially in understanding counterparty risk, where assets are pledged, the value of collateral,” said Klinck, whose company is based in Boston.

Y2K Event

The second group at State Street looks at operational issues, especially those related to information technology. If one or more countries leave the euro, securities may have to be redenominated since national currencies could be readopted. Klinck compared it to preparing for the so-called Y2K event when computer systems needed reprogramming to handle the date change from 1999 to 2000.

At Vanguard, which is the world’s largest mutual-fund provider and manages about $1.8 trillion, a special team is also preparing for the redenomination of securities as well as for potential restrictions on the cross-border movement of capital if a country leaves the euro, according to John Hollyer, head of risk management for the company. The firm’s legal teams are reviewing contracts for references to currencies and to understand the implications.

Nancy Prior, president of the money-market group at Boston-based Fidelity Investments, said the firm has convened meetings internally and with larger clients to discuss operational issues and investment risks related to Europe. Fidelity, which manages about $1.6 trillion, is also preparing to post material on its website for individual clients in the event of a worsening crisis.

Debt Ceiling

“During the debt ceiling showdown last summer we were very proactive in putting information on our website and we’d plan to do that again,” Prior said.

Fidelity and other top money-fund managers have reduced or eliminated holdings of securities from issuers perceived as most at risk in the crisis. The 10 biggest prime U.S. money-market funds cut their holdings of debt issued by euro-area banks by $8.3 billion in May. Fidelity reduced holdings of European bank securities in the past two months and cut the weighted average maturity of those holdings to two days, according to Prior.

Firms whose investments are less liquid have sought to shore up their holdings in the region. Carlyle Group LP, the world’s second-largest private-equity firm, has refinanced its portfolio companies in the region over the past eight months, Glenn Youngkin, the firm’s chief operating officer, said this month.

‘Soap Opera’

“We’ve undertaken refinancings over the course of the last six to eight months, some of which have been herculean in order to get done, in order to make sure that the portfolio can withstand an extended downturn,” Youngkin said at the Morgan Stanley Financials Conference in New York June 12. “Every day is a brand new soap opera.”

Carlyle has several funds focused on Europe, including real estate, growth capital, buyout and distressed, that can take advantage of opportunities when they present themselves, Youngkin added.

During the 2007-2009 financial crisis, money managers saw assets decline and in some cases absorbed losses for investors or relied on emergency government programs to avoid losses. Several money-market fund providers, including Legg Mason and Chicago-based Northern Trust Corp., bailed out investors in 2007 and 2008 after their funds suffered losses in structured investment vehicles, or SIVs. A number of SIVs, created to make money by issuing short-term securities at low interest rates and buying longer-term debt that paid higher rates, defaulted because of investments in mortgage-backed securities.

Reserve Primary

Money funds ran into more trouble after the collapse of the $62.5 billion Reserve Primary Fund in September 2008, which held debt issued by Lehman. The fund’s sudden closure triggered a panic among investors who withdrew $200 billion, or 10 percent of prime fund assets, in two days, helping to freeze global credit markets.

Prime money funds are eligible to purchase debt and other securities issued by corporations and banks, as opposed to funds that invest exclusively in U.S. government-backed debt.

The run abated after the U.S. Treasury Department guaranteed money-fund assets against default and the Federal Reserve began buying assets from money funds at face value to help funds meet redemptions. Among the 10 largest providers, only Vanguard, based in Valley Forge, Pennsylvania, and Legg Mason didn’t tap the Fed’s emergency program.

Compensating Investors

Other managers compensated investors for losses suffered during the crisis after legal action. State Street paid out more than $800 million to clients who claimed the firm misled them about investments in some fixed-income funds. It paid more than $300 million to regulators over allegations it helped some investors get out of a bond fund saddled with risky mortgages, leaving others to shoulder the losses. State Street didn’t admit to or deny allegations made by regulators.

BlackRock Inc., the world’s largest asset manager, declined to comment on how it prepares for a potential worsening of the euro crisis, said Lauren Trengrove, a spokeswoman for the New York-based company. BlackRock has advised governments including those in Ireland and Greece since the start of the sovereign debt crisis.

Pacific Investment Management Co., the Newport Beach, California-based manager of the world’s largest mutual fund, the $261 billion Pimco Total Return Fund, has been conducting stress tests for a variety of outcomes and “tail risks,” said Andrew Balls, London-based head of European portfolio management at Pimco.

‘First Responder’

“Even if they don’t happen you want to prepare for the worst,” Balls said. “You don’t want to be the last responder, you want to be the first responder.”

Legg Mason started its preparations for a euro crisis in 2011, by evaluating how much of its portfolio would be at risk in Europe and forming the European contingency task force, which meets weekly for an hour and a half, Carrier said. The firm also reviewed who its clients were and where their banks were located and then looked internally at operations to assess its relationships with service providers and counterparties, said Carrier, the director of enterprise risk.

“These lessons are cumulative knowledge in the business,” Carrier said. “Maybe not today, maybe not tomorrow, but they will be applied.”

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