6. Pension Fund Investments in Lehman Brothers’ Debt At the time that Lehman Bro

Question

6. Pension Fund Investments in Lehman Brothers’ Debt At the time that Lehman Brothers filed for bankruptcy, financial institutions serving municipalities in California were holding more than $300 billion in debt issued by Lehman. Do you think that municipal pension funds that purchased commercial paper and other debt securities issued by Lehman Brothers were following reasonable investment guidelines? If a pension fund is taking on too much risk, how should regulations be changed to limit such excessive risk taking?

Explanation / Answer

Answer: Municipal pension funds that purchased commercial paper and other debt securities issued by Lehman Brothers were not following reasonable investment guidelines because Pension funds that are willing to accept market returns on bonds can purchase bond index portfolios that have been created by investment companies. The bond index portfolio may include investment-grade corporate bonds, Treasury bonds, and U.S. government agency bonds. It does not include the entire set of these bonds but includes enough of them to mirror market performance. Investing in a market portfolio is a passive approach that does not require any analysis of individual bonds. Some pension funds are not willing to accept a totally passive approach, so they compromise by using only a portion of their funds to purchase a bond market portfolio.

Financial systems have always been prone to boom-and-bust cycles. Arguably, this tendency has been aggravated by the transition to a more markets-based financial system. Regulatory changes such as more risk-sensitive capital requirements, fair value accounting and performance-related pay have accentuated this tendency. Changes must be made in these areas as well as in macroeconomic policies, especially monetary policy, to reduce cyclicality.

http://www.global-economic-symposium.org/knowledgebase/the-global-economy/balancing-risk-taking-and-financial-regulation/proposals/balancing-risk-taking-and-financial-regulation

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