Asset managers making plans in case of euro meltdown

Money managers are making preparations for the unlikely - and once unthinkable - event that efforts to make a more fiscally unified Europe fail and the single-currency area is dismantled in whole or in part.

In addition to steps already taken to lower European investment risks, managers are analyzing operational exposures and thinking through all of the ways a breakup of the euro might affect their entire businesses.

“I'm not sure people are anticipating a total or even partial breakup, but there's the recognition that this is no longer an academic question,” said Martin W. Cornish, partner at law firm K&L Gates LLP, London.

Indeed, a complete dissolution of the 17-member eurozone would be catastrophic for markets worldwide. Plummeting returns could slash manager revenues in half, said Amin Rajan, CEO of the Center for Research in Enterprise and Technology in Europe, known as CREATE Research, Tunbridge Wells, England.

“That basically means the profit margin is wiped out,” he said, adding managers would need to make “massive” staff layoffs to stay afloat.

But a full or even partial breakup of the monetary union also would have immediate effects on managers doing business within the eurozone, challenging the money management industry's ability to value assets correctly, to manage counterparty risks, to communicate with clients and to handle myriad other operational matters.

“The hope is that (contingency planning) becomes a needless exercise. But you can't necessarily hope for something not to happen” and wait to be affected by it when it does, said Geoffrey H. Bobroff, president of money manager consultant Bobroff Consulting Inc., East Greenwich, R.I.

A euro breakup is “an issue everyone is thinking about,” said Manuel Arrive, London-based senior director at Fitch Ratings Ltd. However, “in practical terms, there is not much you can prepare for” because there are so many possible outcomes, most of which rely on political decisions, he added.

“At the moment, clients are just trying to make sure they understand the legal issues and concepts,” Mr. Cornish said. “It's fair to say most haven't made changes (to their contracts pertaining to European investments). It's more about choosing your counterparties carefully and getting” collateral like U.S. Treasuries that wouldn't be directly affected by a breakup.

European equity managers already have endured a loss of half of their collective assets under management since year-end 2007, according to a November report from Fitch Ratings. Withering performance losses and investor redemptions of e115.5 billion ($154.6 billion) combined to cut AUM by 46% to about e300 billion as of Sept. 30. And bond managers began reducing risks 18 months ago by focusing on government debt of core European countries such as Germany, France and the Netherlands, or moving out of eurozone debt altogether (Pensions & Investments, May 31, 2010). This exacerbated the debt crisis for peripheral European countries like Greece, Portugal and Italy.

A possible breakup of the eurozone has been on institutional investors' minds for more than a year (P&I, Dec. 13, 2010).

At least two managers — Schroder Investment Management and State Street Global Advisors — have committees reviewing possible business-wide risks that might arise from a eurozone breakup.

Schroder's group risk committee, a standing committee, meets regularly “whether there's a specific issue or not,” said Alan Brown, chief investment officer, in London.

Years ago, Schroder moved to minimize counterparty risks, to ensure its collateral used in swaps was in cash or safe-haven government bonds, and to use banks based only in core Europe to clear trades to avoid money getting stuck “on the wrong side of a capital control wall” in the event of a breakup, he said. More recently, Schroder began a review of its euro-denominated contracts to assess the impact of a move back to national European currencies.

“It'll be a legal minefield if we have the reintroduction of (national) currencies,” he said, adding the company prefers contracts to be drawn up under U.K. laws so in the event of a euro breakup, any disputes would be adjudicated by U.K. courts.

SSgA set up a task force to analyze eurozone risks in November, said Niall O'Leary, vice president and head of product engineering in Europe, the Middle East and Africa at SSgA in Dublin.

“As a company, we're trying to behave in a responsible fashion” and be prepared to very quickly address these “lower probability but higher impact” outcomes, Mr. O'Leary said.

Managers don't necessarily expect there will be changes to the eurozone's membership. Last week, European leaders appeared committed to create a more fiscally unified union, something that could tip the European Central Bank into taking on the role of lender of last resort.

But experts say that's far from a done deal, and proposals on the table might fall short of solving the crisis.

In a recent Allianz Global Investors survey of 140 executives of pension funds and other institutional investors in Europe representing a combined e909 billion in assets, 20% of respondents said they expect the euro will not survive in its current form. Asked what the most likely change to the euro would be, one in four said a eurozone split, while just one in 10 said a joint European fiscal regime.

“There are so many moving parts ... (we) do have a challenging environment to operate in,” Mr. O'Leary said. Managers can do fundamental analysis of securities, “but when politics plays such an important role in your investment process, it muddies the waters.”

Managers and investors are in “an incredibly uncomfortable position” because “what we're facing is something we hate: a binary outcome,” said Mr. Brown. Instead of the usual range of outcomes clustered around one most-likely scenario, the euro will either break up in part or in whole, or it will go on as usual. Either way, investors lose out if they haven't made the right call.

If the eurozone does break up, it could have a wide array of impacts on markets; too many to be able to knit safety nets beneath all of them, Mr. Rajan of CREATE Research said. As in any crisis, “everybody will be scrambling in the same direction” for the exit, but at this point nobody knows which door is the exit, he said.

“The whole thing has turned into a wing-and-a-prayer situation,” he said. “Everyone says you must do something. But do what? And do it now? Next week?” Mr. Rajan said the topic of a eurozone breakup has come up in every one of the approximately 40 interviews with asset management executives he's conducted since October as part of a forthcoming study on how managers are capitalizing on high levels of volatility.

From a client point of view, a eurozone breakup would be “profound,” said Andrew Dyson, executive vice president and head of global distribution at Affiliated Managers Group Inc., London. “It's hard to imagine any investment market that wouldn't be affected by it.”