Social Leverage: Idiology in Lending and the Sustainability Reinvestment Act of 2009

January 22, 2009

While this post harks from the radical left, in reading about the possibility that the government may take a visible role in nationalizing the banks, it occurred to me that in doing so they might gain more leverage to help spur our sustainable future.

Government ownership, if even only temporary, could provide the Obama administration the leverage it needs to help catalyze a green building revolution and to push America’s infrastructure forward from falling closer in line with the infrastructure of a Third World country.

Government oversight of our banking system could be used to co-opt lending regulations, forcing banks to earmark a certain number of dollars for green, renewable and sustainable investments.  Such a mechanism could be used as a lever in the war on inefficiency, waste and legacy infrastructure.  However doing this would still leave the “last mile” of capital allocation up to the free markets, and allow banks to seek out the most profitable investments.

While seemingly radical, the concept I have in mind would not be far from how the Community Reinvestment Act was created and is still runs today.  The CRA has helped create economic development in some of the most economically blighted parts of the United States.  Under the CRA banks are ranked and rated on the amount of money they lend within documented economic empowerment zones and other economically depressed neighborhoods.  A banks final CRA score is then tied to a number of the federal benefits they receive.  The CRA was created to force capital into areas where capital rarely flowed, offering opportunities to entrepreneurs who were willing to take risk rebuilding some of America’s most forgotten neighborhoods.

While there are some complete idiots who have tried to link the CRA to the current housing mess, their logic is flawed and their motive is pure libertarian.  The CRA has helped, although on a more limited basis than its planners may have hoped, create opportunities in areas where banks once used to never lend money.  For more detail on my argument see one of the many posts by Barry Ritholtz on the subject, one of which is here: More CRA Idiocy

A Sustainable Reinvestment Act (SRA) would more than likely set up a massive national debate.  However, as I heard stated over the weekend: “A financial crisis is a terrible thing to waste.”

Let’s think of all of the ways we can co-opt this crisis to the betterment of our country, the working population, and for consumers around the world.

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Department of Labor Forbids SRI for Pensions

October 20, 2008

Last week the Department of Labor under Secretary Elaine L. Chao—the longest serving Secretary of Labor since World War II, and the only remaining member of the President’s original Cabinet in 2001—announced what has been perceived as significant restrictions on public pensions’ ability to use their large investment pools to affect social change through Socially Responsible Investing.  Regardless of the DOL statement, however, more changes are likely abound at the department after January 2009.

An article in today’s FundFire described the restriction as:

Pension plans are forbidden to invest in socially responsible investment-type strategies unless they can prove that doing so earns as much as other options within the same asset class, the U.S. Department of Labor says in new guidance issued last week. The reminder comes as more pension investors consider socially responsible or green investing.

While I certainly understand the initial spark of rage this caused in the Social Investing Community, I see this as more of a benefit than an enemy to the Social Investing industry as a whole over the long-run. 

SRI has been over-perceived as an investment strategy with an inherent “give-up”.  In other words, a common misperception in the broader investment community is that social investing, on average, underperforms traditional investing.  While there are some good arguments for the reasons behind this, and while there is some evidence to this effect, the truth is gray, not black and white.  While there are a number of social funds on the market and socially oriented investment managers who have track records that lag their non-social benchmarks, there are a growing number of funds and products that are changing that paradigm.

My point here is not to sell or highlight any particular fund, but to offer the perspective that the DOL language that will force institutional investors to defend social investments should be perceived as having a future benefit for the SRI industry.  In the long run, it will weed out acceptance of under performance in social funds, raising the bar for social and fundamental screening criteria to help advance our understanding of the specific metrics that help socially oriented firms accrete value to shareholders. 

Large institutional investor’s timelines are at severe odds with that of management in American public companies whose performance is measured on a quarterly basis.  Institutional investment capital is much more patient that corporate manager’s requirements for returns on investment.  One of the challenges to accreting value to social investments by public companies is that some projects incur near-term charges for what may be long term value creation.  Typically such circumstances cause aversion to making the capital commitments that are better for the planet, for society, and in time for the company as a whole.

I believe in the staying power of socially responsible organizations that recognize that value is created by driving top line growth while minimizing bottom line costs through, at least in part, through social strategy.  This is well understood through the economics of things like employee turnover.  More recent evidence presents itself in the cooperation of public companies with all stakeholders including environmental activists.  Pension Funds and large foundations have a perpetual life; as such they have an obligation to buy companies who they perceive will be thriving in a hundred years.  This is quite contrary to the average holding period for U.S. equities which is averaging less than a year in recent times.

An investor who is considering such a long horizon is going to be tasked with looking to identify firms whose business practices are sustainable so that they may meet their financial obligations over a long period of time. 

An industry that has turned itself into a business case for unsustainable business practices is the mortgage brokerage business of yesteryear.  A great number of these companies built a practice of lending money to low and moderate income borrowers at teaser rates, with no money down, in a predatory fashion.  The brokers were only incentivized to ensure the home buyer would remain in their home for at least six months, long before the ARM (teaser rate) reset.  In the end, this strategy has proven itself to be an unsustainable business practice.  As a result, hundreds of mortgage brokers have gone bankrupt, and more relevantly our entire financial system has been effected.  Countrywide, once one of the largest publicly traded mortgage-related companies, as an investment, was a bad one.  Fiduciaries attracted to Countrywide on fundamental performance up until 2007 would have been right only until they were wrong.  Simple social screens would have precluded an investor from holding Countrywide.

This leads to another problem in the institutional investing industry, which is that fiduciaries are protected from being wrong, if they follow the herd.  At the individual level, a bad investment choice can be acceptable if it has been made by other well informed peers.  Think of the recent turmoil around CDO’s.  Whereas, a bad investment choice made separate from the herd, regardless of the logic and reason behind it, will put a fiduciary’s job at risk.  This cannot be underestimated as part of the problem of discouraging fiduciaries from social investing, regardless of the DOL mandate.  The amplification effect this has on mistakes is fodder for a different entry.

Another simple and more egregious example would be the use of slave labor that occurs in some foreign jurisdictions.  The U.N. Global Compact outlaws such practice, and one must assume that in time slave labor will not be available anywhere on the planet, or at the very least, that trading partners will cease to do business with firms who employ such strategies.  Any cost benefits of slave labor will eventually become expenses as the practice is wound down to a halt.

Another hot topic of recent time has been divestment from Sudan.  Much like the divestment that took place in South Africa which was first advocated in the 1960’s to help end Apartheid, divestment from Sudan to help end genocide has become a hot topic around the world.   Ironically the success South African divestment which helped to end Apartheid culminating in non-racial democratic elections in 1994, has spurred high economic growth prospects in a geography recovering from the effects of decades of underinvestment under an oppressive regime.

Antisocial behavior on behalf of corporations is unsustainable, and in time will become a larger liability than asset, if it is not already.  Long-breath investors must be allowed to consider such items as they make decisions to construct their portfolios.  While the DOL’s mandate is understandably upsetting to the social investing community, it needs to be re-interpreted only as a higher bar. 

While in the short run such the DOL ruling may dissuade some portfolio managers at the largest public funds from considering social products, in the long run it may help bolster the credibility of the emerging body of social products that are in fact producing at least market-rates of return.  Combining social and financial due dilligence as Cambridge Associates and other major consultants have begun to do is an essential part to making social investing much more impactful.  This would intern help to bury the misperception that social investing itself is unsustainable and help more investors make the leap to align their own portfolios with value enhancing social mores. 

For those new to the concept, Socially Responsible Investing is defined by the Social Investment Forum as:

Socially Responsible Investing(SRI) is a broad-based approach to investing that now encompasses an estimated $2.71 trillion out of $25.1 trillion in the U.S. investment marketplace today. SRI recognizes that corporate responsibility and societal concerns are valid parts of investment decisions. SRI considers both the investor’s financial needs and an investment’s impact on society. SRI investors encourage corporations to improve their practices on environmental, social, and governance issues. You may also hear SRI-like approaches to investing referred to as mission investing, responsible investing, double or triple bottom line investing, ethical investing, sustainable investing, or green investing.

Sources:
About Secretary of Labor Elaine L. Chao
Department of Labor
http://www.dol.gov/_sec/aboutosec/chao.htm

Labor Dept. Clarifies Pension Use of SRI
Whitney Kvasager, FUNDfire, October 20, 2008
http://www.fundfire.com/articles/20081020/labor_dept_clarifies_pension

Countrywide Settles Predatory Lending Charges for $8.68 Billion
Consumeraffairs.com, October 6, 2008 http://www.consumeraffairs.com/news04/2008/10/countrywide_settlement.html

South Africa under apartheid
WikiPedia, Accessed October 20, 2008
http://en.wikipedia.org/wiki/Apartheid

What is SRI?
Social Investment Forum
http://www.socialinvest.org/resources/sriguide/srifacts.cfm