Thursday, October 2, 2008

Crisis Roils Europe, Alternative Investments


Plans for a pan-European response to the global financial crisis lay in tatters last night as Greece followed Ireland in unilaterally guaranteeing all bank deposits:

Amid reports that Greek depositors were rushing to withdraw their savings, Greece's Cabinet agreed to protect all deposits whatever their size. Previously the maximum guaranteed was €20,000 (£15,600).

A proposal by President Sarkozy of France to create a European €300 billion bailout fund also collapsed, leaving attempts on this side of the Atlantic to calm investor panic and lubricate the money markets in chaos.

America's rejigged $700billion bank bailout still hangs in the balance, awaiting the approval of Congress today. But after days in which the surprises sprung by European governments had succeeded only in angering each other, the chances of a parallel joint plan from EU nations are, for now, slim to non-existent.

Amid growing concerns, the European Central Bank (ECB) abandoned its long-held line that inflation was the main threat to the Continent's economy and hinted at an interest rate cut that could come as early as next month:

The European Central Bank (ECB) opened the door yesterday to its first cut in interest rates in more than five years, conceding that inflationary dangers have faded as financial turmoil saps the strength of the eurozone economy.

The Frankfurt institution fulfilled market expectations to keep eurozone rates pegged yesterday at a seven-year high of 4.25 per cent for a third month in succession.

However Jean-Claude Trichet, the ECB’s President, signalled that it is now preparing the ground for a reduction in the eurozone’s official borrowing costs. Markets are betting that the ECB will act to cut rates as soon as next month.

Mr Trichet said that the convulsions across financial markets in the past two weeks had created great uncertainty over economic prospects, and that there was clear evidence that the eurozone was now faltering.

Meanwhile, stocks plunged again today on concern that the rescue package will not prevent a recession:

``If banks aren't willing to lend money to a bank, are they going to be willing to lend to an average person? No, they're not,'' said Frank Ingarra, money manager at Hennessy Advisors Inc., which oversees $1.1 billion in Novato, California. ``We could be at the start of a pretty bad recession.''

...

The market for commercial paper plummeted the most on record as banks and insurers were unable to find buyers for the short- term debt. Commercial paper outstanding tumbled $94.9 billion, or 5.6 percent, to a seasonally adjusted three-year low of $1.6 trillion for the week ended Oct. 1, the Federal Reserve said. Financial paper accounted for most of the decline.

``There's a liquidity crisis going on that's putting investors on edge,'' said Alan Gayle, the Richmond, Virginia- based senior investment strategist at Ridgeworth Investments, which oversees about $70 billion. ``Liquidity is like oxygen. Lack of it can cause serious damage in a very short time.''

There is little doubt that credit markets are scarier than stocks . Mergers and acquisitions are frozen amid the credit turmoil:

``The M&A market is all but frozen while politicians around the world grapple with the economic crisis,'' said Simon Collins, head of corporate finance at KPMG. ``With the debt market virtually inaccessible, deal paralysis has also spread into sectors such as energy, which were until recently considered resilient to the world's economic woes.''
Not surprisingly, the turmoil in credit markets is hammering alternative investments such as hedge funds and private equity:

"We are going through a massive, never-seen-before deleveraging across the financial system, which will push us into a total meltdown" said Jan Loeys, head of global asset allocation at J.P. Morgan Securities in London. "We already have a partial meltdown."

"Hedge funds are getting hurt," Loeys said. "They are leveraged organizations like the banks."

"We are going through a massive, never-seen-before deleveraging across the financial system, which will push us into a total meltdown" said Jan Loeys, head of global asset allocation at J.P. Morgan Securities in London. "We already have a partial meltdown."

"Hedge funds are getting hurt," Loeys said. "They are leveraged organizations like the banks."

"Private equity is going through their own funding problems - they don't get runs on private equity like the banks, but you'll see a large number of private equity deals go bankrupt."

In the event of a deep recession, Loeys sees a blended portfolio of private equity, hedge funds, real estate shares and commodities losing 8 percent of its value in the coming year, against a positive return of 1 percent for a typical mixture of equity, bonds and cash.

The growth of alternative investments has been phenomenal in recent years, and it has been highly correlated with the overall growth of debt in the global economy. It has produced some outsized returns for investors and huge paydays for practitioners, and it has been a big source of revenue for banks and the entities formerly known as investment banks.

More than $5.6 trillion is committed to alternative strategies, according to J.P. Morgan estimates, a growth of more than 50 percent in a little more than two years. But that is now coming unstuck.

Hedge funds are down 12 percent so far this year, according to J.P. Morgan, and though transparent data is not available for private equity, returns will have been worse, if anything. Real estate is obviously a disaster and commodities, which were flying high at midyear, are now down 4 percent for 2008. The key is the great deleveraging now under way.

The article goes on to state:

The bursting of a debt bubble has had three very important consequences for alternatives:

First, borrowing is hard to do and more expensive. The more you need it, the worse off you will be.

Second, everyone is trying to sell assets at the same time. This drives prices down and murders forced sellers.

Third, the real economy is taking the strain. That is hurting demand for commodities, real estate and the things and services provided by companies owned by private equity.

The leverage that hedge funds depend upon to magnify returns - indeed, to make many strategies viable - is harder to come by and more expensive.

And stung by a truly awful year, hedge fund investors are asking for their money back at an extremely uncomfortable time.

The ends of quarters, like the one just passed, represent some of the few times that hedge fund investors can get their funds out. If a lot of investors ask for their money at the same time, as many predict will happen, hedge funds all become sellers in a market with very few bidders.

Since 1995, returns in private equity have outperformed public equity by 4 percent a year, according to Cambridge Associates. There is disagreement about why that happened: Private equity executives maintain that their management was adding value, but surely the combination of huge borrowings and a rising asset market, driven by the same huge leverage, was the prime driver.

Now, of course, leveraged money is expensive and scarce and the initial public offering market, the preferred means of selling on private equity investments, is moribund.

But what is truly scary is not the rate of return private equity may make on new deals - that may work out well enough if prices are low - but the risks to existing ones.

Existing private equity deals, especially from the past few years, are generally carrying very heavy debt loads. Much of that will need to be refinanced or will simply default as the economy sours.

In short, investors in alternative investments will not do well. It's also fair to expect that they will represent another leg downward for the financial system and an additional source of systemic risk.

Finally, today I learned that the Ontario Teachers' Pension Plan is cutting back on inflation protection for some future retirees to eliminate a $12.7-billion funding shortfall reported earlier this year:

The inflation cutback was approved Monday in a vote by the board of governors of the Ontario Teachers' Federation, and was filed yesterday with provincial regulators.

Allan said teachers indicated during the survey that they preferred the scale-back of inflation protection to other options -- a 10 per cent cut in future benefits, or raising the full-retirement requirement for age plus years of service to 90 from 85.

Inflation protection accounts for about 25 per cent of the cost of pensions, said Allan.

"When that assumption is changed, it allows the investment team to build an investment portfolio with an asset mix that's better equipped to earn the long-term returns that the fund needs."

Allan said flexibility "is now there, that if a shortfall occurs in the future, there is a tool available to deal with it."

Jim Leech, president and chief executive of the plan, assured members that their future is secure.

With more than $100 billion in assets, there "is sufficient money to pay pensions for many, many years to come," he said.

However, "there are more retirees today than there were before and they are living longer," Leech observed.

He added that the plan is structured to withstand the volatility racking financial markets.

"It's really important to remember that pension plans are long-term investors," he said.

A lot of presidents of public pension funds are sounding more and more like mutual fund salesmen. Mr. Leech failed to mention that OTPP is highly exposed to all sorts of alternative investments, including hedge funds, real estate, infrastructure, commodities, and private equity. Let's not forget that monster leveraged buyout deal on BCE which could easily turn scary.

Diane Urquhart has this comment to share on OTPP's decision:

I think this new OTPP development should frighten all public service employees in Canada. Their inflation indexed pension benefits are no longer sacred. This is the message we gave to the Public Service Alliance and the Institute of Professional Institute of the Public Service of Canada. The public servants are way too complacent about the investment performance of their pension plans.

Diane is right, nothing is sacred and public servants are way too complacent about the investment performance of their pension plans. I could write a book on the problems governing public pension plans.


But given my firm views that we are heading into a long period of debt deflation, OTPP's move may prove to be a wise decision after all. In a deflationary bust, inflation indexed pension benefits become obsolete. The problem arises if stagflation ensues. Then a lot of future retired Ontario teachers will look back at this decision with great disdain.

***Update

For more on Ontario Teachers, read Karen Mazurkewich's article, Debt-ridden Ontario teachers' group alters pension fund formula.

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