Tuesday, November 11, 2008

The End of the Great Pension Con Job?

The Dow had another rocky session today, hitting a low of 8,560.71 before closing at 8,693.96. At one point I called the Financial Ninja to get his read on whether or not we are going to retest the October 10th low of 7,773.71.

"The way these markets are going it could happen over the next few weeks or the next few days, but it looks likely."

I told him I doubt we will retest those lows this year and that I still believe in my vested interests theory which states that hedge funds, mutual funds and pension funds are hemorrhaging so much that this week is just another buying opportunity before they bring this sucker right back up going into year-end.

The Ninja and I then talked about some really scary charts he posted on his blog. It seems the Fed is taking a page straight out of the Canadian Public Pension Fund Handbook on Non-Transparency, refusing to identify the recipients of almost $2 trillion of emergency loans from American taxpayers or the troubled assets the central bank is accepting as collateral:

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson said in September they would comply with congressional demands for transparency in a $700 billion bailout of the banking system. Two months later, as the Fed lends far more than that in separate rescue programs that didn't require approval by Congress, Americans have no idea where their money is going or what securities the banks are pledging in return.

``The collateral is not being adequately disclosed, and that's a big problem,'' said Dan Fuss, vice chairman of Boston- based Loomis Sayles & Co., where he co-manages $17 billion in bonds. ``In a liquid market, this wouldn't matter, but we're not. The market is very nervous and very thin.''

Bloomberg News has requested details of the Fed lending under the U.S. Freedom of Information Act and filed a federal lawsuit Nov. 7 seeking to force disclosure.

The Fed made the loans under terms of 11 programs, eight of them created in the past 15 months, in the midst of the biggest financial crisis since the Great Depression.

``It's your money; it's not the Fed's money,'' said billionaire Ted Forstmann, senior partner of Forstmann Little & Co. in New York. ``Of course there should be transparency.''

It is your money and people are justifiably outraged at the misuse of funds and the lack of transparency:

Many Americans are understandably outraged by the bailout fever that has gripped Washington this year. But even those who believe the bailouts are a "necessary evil" would have a hard time defending some of the bailout-related items that have come to light in recent days, including:

  • Financial institutions using TARP bailout money to pay executive bonuses. The firms, of course, say it's "different" money and bonuses are key to retaining top employees. But if you need to come to the government for a handout, shouldn't your executives forgo a bonus? Or shouldn't the government make canceling bonuses a condition of getting aid, as is the case in Europe?
  • The Fed refusing to reveal who received almost $2 trillion in non-TARP loans, or what collateral it has accepted from "emergency" loans made to struggling firms, as Bloomberg reports.
  • The Treasury Department providing a tax break to banks involved in acquisitions that could amount to $140 billion. The Washington Post reveals the change to the tax code was issued on Sept. 30, while Congress was debating the $700 billion TARP bill.

The bailouts are bad enough. But this kind of chicanery and lack of transparency makes me recall a line from another time when fear and deceit dominated Washington: Have they no shame, at long last?

Have they no shame? Apparently not, just like public pension fund presidents and senior officers have no shame collecting huge salaries and bonuses after losing astronomical amounts. They will tell you that they delivered "alpha" investing in alternative assets thus deserving their "hard-earned" bonuses but that is a blatant lie.

The truth is that for years pension fund managers were plowing billions into alternative asset classes convinced that they were a panacea against declining public equities. They then set up bogus benchmarks for these asset classes so they can easily beat them, allowing them to reap huge bonuses at the end of the year as they boasted of adding "significant added value" in hedge funds, private equity and real estate.

Well the great pension con job is over as delusions of an alternatives paradise have given way to a sober reality after a year of hedge hell and the realization that the private market bubble has popped too as private equity sours along with the economy and commercial real estate is set to crash in 2009:

Hedge funds lost an average 5.52 percent in October, marking their fifth consecutive monthly drop as managers faced sharp stock market swings and angry clients who demanded their money back, new data shows.

The average hedge fund has now lost 15.30 percent in the first 10 months of 2008, putting it in line to post its worst year ever, according to data released by hedge fund performance trackers at the Hennessee Group.


The U.S. private equity industry is suffering along with the rest of U.S. economy. According to new findings by research firm PitchBook Data, deal flow declined 34% in the first three quarters and inflows dropped by 57% from $354.5 billion to $152.3 billion from the same period last year.

Despite the industry’s dramatic declines from 2007, the first three quarters of 2008 remained relatively strong compared to historical levels, according to the study. The amount invested through the third quarter of 2008, $152.3 billion, was the third-highest on record, behind the record-breaking 2007 and the $160 billion invested during the same period in 2006.

The median size of p.e. deals this year is a more conservative $66 million, compared to $76 million in 2007. The median size of leveraged buyout deals dropped more significantly, from $106.5 million in 2007 to $82 million, a 23% decline.

“There is no disputing that the current economic environment is hindering private equity deal flow as credit for LBOs has become increasingly difficult to secure,” said John Gabbert, CEO of PitchBook. “The private equity industry is going through a correction as it returns to pre-bubble transaction levels, valuations and deal terms.”


Are you ready for more apocalyptic predictions? How about this one:

“The next tsunami to hit will be the Commercial Real Estate market.”

Thomas Barrack, the founder of Colony Capital, wrote this prediction in his real estate private-equity firm’s October investor letter, which Deal Journal has reviewed. It is scary stuff. Commercial real estate has been among the last dominoes left to fall in the credit markets, and it has avoided much of the disaster raging through subprime residential loans.

Barrack predicts that commercial real estate is due for its turn. It wouldn’t be a tremendous surprise; many believed the subprime crisis would soon lead the market wolves to commercial loans.(And read this Heard on the Street column from colleague Lingling Wei).

A commercial real-estate crash would be devastating to the economy. Commercial real-estate loans, including commercial mortgage-backed securities and collateralized debt obligations, total $3.7 trillion. It is only a slow burn right now: Many of those CMBS and CDOs mature in 2010 and 2011, leading Barrack to predict a “refinancing crisis” in the next three years–and with buyers drying up, egress will be difficult.

“The overriding problem for all refinancing issues is that sale is not a viable option. Transaction volume is dwindling; to date, retail center sales volumes are down 85%, office is down 75% and hotels 95%,” Barrack wrote.

Who stands to hurt the most? The list starts with the biggest holders of the loans, which include insurance companies, hedge funds and banks, specifically regional banks, Barrack wrote. Even as those banks are struggling with liquidity, they are “the reservoirs of some of the most dangerous pools of commercial real estate loans.”

He reasons that investment banks took many of the highest-quality loans, leaving regional banks holding those commercial loans without stable income streams, often from their own banking clients.

As I read these articles, I am amazed to see pension funds increasing allocations to alternative asset classes.

Even the mighty Harvard Endowment fund - the model for alternative investments - is now at risk of losing 30% this year.

Going into 2009, I am less worried about some hedge funds as I am about private equity and especially commercial real estate, but they are all going to struggle next year.

And pension funds? They will struggle the most as they try to figure out how they are going to clean up their portfolios and get back to matching assets with liabilities without taking undue risks.

One thing is for sure, the great pension con job that allowed pension fund managers to collect huge bonuses as they carelessly plowed billions into alternative investments over the last five years has been exposed and there will be nowhere left to hide in 2009.

Finally, this Remembrance Day, please remember to donate to Disabled American Veterans as well as to visit the Royal Canadian Legion site to see how you can help Canadian Forces.

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