Friday, November 28, 2008

Pension Meltdown Will Only Get Worse

U.S. stocks gained, capping the biggest weekly advance for the Standard & Poor’s 500 Index in 34 years, on speculation that government bailouts will shore up the economy:
Citigroup Inc., which had $306 billion in troubled assets guaranteed by the government last weekend, rallied 18 percent for its fourth straight gain. General Motors Corp. climbed 8.9 percent and Ford Motor Co. surged 25 percent as the automakers considered cutting debt and labor costs to win federal aid. Target Corp. slumped 3.9 percent as retailers extended discounts to lure shoppers amid what is forecast to be the slowest holiday shopping season in six years.

“It’s going to be a really tough Christmas shopping season, but a lot of this is built into the stocks, and there is huge stimulus coming down the pipeline,” Alan Gayle, senior investment strategist at Ridgeworth Capital Management in Richmond, Virginia, said on Bloomberg Television. “We are cautiously bullish.” Ridgeworth manages $70 billion.

The S&P 500 climbed for a fifth day, adding 1 percent to 896.24 to complete its longest streak of gains since July 2007. The Dow Jones Industrial Average rallied 102.43 points, or 1.2 percent, to 8,829.04, while the Nasdaq Composite Index increased 0.2 percent to 1,535.57. Almost two stocks rose for each that fell on the New York Stock Exchange.

The S&P 500 surged more than 12 percent this week, its best weekly performance since 1974, as the Federal Reserve committed as much as $800 billion to help resuscitate lending markets and investors speculated President-elect Barack Obama’s economic team will bolster growth. Obama said Nov. 26 that he will implement plans to shore up the economy on “day one” of his presidency.

About 787 million shares changed hands on the NYSE in the slowest trading session of the year. U.S. exchanges were shut yesterday for the Thanksgiving holiday and closed at 1 p.m. today.
This Santa Claus rally will likely last till Christmas because hedge funds, mutual funds and pension funds are going to be in buy mode going into year-end, trying to salvage whatever they can from one of the most brutal years in stocks ever.

But before you warm up to stocks, listen to what professor Robert Shiller, author of Irrational Exuberance, had to say in a recent lecture:
The lecture kicked off with a quick recap of how we got to where we are. These were the highlights:
  • Psychological factors played a huge role. Irrational exuberance (a term coined by Alan Greenspan and borrowed by Shiller for the title of his 2000 book) caused bubbles to appear all across the world . Word spread that by simply buying stocks, or a house, you can become effortlessly wealthy. You can’t.

  • Genuine financial advice was only available to the wealthy. Anyone who gives you free or “affordable” advice isn’t really advising you at all. They’re trying to sell to you. Hence many subprime borrowers got in over their heads – basic questions like “Can you afford this?” “What if interest rates rise, or you lose your job?” were left unasked.

  • Individuals fell victim to Groupthink. Groupthink is where it’s in the interests of individuals to subordinate what they really think to what is acceptable to the consensus. Imagine a rating agency employee in 2006 saying to his boss: “I want to downgrade this debt. I think we’re going to have another Great Depression…” Not exactly a smart career move!

We were then shown charts of stock indices, p/e ratios and volatility going all the way back to 1870. Let’s start with the volatility.

There are only three points in history where we observe extreme volatility. One is right now. The others are 1987 and 1929.

The real terms p/e ratios chart was even scarier. The big bubble run up from 1982 to 2000 appears like the Matterhorn rising out of some hillocks. This, of course, is the bubble that’s now being corrected (for more on this see The Daily Reckoning, below).

In percentage terms, we’ve only ever seen such a bubble once before since 1870. Yep, you guessed it…before 1929!

Shiller told us that, in real terms, the S&P fell 80% in the 1930s. So far it is only down 54%.

This means you still have a once-in-a-lifetime opportunity to lose a lot of money very quickly. Will you take it? I for one hope you don’t…

Most of us have never been in this position at any time before throughout our lifetimes. Who alive today has first-hand experience of investing during a prolonged, worldwide, stock market and real economy Depression?

Moreover, there are disturbing signs that the meldown is far from over as a new mortgage crisis looms:

Black Friday's retail shoppers hunting for holiday bargains won't be enough to stave off what's likely to become the next economic crisis. Malls from Michigan to Georgia are entering foreclosure, commercial victims of the same events poisoning the housing market.

Hotels in Tucson, Ariz., and Hilton Head, S.C., also are about to default on their mortgages.

That pace is expected to quicken. The number of late payments and defaults will double, if not triple, by the end of next year, according to analysts from Fitch Ratings Ltd., which evaluates companies' credit.

"We're probably in the first inning of the commercial mortgage problem," said Scott Tross, a real estate lawyer with Herrick Feinstein in New Jersey.

That's bad news for more than just property owners. When businesses go dark, employees lose jobs. Towns lose tax revenue. School budgets and social services feel the pinch.

Companies have survived plenty of downturns, but economists see this one playing out like never before. In the past, when businesses hit rough patches, owners negotiated with banks or refinanced their loans.

But many banks no longer hold the loans they made. Over the past decade, banks have increasingly bundled mortgages and sold them to investors. Pension funds, insurance companies, and hedge funds bought the seemingly safe securities and are now bracing for losses that could ripple through the financial system.

"It's a toxic drug and nobody knows how bad it's going to be," said Paul Miller, an analyst with Friedman, Billings, Ramsey, who was among the first to sound alarm bells in the residential market.

Unlike home mortgages, businesses don't pay their loans over 30 years. Commercial mortgages are usually written for five, seven or 10 years with big payments due at the end. About $20 billion will be due next year, covering everything from office and condo complexes to hotels and malls.

The retail outlook is particularly bad. Circuit City and Linens 'n Things have sought bankruptcy protection. Home Depot, Sears, Ann Taylor and Foot Locker are closing stores.

Those retailers typically were paying rent that was expected to cover mortgage payments. When those $20 billion in mortgages come due next year – 2010 and 2011 totals are projected to be even higher – many property owners won't have the money.

Some will survive, but those property owners whose loans required little money up front will have less incentive to weather the storm.

Refinancing formerly was an option, but many properties are worth less than when they were purchased. And since investors no longer want to buy commercial mortgages, banks are reluctant to write new loans to refinance those facing foreclosure.

California, New York, Texas and Florida – states with a high concentration of mortgages in the securities market, according to Fitch – are particularly vulnerable. Texas and Florida are already seeing increased delinquencies and defaults, as are Michigan, Tennessee and Georgia.

The worst-case scenario goes something like this: With banks unwilling to refinance, a shopping center goes into foreclosure. Nobody can buy the mall because banks won't write mortgages as long as investors won't purchase them.

"Credit markets have seized up," corporate securities lawyer Michael Gambro said. "People are not willing to take risks. They're not buying anything."

That drives down investments already on the books. Insurance companies are seeing their stock prices fall on fears they are too invested in commercial mortgages.

"The system has never been tested for a deep recession," said Ken Rosen, a real estate hedge fund manager and University of California at Berkeley professor of real estate economics.

One hope was that the U.S. would use some of the $700 billion financial bailout to buy shaky investments from banks and insurance companies. That was the original plan. But Treasury Secretary Henry Paulson has issued a stunning turnabout, saying the U.S. no longer planned to buy troubled securities. For those watching the wave of commercial defaults about to crest, the announcement was poorly received.

"He's created havoc in the marketplace by changing the rules," Rosen said. "It was the stupidest statement on Earth."

The Securities and Exchange Commission is considering another option that might ease the crisis, one that would change accounting rules so banks don't have to declare huge losses whenever the market declines.

But the only surefire remedy is for the economy to stabilize, for businesses to start expanding and for investors to trust the market again. Until then, Tross said, "There's going to be a lot of pain going forward."

The commercial real estate crisis will hit pension funds hard in two ways. First, through direct investments in commercial real estate and second, through their holdings of commercial mortgage-backed securities (CMBS).

Now, let's look at this recent Toronto Star article that states that Canadians can grow old knowing their pension plans are in good hands thanks to real estate investments:

What do landmarks such as First Canadian Place, Toronto Eaton Centre, The Fairmont chain of hotels, and Yorkdale Mall have to do with you?

Chances are, you may own them – or at least a share of them.

That's because Canada's leading pension funds, to which most working Canadians contribute, own much of the country's top office and retail properties.

And so, that makes Canadians the largest owners of major commercial real estate properties across the country.

"Historically, real estate has always been good for investors," explained Graeme Eadie, senior vice-president of real estate investments at the Canada Pension Plan Investment Board (CPPIB), an independent body formed in 1997 to manage funds for the Canada Pension Plan (CPP), which administers benefits.

"It is a source of good, long-term, stable income which is always good in terms of a pension plan's liability."

That is why major funds like OTPP (Ontario Teachers' Pension Plan), and OMERS (Ontario Municipal Employees Retirement System), in addition to CPPIB, all have significant holdings in real estate.

"Urban areas are showing continued growth and high quality real estate does not sell frequently because it is a valuable asset to any portfolio," Eadie said.

And, the value of such an investment is particularly evident to CPPIB since it only introduced the real estate class of assets in 2005. Already, though, it represents 6.2 per cent of its entire fund.

In other words, out of the complete fund, which is valued at $117.4 billion, real estate accounts for $7.2 billion and includes properties such as Toronto's First Canadian Place and Royal Bank Plaza, in addition to a collection of other office and retail properties across Canada.

According to Eadie, because the CPPIB was only formed a decade ago, it took some time to get it up and running and only then could new assets be moved into the program, such as real estate.

"It's a good pace," commented Eadie, "and my expectation is it will certainly grow."

By comparison, the OTPP has been investing in real estate for a longer period and, as of December 31, 2007, its net assets totalled $108.5 billion, of which $16.4 billion was in real estate investments.

According to OTPP director of communications Deborah Allan, since 1991 -– when the OTPP overhauled its entire pension plan by diversifying beyond a bond-only plan – real estate has represented a considerable share of the plan's overall assets.

By 1995, the OTPP acquired 20 per cent of its property manager, Cadillac Fairview Corp. Ltd., and by the year 2000, acquired the remaining 80 per cent. As of last December, real estate represented 17 per cent of the OTPP's total investment assets.

"Real estate falls under inflation-sensitive assets, so we have it as a hedge," explained Allan. "Our pensions have inflation protection so we require assets that correlate with that liability."

The OTPP's Top 10 holdings include Vancouver's Pacific Centre, Calgary's Chinook Centre and Toronto's Sherway Gardens, Toronto-Dominion Centre Office Complex and the Toronto Eaton Centre.

All plans, if looked at in their entirety, are diversified, and for good reason. They must be able to balance between private and public assets and be able to weather economic storms such as the volatility in the current financial market. The various pension fund managers interviewed said they are optimistic that their real estate assets will provide gains in the long term.

"My expectation is it will continue to grow," explained Eadie. "The current economy and other slowdowns in other markets gives us buying options we wouldn't normally see."

John Pierce, vice-president of corporate communications at OMERS – one of Canada's largest pension plans that provides retirement benefits to 380,000 members across Ontario – agreed.

"Real estate is an important part of our private asset investments and we're looking at moving more toward increasing those assets because of their long-term stability," he said.

With more than $52 billion invested in a wide range of companies and assets around the world, $10.9 million of OMERS assets are in real estate, representing 12.5 per cent of the entire fund, as of December 31, 2007.

Oxford Properties Group (Oxford), a wholly-owned subsidiary of OMERS, manages all of its real estate investments. Some of OMERS best-known properties are its hospitality real estate that includes 100 per cent of the shares in The Fairmont's Banff Springs, Chateau Lake Louise and Chateau Whistler, to name a few. It also holds shares in retail, office, industrial and residential properties.

Most funds, in addition to their considerable holdings in Canada, also invest globally. And with markets faring as they are, pension plan investors expect there to be greater buying opportunities outside Canada. Both the CPPIB and the OTPP own shares in U.S. real estate as well as in the United Kingdom, South America and elsewhere.

"We are always looking across the global market, " Eadie said.

During better economic times, the CPPIB bought little real estate in the United States because prices were too high, but now is a good time to look globally, according to Eadie, since properties are becoming more affordable.

Nevertheless, Canadian real estate remains predominantly in the hands of large pension funds and will remain as such since, as one banker put it, "land doesn't go away."

So, the next time you are shopping or banking or meeting at a high-powered attorney's office, consider that you are perhaps surveying the fruits of your labour, literally, since your pension plan investment has possibly made you part owner of that very location.

What this article neglects to tell you is that real estate can and will get whacked hard if this recession is deep and protracted. This decline will be unlike anything pension funds have ever seen before.

Another important thing you should keep in mind is that pension fund managers allocate to private asset classes like real estate claiming diversification benefits but the reality is that that they fudge the benchmarks in private markets to easily beat them, allowing them to reap big bonuses at the end of their fiscal year.

You should remain very skeptical about all these pension funds buying up commercial real estate at this time thinking there are "tremendous opportunities". Nobody knows how bad this recession could get and commercial real estate prices have lots of downside risk from these levels.

Amazingly, CNBC posted an article today stating if you are looking for upside, try commercial property bonds:

“Those bonds today are trading at 14-16 percent yields—it’s outrageous," Darrell Wheeler, a CMBS analyst with Citigroup. "I’d rather have that than a US Treasury—that’s how dislocated the market is.” [with good reason!]


But investors should drill down into these trusts' portfolios because the investment focus may have put them lower in the capital structure through purchases of subordinated debt or construction loans that may not have a recession full priced in, cautions Wheeler.

Indeed, JPMorgan cautions against overweighting Triple-A bonds “solely because of the wider spreads,” in part because “the year-end delevering still appears to have some legs.”

Here is my advice to you: never trust anything that is peddled on CNBC!

As I read about pension plans being disappointed with the federal government's relief proposal, I wonder if extending the pensions' top-up time by 20 years will be enough. If we get a Japanese style deflationary episode, commercial real estate prices can and will tank for a very, very long time.

Finally, you should read about how BCE Inc. and its retreating suitor Ontario Teachers' Pension Fund are feuding again, this time over a $1.2-billion termination fee:

Under the terms of Teachers' agreement to acquire BCE, the pension fund must pay what is known as a reverse break fee if its actions trigger the deal's collapse. Legal experts said that to win the fee, technically BCE would have to demonstrate that Teachers gave KPMG's auditing team incomplete or erroneous information for their solvency analysis.

KPMG concluded from data supplied by BCE and Teachers that the company would not meet a solvency test because its debts would exceed its assets after $32-billion of takeover debt was tacked onto the company. According to sources, KPMG estimated Teachers would have had to inject an additional $3-billion of equity to ensure BCE's solvency. BCE disputes the findings and a team of senior financial officers are reviewing the analysis with the auditing team.

It is understood that Teachers strongly disputes any wrongdoing, but the pension fund may opt to negotiate paying a lower break fee to BCE to avoid a messy and protracted legal dispute.

Also working in BCE's favour are the enormous legal costs and time its management devoted to preserving Teachers' bid in the face of legal challenges from bondholders and financial stresses weathered by banks backing the takeover. Indeed, BCE was so accommodating that the company helped its prospective buyer this year by cutting its dividend to conserve cash and bowing to its request for company executive George Cope to take the reins as chief executive officer.

“Teachers owes BCE. It bent over backward to make this deal happen,” said one person close to BCE.

My advice to Ontario Teachers is to suck it up, pay it and move on. Had they proceeded with this mega buyout, it would have cost them a lot more than this termination fee.

***Special Note on Profiting from the Real Estate Bust

I was reading David Spurr's comment on Displaced EMA where he sees a nice short setup on the Russell 2000. I agree that there will come a time when you want to short small caps again, but do not buy any ultra short proshares just yet.

Then I looked at the chart of the Ultrashort real estate proshares (SRS). I recommended it in early October at $84 and it popped up, reaching a high of $295 before selling off. It is now trading at $121.86 and you should keep an eye on it. If it falls anywhere near or below its 200-day m.a., start slowly building positions.

But I warn you, these ultrashort proshares are very, very volatile and are not to be bought for buying and holding puposes. Some of them are not very liquid, adding to their volatility. But if you like to swing trade on the long and short side, you should read more about proshares by clicking here.

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