Tuesday, November 25, 2008

Will Central Banks Backstop Pension Funds?


I just got back from Toronto. I flew with Porter Airlines, which I liked, but I simply hate the hustle and bustle of airports (note to self: next time you go to Toronto, take the train!).

I went to listen to the Canadian Business Outlook 2009 and to my surprise, I found it quite interesting (I usually dread these events and avoid them like the plague but duty called so I went).

There were several interesting presentations. Professor Roger Martin, Dean of the Rotman School of Management, opened things up with a discussion on creating conditions for prosperity.

He discussed productivity trends in Canada. He highlighted several interesting points, but the ones that stuck with me were that at in the 1990s, Canada started spending more on health and financed it by cutting back on spending on education. The U.S. kept up its spending on education and according to professor Martin, this explains a lot on the "prosperity gap" between Canada and the U.S.

He also noted that U.S. workers work more than anyone else. It used to be that Japanese workers worked more but as they prospered, they work less. The same for Canadians and most other countries, as they prosper, they work less.

On Canadian tax policy, professor Martin does not have a problem with the level of taxation but with the structure of taxation which he calls "stupid". For example, Canada has the highest level of taxation on the service economy in the industrialized world, which he thinks is ridiculous.

The following speaker was Andy Canham of Sun Microsystems. Mr. Canham discussed enhancing workforce productivity in a collaborative economy. He opened his remarks by stating propserity is just about working longer hours, it's also about being happy. Sun Microsystems has created a work environment were 50% of the work is home based.

Think about how much time we waste in traffic or getting to work and how we could better use that time to work from home. Sun has created a method to ensure the security of the data in a business and use computers that are linked to a few main servers to increase workplace productivity. He referred to the example of a hospital that used Sun to computerize the way they track patients at the hospital (Health Canada should implement this nation wide!).

He also stated that the most incredible revolution happening in the internet is open source code where peope can download computer code. Sun Microsystems bought MySQL and they noticed that the biggest use of open source code comes from emerging markets.

Importantly, when it comes to technology, Mr. Canham notes that productivity gains are non-linear, typically "jumping" from one period to another. Once people start implementing new technology and feel comfortable with it, then you see incredible productivity gains.

After a small break, Joe Chidley, editor of Canadian Business, moderated a discussion between Benjamin Tal of CIBC, David Wolf of Merrill Lynch Canada, and Derek Burleton of TD.

Mr. Tal got things rolling stating that economists like to use "first derivatives" when all else fails. He said that even though house prices are falling in the U.S., they are falling at a slower rate, which he thinks is encouraging.

He believes the recovery will be a U-shaped or W-shaped one and even though it will happen over the next 18 months, it will take years before we return to normal conditions.

Mr. Tal also thinks protectionism will come back under an Obama administration as he has already hinted to a carbon tax on Chinese goods, which has the "dual purpose of protecting the environment and U.S. jobs."

Mr. Wolf said for him the key indicator to look at is the confidence index. If confidence does not come back, neither businesses nor consumers will start spending again.

At one point, after their speeches, Sherry Cooper, Chief Economist of BMO Capital Markets, walked into the room to prepare for her closing keynote presentation. I stood up and asked them about the risks of global deflation.

All three economists saw little if any risk of a 1930s or Japanese deflationary episode. Mr. Burleton remarked that Fed Chairman Bernanke is a student of the Great Depression and has been quantitatively easing the money supply to buy back debt. "The Fed's own balance sheet has increased dramatically in recent weeks".

Mr. Wolf said that even though headline inflation in Canada and the U.S. will slip into negative territory next year, a long period of deflation is unlikely because of aggressive monetary and fiscal action.

Mr. Tal agreed stating that unlike in Japan, authorities responded quickly to this crisis. He sees a buying opportunity in commodities over the next six months.

Dr. Cooper said that U.S. consumers are tapped out and they are starting to save. This poses a challenge to authorities who want them to spend. She noted that the Treasury has created new facilities to lend as much as $200 billion on a non-recourse basis to holders of AAA-rated asset-backed securities backed by “newly and recently originated” loans, such as for education, credit cards, automobiles and loans guaranteed by the Small Business Administration.

"This is as close as you get to lending money to consumers".

Even if these measures fail to bolster confidence, Dr. Cooper notes that the Fed will do "whatever it takes" to avoid deflation. "If the Fed needs to start buying long bonds, it will, if it needs to buy corporate bonds, it will, if it needs to buy stocks, which it is already doing, it will".

But then she noted: "Who will pay for all this?" Like Mr. Tal, she said that in the end, there will be a run on the U.S. dollar and that will be inflationary.

I agree with many points. However, if inflation does come back into the system and rates rise too fast, that will put more pressure on over-indebted consumers, ultimately increasing the risks of debt deflation.

Moreover, any slowdown in China is deflationary. I wouldn't be surprised to see another round of goods deflation coming from China in mid-2009.

The other big kink in all of this is that we avoid a major war, which will guarantee hyper-inflation. Let's hope we do not reach that point.

There is another issue that I want you to think about. Who will bail out pension funds? Will the Fed and other central banks lend them billions of dollars to make up for their shortfalls? Don't laugh, it might reach that point.

Speaking of pension funds, Andrew Willis of the Globe and Mail reported that Caisse sold equities to shore up or shut down money-losing positions in areas such as currency hedging and derivatives, along with international real estate and private equity.

The article cites a figure of $10 billion. I chuckled coming back from the airport listening to Michel Nadeau on the radio. I asked the cab driver to pump up the volume. The former second in command of the Caisse said that it was right to sell equities in October as equities declined more in November. Too bad Mr. Nadeau did not take the same steps with Nortel back in 2000 (I can't blame him, I and millions of others, got royally screwed with Nortel too!).

I also read another article in the Globe and Mail that Alberta Investment Management Corp. (AIMCo) chief executive officer Leo de Bever has recruited two former colleagues, George Engman and Brian Gibson, to join AIMCo as senior vice-presidents of direct private equity and equities, respectively:

"I need depth, I need experience, and I need people with a track record of being able to take opportunities and realize them," Mr. de Bever said yesterday in an interview, adding he plans to announce further hires in the coming weeks.

"Leo was given a mandate to build a top-class investment management organization and this is evidence he is executing on his mandate," said Keith Ambachtsheer, director of the Rotman International Centre for Pension Management at the University of Toronto.

As I have written in the past, Mr. de Bever is one of the most brilliant people I've met in the financial industry (contrary to popular belief, there aren't many brilliant people in finance) and AIMCo is lucky to have him as their leader. He is recruiting the right people to join him.

The sign of true leaders is that they are not afraid to recruit experienced people that challenge them. Conversely, dumb leaders who lack self-confidence surround themselves by "yes-people" who continuously stoke their fragile egos.

Let me end this post with a few thoughts on risk. After this morning's presentations, I hooked up with a buddy of mine for lunch.

We started talking about the Caisse and other pension funds that lost billions in the market rout. My buddy remarked that pension funds should have allocated a lot more to bonds and they should have protected their gains through the use of options.

"You'd think they would buy premium to protect their downside. Why didn't they sell call options to finance the purchase of put options?"

At the airport afterward, I ran into a former colleague of mine who echoed the same sentiments:

"These 'sophisticated' pension funds were buying all sorts of OTC complex crap and they couldn't figure out plain vanilla option strategies to protect their equity gains. It's ridiculous. That's what happens when you have theoreticians running investments instead of market guys who understand risk."

He told me that pension funds should start implementing option strategies to protect their gains. You can read more about using options to hedge equity risks in pension plans by clicking here.

One final note. Yesterday, I referred to an Expert Commission on Pensions headed by Harry Arthurs. In a report submitted last week, Arthurs makes several proposals to encourage new or expanded pension plans and argues for reinventing the Canada Pension Plan.

One professor of economics from McGill university sent me this comment:

Just a note on the Arthurs suggestion: one of the features of inter-generational PAYGO plans is that the first generation always benefits, and the last generation (yes, there must be a last generation some time!) is left holding the bag. Doubling the size of the CPP is turning the current generation into a first generation, and leaving some people down the road holding twice as big a bag.

The problem with all that is the demographic structure in most OECD countries makes PAYGO arrangements unsustainable at the intended level of real benefits in a reasonably short time. Why people like Arthurs are blind to the obvious, is not clear to me.

People are blind to a lot of things. They think that stocks will come back roaring and pension shortfalls will magically go away.

Not this time. As Dr. Cooper mentioned in her presentation, the new Goldman Sachs and Morgan Stanley will have leverage ratios of 10 to 1 - like most commercial banks - not 30 or 40 to 1. This means that the era of double digit index performance is over.

That leaves me to ask, who will bail out pension funds? The Fed? The Bank of Canada? Other central banks? If so, it's just another bailout of negligence that we will all end up paying.

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