Tuesday, December 30, 2008

2008: Year of Reckoning for Pensions?


How will you remember 2008? Most investors will remember 2008 as a year of turmoil:

The past 12 months will be remembered as a gut-wrenching confluence of unlikely defining trends, almost all unpleasant: a puncturing of the housing bubbles in the U.S. and Western Europe; a paralyzing credit freeze among banks worldwide; an abrupt plunge in commodity and stock prices; global government bailouts of banking, auto and other sectors, and of consumers (through "stimulus packages"); and the re-emergence of unapologetic deficit spending to put an economic Humpty Dumpty back together again.

But the year is better understood as one of reckoning, of forced atonement for past sins. The industrialized world has long been living beyond its means, floating everything from unaffordable house purchases to highly leveraged corporate takeovers on a sea credit of unprecedented volume. When the tide of easy money that characterized most of the decade finally went out, crises long in the making suddenly emerged full-blown almost everywhere one looked.

The ceaseless reporting of crushing bad news – the U.S. housing collapse is killing our forest sector; the world's largest industrial enterprise, General Motors Corp., said in December it didn't have enough cash to make it to the end of the year – was so grim and unfathomable that it provoked comparisons with the Great Depression, when everything was falling apart and no one knew why.

The meltdowns in various realms of the global economy often have no equal since the Dirty Thirties, to be sure. But they have unfolded with predictable logic, as naturally as the connections made in a child's join-the-dots puzzle.

The only question is whether we will heed the lessons learned from this year's debacles, which come only a few years after the irrational exuberance of the tech- and dot-com collapse.

1. Housing bubble. This is ground zero for the worst global economic downturn since the 1930s. For about four years ending in 2007, a buying mania overcame aspiring homeowners in pockets of the U.S. (most notably California and Florida) and in Western Europe.

It was fueled by an unreasonably prolonged period of low interest rates; a mistaken belief, especially in the U.S., that house values never fall; and aggressive mortgage vendors whose terms were no down payment, no collateral, no proof of income, and initial low "teaser" rates that would "reset" at much higher monthly payments in years ahead, by which time the house would have vastly increased in value and become essentially self-financing.

That was the theory, and it held until last year when the U.S. Federal Reserve Board finally reacted to the overheated housing market by boosting its key lending rate to more than 5 per cent, just in time for the first "resets" to kick in.

By the fall of 2007, house prices in San Diego; Port St. Lucie, Fla.; Reading, England; and suburban Barcelona were beginning their plunge by 50 per cent to 70 per cent. (In Canada, where the phenomenon of subprime mortgages to high-risk buyers occurred on only a modest scale, average home prices slipped just 11 per cent from May to December of this year.) Tens of thousands of Americans and Europeans who had bought more house than they could afford simply walked away from their properties or lost them through foreclosure. And why not? There was no down payment to lose, only a string of modest monthly teaser payments.

There now remains a huge overhang of vacant properties that remain unsold even at knock-down prices because of the subsequent U.S. and European recessions. The current widespread fear of job loss trumps buying a home at any price – bad news for a Canadian forestry sector reliant on U.S. exports.

Lessons learned: For buyers, when a deal looks too good to be true, it is. For lenders, don't be surprised if you're stuck with vacant homes in which the buyers had not sunk much of their life savings. For central bankers, the economy pays a fearsome price for the reluctance to raise rates and end the party before the revelry gets out of hand.

2. Global banking collapse. Wall Street bundled those dubious home mortgages taken out by buyers with poor credit histories into packages of $250 million (U.S.) or so, and flipped them to banks, insurers, pension funds, hedge funds and other financial institutions worldwide, which re-flipped them, until no one knew who held the mortgage on the split-level at 83 Cherry Orchard Lane in a new Oakland, Calif., subdivision. It might be held by UBS AG or Royal Bank of Scotland PLC, the biggest banks in Europe and Britain, respectively; or by Citigroup Inc., the No. 1 U.S. bank; or by one of Wall Street's Big Five brokerages; or by the Canadian Imperial Bank of Commerce – all of which have written off several billion dollars worth of soured mortgages.

Because so few of these venerable, giant institutions had sufficient underlying capital to cover the loss if a sizeable chunk of those dodgy mortgages should fail, when the worst-case scenario occurred, the demise of Merrill and two of its Big Five peers was not far off.

Royal Bank of Scotland had to be nationalized in a British government bailout. And Uncle Sam twice injected emergency rescue funds into Citigroup last fall. To date, Washington has had to put up a stunning $8 trillion to prevent the collapse of America's banking system – a move replicated by most West European governments.

Lessons learned: All movements go too far. Couples with $30,000 in combined earnings should not be purchasing $650,000 townhouses. The noble goal of bringing home ownership within reach of all Americans, promoted by the Bush administration since 2002, should have proceeded with more safeguards for the lenders, who themselves were reckless in their pursuit of upfront fees on mortgage sales. And we learned that it's best for the risk attached to a loan to stay with the initial lender, which must satisfy itself that the borrower can handle the debt and is there to renegotiate the terms if the borrower runs into trouble.

3. Global recession. With troubled banks unable or unwilling to lend, even the most creditworthy consumers and businesses have been denied loans for a car purchase or plant expansion. And countless more prospective borrowers have lost their appetite for credit cards and lines of credit, as a growing fear of losing jobs and houses and of disappearing corporate profits has made concerns about a recession a self-fulfilling prophecy.

By year-end, Japan, the U.S., Canada and most of Europe were in recessions. Iceland, a member of the Organization for Economic Co-operation and Development, club of the wealthiest nations, became effectively insolvent. And the International Monetary Fund rushed financial assistance to Pakistan, Hungary and Latvia.

Lessons learned: Globalization is real. The freeze-up in credit for U.S. corporate borrowers has thinned the order books of industrial-equipment makers in Germany and Britain. American consumers who've snapped their wallets shut have doused the red-hot GDP growth of China, triggering civil unrest in that export-driven economy. Given the widespread wreckage from the troubled global financial system, the system will have to be rebuilt with uniform standards worldwide for lending practices and for monitoring banks and other lenders to ensure prudent risk management.

Financial authorities in Tokyo and Frankfurt will have to recognize that quick-buck purveyors of predatory mortgages in Alabama could someday pose a threat to Asian and European banks in the absence of co-ordinated global intervention to curb destabilizing practices.

4. Stock-market crash: In the short space of a few months in the summer and fall, stock-market prices plunged about 40 per cent in Canada and the U.S. in response to a global banking system that stubbornly refused to recover despite many government bailout attempts, which in turn signalled a halt in corporate profit growth.

The two-thirds plunge in crude oil prices from their peak in July, and rising jobless numbers in western economies (the U.S. lost two million jobs this year), were further evidence of a looming drought in profits and dividends. By late summer, investors had started stampeding for the exits, and mutual-fund withdrawals reached record levels. That was another self-fulfilling prophecy as selling begat more selling, blindsiding even the most sophisticated investors. Warren Buffett's Berkshire Hathaway Inc. lost about half its value by December.

Lessons learned: Vigilance is required in monitoring any investment that can go to zero. An investor in 2007 and into early this year who watched U.S. and European authorities cope with the global banking meltdown was adequately warned to get out. The Canadian market peaked in June of this year, and began its rapid plunge in tandem with weakening prices for oil and other commodities and worsening conditions in Canada's most important export market, the U.S.

5. Deficit chic. After decades of balanced-budget orthodoxy, North American and European governments cast aside fiscal surpluses as a policy goal, and embraced Keynesian pump-priming with as much vigour as Franklin D. Roosevelt did 65 years ago.

In the late fall, Ontario pledged to run a deficit rather than cut social services. By December, the federal Tories, who had projected a modest fiscal surplus for 2009 in the October election campaign, had embraced deficit spending on infrastructure and other programs to the tune of about $30 billion Canadian. Next month, the new Obama administration will roll out a stimulus package likely to top $850 billion (U.S.), despite a current-year deficit estimated at more than $1 trillion.

That radical shift in public policy – and the public-opinion support behind it – might be the most enduring legacy of 2008.

For pensions, 2008 will be remembered as a year of reckoning. All of them were highly exposed to equities and most of them followed the dumb advice of their consultants and diversified away from government bonds, investing billions into alternative investments like hedge funds, private equity funds and real estate that were suppose to offer absolute returns.

It all sounded so sophisticated and for many years it seemed like the winning strategy. But the music has stopped and all I hear is the deafening sound of silence as pension funds scramble to recover from a year of brutal losses:

The median public fund losses from the beginning of the year to Nov. 30, the most recent date for which data is available, was 28.7 percent, according to data from the Northern Trust, a company that represents hundreds of funds. A similar index, the Wilshire Cooperative Universe, has a median of 25.6 percent losses. The decline across the Standard & Poor's 500 pension funds index, according to a report released Tuesday, was 41 percent.

"To put that in context, that's by far the worst year we've ever seen, going back 30 years," said Bill Frieske, a Northern Trust consultant for investment risk and analytical services.

Let's attach some figures to these results. If your pension fund was worth $100 billion at the beginning of the year and lost 30%, it is now worth $70 billion (ignore contributions).

This means it will take four years growing at 10% to recoup those losses. And that is a very optimistic (and highly unlikely) scenario. The more likely outcome is that it will take a decade or longer before most of these large pension plans recoup these losses.

Let this be a lesson to all you retail investors who chase returns. What goes up fast typically comes slamming down hard, erasing all your gains. This is why you need to always think about minimizing your downside losses.

Very few pension funds thought that they would ever experience 30% losses in any given year. They were lulled into believing that a well diversified portfolio of stocks and alternative investments would by its very construction minimize downside losses.

Their consultants performed "stress tests" using sophisticated financial models but those models were largely based on erroneous assumptions that these asset classes would never be highly correlated.

As a practitioner who was working in many of these asset classes, I was always looking at the big picture and scratching my head in disbelief. I would go to conferences and hear things like "you can't lose money in hedge funds, real estate and private equity".

Yeah right! These large and sophisticated pension funds lost billions of dollars in these asset classes because they never stopped to think that what if this is all one HUGE bubble?!?!?

Now they are scrambling to redeem from hedge funds and many are selling their private equity stakes at deep discounts on the secondary market. I can hear the board of directors screaming "Just get us out of alternatives!!!".

The problem is that once you invest in private equity funds or real estate funds, you're pretty much stuck with it for a long time unless you are willing to take haircut and sell your stakes in the secondary market at deep discounts.

But unless public equity markets come back, there are no exit strategies for these private equity companies. This is why investors should be in no hurry to up the private equity ante:

Public markets and private equity can sometimes make uneasy companions. No more so than in 2008, when a combination of moribund debt markets, the limited ability of private equity companies to sell on their investments and fears over the underlying value of their portfolios caused the sector to fall to an all-time low.

Last month, listed private equity in Europe was collectively trading at less than half its reported book value – a 52 per cent discount to reported net asset value, cheaper than at any other point since the post2001 sell-off, its previous nadir.

Evidence of that predicament is everywhere. Shares in 3i Group, the British sector’s grandaddy, have lost more than three quarters of their value this year, making it the fifth-worst performer in the FTSE 100 and taking it below its issue price for the first time since it floated in 1994. Elsewhere, SVG Capital, which backs investments made by Permira, has written down the value of its funds by £467 million.

Two weeks ago it launched a heavily discounted £200 million rights issue. In total, the seven most closely tracked UK-listed private equity vehicles (see table) have lost more than 60 per cent of their value this year, a sharp contrast to most of this decade. In the five years to 2007, the AIC private equity price index rose by a compound 18 per cent a year, comfortably outpacing the FTSE all-share index.

But has the stock market overreacted to what might otherwise be seen as a cyclical setback in the industry’s long-term structural growth? Certainly, the short-term challenges posed by recession are formidable.

First, the default rate on leveraged buyout debt cannot help but rise. On Standard & Poor’s data, only 1 per cent of the debt payments backing private equity deals were not met in 2007, against a long-run average of about 4 per cent. However, with company profits starting to fall, more and more buyouts are set to run into debt-servicing problems. UBS expects default levels to rise to “at least” 10 per cent next year.

Second, having been reasonably stable in the first half of the year, net asset values for private equity funds are due to follow the stock market sharply lower. The value of quoted investments will be marked to market, while those of unquoted companies will have to reflect the decline in earnings multiples of their quoted peers – a drop that is all the more severe if those investments are also heavily geared.

Third, falling stock markets make it more difficult for private equity firms to realise cash from their investments. Flotations become unattractive or impossible to achieve, and potential trade buyers with the necessary funding can push for better terms. Not only are private equity investors not getting their cash back, but it becomes harder to finance further buyouts, meaning that they have to invest more equity and so dilute their returns.

It used to be that private equity funds had more cash than they could swiftly invest, leading to a “cash drag” on their portfolio returns. Now, however, the opposite problem applies: that they have committed to make follow-up investments that they cannot honour.

Fourth, some funds made the bulk of their investments near the top of the market, making the scale of potential writedowns all the greater. UBS points out that Electra Private Equity has a relatively immature portfolio, having made more than 80 per cent of its unquoted investments in 2006 and the first half of 2007.

Investors should be in no hurry to buy into listed private equity until the full-year reporting season provides greater clarity on how their portfolios are faring. But for those willing to be patient, and to take a three- to five-year view, discounts of the scale of those on offer historically have proved a good point of entry.

Although HgCapital Trust, up 5½p to 663½p, has not fallen nearly as far as its peers, because of its 493p a share in cash, its lack of gearing, its strong track record and its midmarket focus make it one of the better places to start.

And the problems in commercial real estate are only getting started. As residential house prices keep plunging, commercial real estate is going to suffer a multi-year decline in prices.

If you thought hedge funds putting up redemption gates or selling private equity stakes in the secondary market was bad, what are these pension funds going to do when they see the value of their most illiquid real estate holdings plummet?

It's going to get ugly in 2009 and it's going to take a long time to sort this mess out.

But the important question to ask is how did all these intelligent people fall prey to the illusion of stability? Why did they underestimate systemic risk? Why weren't they prepared for the worst case scenario?

Back in 2005, I was arguing that we'd better be prepared for the ripple effects of the collapsing U.S. housing bubble. I kept insisting that we take the deflation scenario very seriously in our asset allocation. As God is my witness, I knew this mess was inevitable and that when it all breaks down, pension funds would suffer unfathomable losses.

I will leave you with some food for thought for 2008. Today officials said that South Korea's state pension fund -- the country's largest institutional investor -- will post its first-ever loss this year due to tumbling stock prices:

The Ministry of Health, Welfare and Family Affairs, which supervises the fund, said the National Pension Service posted a 0.75 percent loss, amounting to 1.76 trillion won (1.4 billion dollars), as of December 26.

It marks the first annual loss since the fund, which now has more than 230 trillion won in holdings, was created in 1988.

The ministry said the problem stems from its investment in stocks, which reported a loss of 41.20 percent.

South Korea's benchmark KOSPI stock market index has fallen nearly 40 percent so far this year amid the global financial meltdown, with overseas bourses similarly hard hit.

Last year the fund reported a 7.05-percent return on assets.

The ministry said Monday the pension fund would reduce its stockholdings next year from the current 29.7 percent to 20.65 percent of total assets.

It plans to increase its holdings of bonds and other investments from 66.4 percent to 73.4 percent.

Let this be lesson to all those pension funds that blindly followed Harvard, Yale and Ontario Teachers' Pension Plan into alternative investments. Instead of losing 30% or more, you could have lost 0.75% just like the South Korean national pension fund did last year.

Importantly, it often pays to err on the conservative side and keep your asset allocation simple and safe.

Unfortunately, pension funds got too cute and too sophisticated with other people's money and taxpayers are going to end up paying for their lack of investment prudence and judgment.

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