Friday, December 5, 2008

Caisse Sera Sera

U.S. stocks shook off a dismal employment to rally strong into the close:
Wall Street put an upbeat spin Friday on the government's report that the nation lost more than half a million jobs last month. Stocks reversed early losses and closed sharply higher as the data raised hopes that Washington will again step in to help the economy.

The Dow Jones industrial average closed up nearly 260 points as investors' shock dissipated over the Labor Department's report that employers slashed 533,000 jobs in November compared with the 320,00 that economists forecast. Ultimately, even a terrible reading on employment wasn't surprising to a market that has been drubbed by a stream of bad economic news.

The market's advance in light trading volume left Wall Street with moderate losses for the week, the result of a nearly 680-point slide in the Dow on Monday. More important, the market was able to claim a victory of sorts over the course of the week -- except for Monday's drop, stocks repeatedly overcome bleak economic data and corporate announcements.

Demand for the safety of government debt eased slightly Friday but remained high. In the past week, Treasury yields have plunged to their lowest levels since the government started issuing them.

Remember what I told you, hedge funds, mutual funds and pension funds all got slaughtered in Q3, so they are all in 'buy mode' going into the final stretch of the year to try and recoup some of those losses.

The fact that stocks rallied after such a dismal jobs report might seem strange to the average investor, but it's all part of the 'trading game'. Traders are now buying after bad economic news hits the news wire. This is bullish in the short-term.

The story that caught my eye this morning was Diane Francis' article in the National Post, Caisse has some explaining to do:

All the nonsense in Ottawa has diverted attention from a very important financial story behind the Quebec provincial election. It involves the Caisse de Depot et Placements du Quebec, which has had a rough ride this year, along with all pension funds globally.

But the Caisse, Canada's largest at $155-billion in assets, recently sold $10-billion in equities and the public deserves an explanation as to why. A press conference on Nov. 21 said the pension fund had no problems.

But one Caisse source said that the dumping of $10-billion may be due to the fact that Lehman Brothers was the Caisse's trader of choice. This means that Lehman held tens of billions of dollars worth of Caisse assets as collateral -- assets now tied up in a lengthy Lehman bankruptcy proceeding that may take months or years to untangle.

In another unusual recent action, its president, Richard Guay, took a temporary medical leave, coincidentally to last the duration of the Quebec election.

Over the weekend a new president was appointed with considerably more investment experience. Why Guay's sudden departure?

Here are other questions the Caisse should address:

-What is the full extent of the Caisse's entanglement with Lehman Brothers? Or with others? Why the $10-billion dumping of stocks in a terrible market? How long will the bankruptcy proceedings last? Are Caisse trades frozen, unable to be reversed or mitigated?

-The Caisse overheads have grown dramatically on former head Henri-Paul Rousseau's watch. From 2003 to 2007, the Caisse's assets increased by 60%, most of it through market appreciation, according to financial reports. But operating costs increased by 61%, or $205-million, to $330-million, over the same period. Why would the Caisse need to spend an extra $125-million a year to manage assets, which increased mainly through market appreciation as well as through new contributions by clients?

-The Caisse's risks are not evaluated on a real-time basis because its IT systems are antiquated. In 1996, the Caisse outsourced its IT functions to CGI and by 2003 problems and inefficiencies led it to reorganize its own internal IT department. Unfortunately, there was no cutback on the CGI contract costs even though an internal department was created. The result is IT costs are duplicated and bloated. Why is this, and has it impaired prudent risk management?

-External management fees for investment purposes jumped from $54-million to $61-million between 2006 and 2007. Are these fees higher than other pension plans as some suspect and if so why?

-The Caisse wrote down only 15% of the value of its asset-backed commercial paper holdings (ABCP) in 2007, or $1.9-billion of the $12.6-billion invested, even though other entities have written down 30% or as much as 70%. Why are writedowns so low by comparison?

-If the writedown were 30%, totalling $3.8-billion, would Rousseau and Guay have qualified for their large 2007 performance bonuses?

On page 48 of the Caisse's 2007 financial report, the fund said its overall "underperformance" was 0.57% of $155-billion, or $855-million. However, it said that if the $1.9-billion were excluded for ABCP, the Caisse would have outperformed by 0.72%. Why would any losses ever be excluded and why would the financials state that?

-Commodity trading underperformance is stated to have been 4.27% in 2007. On assets of about $2.5-billion, that is more than $100-million. Indications are that the experienced commodities team left and was replaced by less-experienced people who lost this amount in a few months. What is going on with commodities in 2008 and how significant are losses?

-The Caisse's 2007 financials state that its real estate portfolio under-performed by 3.43% in 2007. Based on total assets of $29.1-billion, that amounts to $848-million. That calculation is apparently not based on market to market, which is the only valid appraisal, and why is that the case? Are losses understated, and how dramatic are they in 2008?

-In 2007, Rousseau and Guay received millions in bonuses despite losses. Their 2007, bonuses were $1.575-million for Rousseau and $1.05-million for Guay. Why was this only slightly less than their bonuses in 2006 ($1.6-million for Rousseau and $1.1-million for Guay) when the Caisse performed well?

-How does the Caisse bonuses, and overheads, compare with the Ontario Teachers Pension Plan and other higher-performing pensions?

"The Caisse lost money last year and Mr. Rousseau and Mr. Guay did not deserve a bonus. The Caisse statements are not an example of clarity. Read them and you will see," said a source.

I will address some of these questions below, but first let me commend Diane Francis for publishing this article. My only criticism is that it narrowly focuses on the Caisse, leaving the impression that problems there are worse than at other large penson funds.

But as I have been repeating in this blog, almost all of the large public pension funds in Canada have been getting away with murder over the last few years, claiming to add significant alpha in private equity, real estate and infrastructure when all they were really doing was beating bogus benchmarks.

They are all guilty of doing this and they continue to play this game of using bogus benchmarks in alternative investments.

However, the great pension con job is coming to an end. As the bubble in alternative investments implodes, pension funds are taking another pounding. And it's only going to get worse in 2009 as commercial real estate tanks across the world (it is a global recession).

But let me address some of the issues raised in Diane Francis' article.

First, I was surprised to read that a new president was appointed over the weekend. Huh? Last I read, the Caisse's Board of Directors still backs Richard Guay. There are rumors that he was set up to take the fall but I have not heard that he was replaced.

Second, the Lehman bankruptcy proceedings might have impacted the Caisse and other pension funds who traded with them but I would be surprised if the trades are "frozen". If this is the case, then they should disclose it immediately.

Third, the Caisse overheads did grow dramatically on former head Henri-Paul Rousseau's watch, but so did assets, including private market assets which require a lot of overhead.

Nonetheless, the Caisse should disclose all fees paid to hedge fund, long only funds, private equity funds, real estate funds and infrastructure funds and compare its administrative costs to other pension funds. This should be mandatory for all pension funds.

Fourth, the Caisse's risks are not evaluated on a real-time basis because its IT systems are antiquated. This hardly shocks me. So many pension funds use antiquated IT systems that do not keep up with the complexity of the investment strategies.

Only an independent performance and operational audit conducted by professionals can give you a full picture of the performance and operational risks at a pension fund. This should be mandatory for all public pension funds every year and the results should be disclosed on their websites.

Fifth, the Caisse did not take the appropriate writedowns in ABCP. Neither did PSP Investments who wrote their ABCP down 30%. These ABCP investments should be written down 70%. They are worthless junk paper and should be treated as such.

Sixth, commodities got whacked this year as oil plummeted from its record high prices in July. Ontario Teachers invested in commodities through the Goldman Sachs Commodity Index, which is made up of 75% oil futures. The Caisse invest in the Dow Jones AIG Commodity index, which is more diversified because it has less exposure to oil futures. Nevertheless, these investments got slaughtered in 2008.

Seventh, losses in almost all real estate portfolios are grossly understated. Go back to read this Guardian article that discusses research from IPD claiming that four out of five commercial properties could still be overvalued, casting doubt on the worth of property funds.

Eighth, as far as "clarity of annual reports", none of the major public pension funds in Canada clearly present their benchmarks for internal and external managers in various investment activities.

Again, all major public pension funds that invest in alternative asset classes are all guilty of this. They deliberately obfuscate their results, burying important details in a plethora of obtuse footnotes that leave most people bewildered when trying to make sense of their performance.

Finally, as far as bonuses are concerned, none of the major CEOs and senior pension officers at the large Canadian public pension funds deserve to be paid the way they were after losing billions last year. This is especially true for those who use bogus benchmarks in private markets.

Importantly, if you wipe out five years worth of "alpha" - even if it is bogus alpha - in one year, then you should impose bonus freezes until you make up those losses.

I invite any senior pension fund manager to reply in my comments section at the end of this post to prove to me that the benchmarks they use in private markets accurately reflect the beta and risk of the underlying investment portfolio.

Then again, it's all a big "pension club" and nobody wants to expose the truth, especially if it hits their pockets.

Taking the long view? I got a better idea. Why don't we demand clawbacks on bonuses that were based on bogus benchmarks in private markets and stick high water marks on senior pension fund managers who recklessly lost billions investing in the great alternative investment bubble? That sounds perfectly reasonable to me.

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