Tuesday, December 23, 2008

The Grinch Who Stole Pensions' Christmas

Dear Santa,

2008 has been a terrible year for global pension funds. What looked like a contained subprime crisis spiraled into a full blown global credit crisis wiping out trillions of dollars from the balance sheets of global pension funds.

All asset classes got hit, including those beloved alternative investments that were suppose to deliver "absolute returns" when equity markets tank.

That's right, Santa, hedge funds are down this year and it now looks like private equity and commercial real estate are going to tank too.

How can you let this happen Santa? How can you allow the Grinch to steal precious alpha from our pension funds? Don't you realize that we invested billions of dollars into alternative investments so that we can go back to our stakeholders at the end of the year and claim we added significant added value in private equity, real estate and hedge funds?

It was all so beautiful while it lasted. We adopted ridiculous benchmarks in these alternative investments, taking on more risk and disguised beta, allowing us to reap huge bonuses at the end of our fiscal year.

For several years we managed to fool our board of directors, our stakeholders, the financial media and the general public. Hell, we even managed to fool ourselves believing that we were adding alpha and that the party in alternative investments would last for decades.

However, something went awfully wrong this year. We got our first warning back in June when the SEC charged two former Bear Stearns hedge fund managers with fraud.

But we chose to ignore it, believing in Alan Greenspan's theory that the U.S. economy and its financial system is "unbelievably resilient" and can withstand any financial shock.

Well, you know what happened next. Credit markets seized up, counterparty risk exploded, toppling giants like Lehman Brothers, AIG, and a slew of others. Then hedge fund liquidation set in and the markets capitulated...for now.

It turns out the Maestro was suffering from the same illusion of stability that made turkeys of global bankers and pension fund managers. The only "resilience" these days is the resilient economic downturn that threatens the global economy.

The decline in equities has hit pension funds across the world very hard. Today, Standard & Poor's said U.S. pensions are expected to register record underfunding levels for 2008:

Standard & Poor's analyst Howard Silverblatt expects pension funds of companies in the benchmark S&P 500 index .SPX to be underfunded by $257 billion in aggregate this year, beating the previous underfunding record of $219 billion set in 2002.

By contrast, S&P 500 pension plans were overfunded by $63.4 billion in 2007, S&P said.

"Any pension fund manager that came remotely close to breaking even in 2008 is quietly celebrating that they survived one of the worst markets in the modern era," said Silverblatt.

The Standard & Poor's 500 index has dropped about 40 percent this year.

At the end of last year, pension plans of S&P 500 companies had 61 percent of their money in stocks, 28 percent in fixed income, 4 percent in real estate and 7 percent in other categories, according to Silverblatt.

S&P noted that under U.S. accounting rules, companies typically smooth their pension funding status by averaging historical returns over several years, which actually reduces reported losses.

In the past few months, U.S. businesses have pressured the U.S. Congress for relief on 2006 requirements to fully fund their pension obligations.

Earlier this month, the U.S. Senate approved legislation allowing generally healthy multi-employer pension plans hurt by the decline in the stock market to avoid having to make drastic pension plan contribution increases to fund their plans.

[Note: President Bush signed that into law today]
Global pension funds are not faring any better. In Australia, pension funds have lost A$91 billion ($62 billion) in the year to Sept. 30, the equivalent of about 8 percent of the nation’s economic output, as the global credit crisis devalued assets globally.

In Britain, the savage fall in the market is wreaking havoc on corporate and public pension deficits:

Analysts at HSBC have carried out a controversial analysis that attempts to flag up those companies whose pension deficits could start alarm bells ringing in the next few years.

It makes intriguing reading. Top of the worry pile is UK Coal, with pension obligations equivalent to more than 320% of its market cap based on HSBC’s estimates using the 10-year average AA bond rate.

Next worst is Johnston Press, followed by National Express, Arriva, Fenner, FirstGroup, Croda International, Mecom Group, Kier and Currys owner DSG.

Other notable names in the top 20 include British Airways and Taylor Wimpey, the housebuilding giant.

HSBC reckons that in these difficult times, pension deficits could put additional strain on company balance sheets – especially if the pension obligations are many times bigger than the stock-market capitalisation of the business concerned.

And Santa, those alternative investments are turning out to be a real nightmare. With each passing day, the news keeps getting bleaker and bleaker.

Today the Blackstone Group announced it plans to liquidate two hedge funds as a lack of outside investing amid tight credit markets will prevent them from getting big enough to be meaningful to the company.

Another hedge fund, Cerberus Capital Management, is limiting investor withdrawals from one of its hedge funds after it lost 16 percent this year through November.

Yet another one, Tontine Capital, is liquidating two hedge funds after losses of more than 60 percent this year and plans to start a new fund in February.

Santa, even funds of hedge funds - the so-called experts of hedge funds - are struggling this year. And if Simon Hopkins, chief executive of Fortune Group, is to be believed, the pain is far from over, with a myriad of fund of hedge fund operators likely to bite the dust in the year ahead.

Perhaps this is why GAM, one of the biggest investors in hedge funds, will allow clients to withdraw from most of its funds of hedge funds only once a quarter rather than once a month, as the industry tightens redemption terms.

It is not just investment banks and hedge funds that must reinvent their business model. Private equity has to do things differently in the future, otherwise backers will disappear, the money will dry up and credibility for the profession will be destroyed:

Some of the problems are externally generated; but many are self-inflicted. The difficulties of 3i, its shares at a 75 per cent discount to book and below their issue price, is a demonstration of the underlying crisis.

Many limited partner (LP) investors are finding it difficult to meet their capital calls, thanks to a lack of liquidity.

Permira has already announced that it will not draw down 40 per cent of its last fund. Institutions over-committed to the asset class, assuming that cash returns would continue as normal. But exits have stopped, so LPs are getting no money back. Meanwhile their other allocations to assets including property and equities have plunged in value. SVG, the quoted fund of funds, has launched a rescue rights issue to prevent it defaulting.

Most major buy-out houses have carried out over-priced, over-leveraged deals that are underwater.

Examples abound: EMI, Boots, Countrywide, Harrahs, Hilton, McCarthy & Stone, GMAC, Chrysler, Freescale, Gala Coral, Pilgrim’s Pride and so on. In some, the bond prices indicate the equity is worthless; for others, the LPs have revealed huge writedowns. No doubt at year-end many auditors will insist on painful impairment provisions. The total paper losses will be at least $50bn (€36bn, £34bn) – and quite possibly more.

Inevitably, gearing has amplified these. An astute observer of the scene in New York suggested participants should assume a 40 per cent markdown in values from June to December this year.

As you can see, Santa, in private equity, it's not just a downturn, it's devastation. Perhaps this is why Barclays may sell its private equity business and why TPG Inc., manager of a $20 billion buyout fund, will allow investors to trim their commitments as they seek to conserve cash amid losses across financial markets:
The firm told clients in a letter that they can hold back as much as 10 percent of their original pledges, said the person, who asked not to be identified because the fund is private. TPG’s backers include the Washington State Investment Board and California Public Employees’ Retirement System, the biggest U.S. public pension plan. Calpers’s assets tumbled 28 percent in the past year to $182.5 billion.
Finally Santa, there is commercial real estate. This is the biggest bubble of all because pension funds refused to heed the warnings of smart real estate investors like Tom Barrack who warned us three years ago when he cashed out of real estate.

Now we are going to pay a dear price. Today, Moody's reported that commercial real estate prices as measured by Moody's/REAL Commercial Property Price Indices (CPPI) decreased in October by 2.4% over the previous month. Prices are down 11.5% from their peak in October 2007 and are 0.4% lower than they were two years ago:

For the past five months, the index has hovered about 11.5% below the October 2007 peak.

"Markets are rarely smooth as they go through the price discovery process," says Moody's Managing Director Nick Levidy. "We expected that the Moody's/REAL CPPI would experience some turbulence during this transition phase as overall price trends are captured in transaction activity."

Since the index first registered a decline in commercial property prices beginning in September 2007, ten of the last fourteen months have recorded negative price returns, with half of those ten declining more than 2%.

This month's report included the annual indices which, for the first time, all experienced negative growth.

The southern industrial sector saw the largest decrease in the annual indices, with prices falling 11% over the last four quarters. The three major office markets, San Francisco, New York, and Washington DC all saw decreases in property prices in October, although prices in all three cities are still significantly higher than they were two years ago.

As you can see, Santa, this isn't much of a Christmas for us pension funds. We were expecting another year of alpha in alternative investments and big bonuses based on bogus benchmarks at the end of the fiscal year.

Instead we are getting no diversification, negative returns, redemption withdrawals, illiquidity and all sorts of headaches that come along when a bubble burts and the hangover sets in.

Santa, given the circumstances and our complete underestimation of systemic risk, would you be so kind as to stuff our stockings with some alpha? Hell, we would even accept positive beta and will work to disguise it as alpha (we are very good at that).

At this juncture, we would also accept the safety of good old government bonds because after reading Martin Weiss' latest on the biggest sea of change of our lifetime, we are petrified of the prospect of deflation.

Finally Santa, if you do not have any alpha, beta or bonds left, we would not be ashamed to follow the big banks that got us into this mess and ask the government for a bailout. These days it seems that bailout madness is sweeping all nations.

What's the difference? Either way, the taxpayers are on the hook.

Thanks for understanding our plight Santa. We left you milk, cookies as well as some ABCP, CDOs and CDS by the chimney.


The Association of Pension Funds ABCP.

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