Saturday, August 30, 2008

McCain's Big Gamble: A Gift To Democrats?


This morning everyone is asking themselves: Who is Sarah Palin? In a bold and risky move, Senator John McCain selected Alaska's governor as his running mate.

Palin, a self-described "hockey mom," is a staunch social conservative with a reputation as a crusading reformer after pushing through higher taxes on oil companies. However, she has been tarnished by revelations that members of her staff tried to have her former brother-in-law fired from his job as an Alaska state trooper:

State lawmakers have launched a $100,000 investigation to determine if Palin dismissed Public Safety Commissioner Walt Monegan last month because Monegan wouldn't fire a state trooper involved in a messy custody battle with her sister.

She also is under fire from environmentalists for opposing the Bush administration's decision in May to list the polar bear as a threatened species under the Endangered Species Act because global warming is melting the polar ice cap. Palin said the decision could damage the state's and nation's economy.

Palin's rapid ascent in politics followed her appointment in 2003 by then-Gov. Frank Murkowski to Alaska's Oil and Gas Conservation Commission. From that post, she exposed ethical violations by the state GOP chairman, also a fellow commissioner, who got too close to the oil companies, and later exposed a similar problem involving the state attorney general. Palin's record on oil is not a simple one.

She supports opening the Arctic National Wildlife Reserve to drilling. But over opposition from oil companies, she pushed through the Alaska Legislature new taxes on the profits from oil pumped on Alaska's North Slope, arguing that an earlier tax proposal by her predecessor, Murkowski, was too lenient to the industry.

With oil prices soaring, Alaska collected an estimated $6 billion from the new taxes last fiscal year. With the state treasury bulging, she won legislative approval for a special $1,200 payment to every Alaskan to help pay for high energy prices.

She supports a TransCanada Corp. pipeline opposed by Exxon Mobil Corp., ConocoPhillips and BP PLC, the major gas lease holders on the North Slope. They have proposed a separate pipeline venture.

Palin's approval ratings have ranged from 79 to 86 percent, says Mark Hellenthal, a Republican pollster in Alaska.

"She's like Saint Sarah up here," according to Hellenthal.

But she's hardly without strong critics.

Dermot Cole, a longtime columnist for Alaska's second-largest newspaper, the Fairbanks Daily News-Miner, called McCain's choice of Palin reckless and questioned her credentials.

"Sarah Palin's chief qualification for being elected governor was that she was not Frank Murkowski," Cole said of her enormously unpopular predecessor, who lost favor with Alaskans in part because of unpopular budget cuts. "She was not elected because she was a conservative. She was not elected because of her grasp of issues or because of her track record as the mayor of Wasilla."

Clearly McCain is taking a big gamble with Ms. Palin:

“Here’s what I’m worried about,” said Ed Rogers, a Republican lobbyist and former aide to Presidents Ronald Reagan and George Bush. “McCain had to protect his reputation as an opponent of status quo Washington. He had to pick someone with the shortest Washington résumé. He did that. He picked someone the right wing is going to be happy about. But it’s a gamble.”

“The question is,” Mr. Rogers continued, “what does it do to the argument that Obama’s not ready?”

The question is particularly acute for Mr. McCain, who turned 72 on Friday and would be the oldest person elected to a first term as president if he won in November. His campaign now needs to convince the public that it can imagine in the Oval Office a candidate who has spent just two years as governor of a state with a quarter of the population of Brooklyn.

...

“In a way, McCain has set a trap on the experience argument,” said Scott Reed, who managed Bob Dole’s presidential campaign in 1996, “because if they start picking on her on experience, it’s going to backfire with women.”

Clearly McCain selected Ms.Palin to attract religious conservatives and more importantly, women who voted for Senator Clinton:

As much as Republican analysts/apologists would love to allay the critiques that Palin’s nomination is driven by her “maverick” political past (more on that later), her candidacy is transparent. The choice of a white, motherly, middle-aged woman is obviously a demographic ploy to further disunite the Democratic Party immediately after Thursday’s conclusion of its convention.

The timing of the announcement in the wake of Barack Obama’s choice of Joe Biden instead of Clinton as a running mate and the inclusion of a woman on the Republican ticket with its own history-making possibilities just scream reactionary cynicism. Not that an election campaign is much more than a performance in poll dancing, but the use of gender in McCain’s choice for vice president is still disturbingly shallow.

...

Her support for big oil companies, destruction of polar bears aside, leads her to advocate strongly for drilling in the Arctic National Wildlife Refuge, an idea that has for ages been disregarded as a reactionary and foolish Band-Aid on the larger problem of the country’s dependency on oil, foreign or domestic.

She further displays her Republican convictions through wanting to overturn Roe v. Wade; not believing in even the bastardized idea of gay civil unions; and being a proud, gun-toting/photo-oped member of the NRA. Although called a political outsider and reformer by analysts in Alaska, Palin has had an approval rating of over 80 percent during most of her two years as governor.

But her maverick status—the standards of which now have fallen to mean (1) you don’t come from a pre-existing political family and (2) you don’t allow people in your administration to do obviously illegal things—is now the focus of the mainstream media. Palin did blow the whistle on the Alaska state Republican chairman after a conflict-of-interest case went untouched, but clearly the word maverick has become empty when it can be so generously applied to someone thrown onto the national political stage after only a handful of years in her political party.

The choice of Palin, as much as it is a performance supplement to McCain’s diet of jowl-shaking diatribes against Obama’s celebrity and spryness, does offer a considerably unified platform from which to launch the Republican Party into its convention in St. Paul next week. The ways the Democrats will respond, both immediately and in terms of their long-term strategy to win in November, will be interesting to watch, as will the requisite deluge of comments about Palin’s attractiveness and femininity. Oh yeah, the governor-turned-vice-presidential-candidate was a runner-up in a Miss Alaska beauty pageant. Let the cable news commentary commence.

But others see this move as possible political genius:

That's because the very issues that Democrats say make her a political risk -- her newness to the political world stage, her anti-choice stance, her opposition to gay marriage, her support of capital punishment, her disregard for the environment -- matter very little in determining the outcome of elections.

Voters -- some of whom dissect policy issues daily, but most of whom don't -- ultimately cast their ballots based on emotion. Not logic. Not knowledge of "the issues."

Most analysts agree that the selection of Ms. Palin as a running mate is a big gamble that may prove to be the smartest move yet from the McCain Camp or it could backfire in a big way, paving the way for a landslide victory for the Democrats this November.

Stay tuned, the U.S. election scene just got a whole lot more interesting.

Friday, August 29, 2008

Obama and Gore: Saving the Best for Last!




We are living history. Last night, more than 80,000 Democrats gathered to listen to Senator Barrack Obama accept the nomination for the presidency of the United States of America.

It was a historic moment because Senator Obama becomes the first African American to lead a major political party into presidential elections. Forty-five years ago, Martin Luther King Jr. gave his historic speech, calling on all Americans to unite to overcome hate and bigotry and fight for equal rights among all U.S. citizens.

Last night, Barack Obama delivered a phenomenal speech, invoking the promise of Martin Luther King in a pledge to end "the broken politics in Washington and the failed presidency of George W. Bush."

In doing so, Obama stuck to the facts and hit McCain on all the issues, emphasizing the following:

It’s not because John McCain doesn’t care. It’s because John McCain doesn’t get it.

For over two decades, he’s subscribed to that old, discredited Republican philosophy – give more and more to those with the most and hope that prosperity trickles down to everyone else. In Washington, they call this the Ownership Society, but what it really means is – you’re on your own. Out of work? Tough luck. No health care? The market will fix it. Born into poverty? Pull yourself up by your own bootstraps – even if you don’t have boots. You’re on your own.

Well it’s time for them to own their failure. It’s time for us to change America.

You see, we Democrats have a very different measure of what constitutes progress in this country.

We measure progress by how many people can find a job that pays the mortgage; whether you can put a little extra money away at the end of each month so you can someday watch your child receive her college diploma. We measure progress in the 23 million new jobs that were created when Bill Clinton was President – when the average American family saw its income go up $7,500 instead of down $2,000 like it has under George Bush.

We measure the strength of our economy not by the number of billionaires we have or the profits of the Fortune 500, but by whether someone with a good idea can take a risk and start a new business, or whether the waitress who lives on tips can take a day off to look after a sick kid without losing her job – an economy that honors the dignity of work.

The speech was so formidable that afterward, CNN's David Gergen (former counselor to Presidents Nixon, Ford, Reagan and, yes, Clinton) called it a "masterpiece."

The Republicans scrambled to quickly respond:

"Tonight, Americans witnessed a misleading speech that was so fundamentally at odds with the meager record of Barack Obama," spokesman Tucker Bounds said. "When the temple comes down, the fireworks end, and the words are over, the facts remain: Senator Obama still has no record of bipartisanship, still opposes offshore drilling, still voted to raise taxes on those making just $42,000 per year, and still voted against funds for American troops in harm's way. The fact remains: Barack Obama is still not ready to be President."

The fact is that Americans are sick and tired of the Bush/Cheney policies that have wreaked financial and moral damage over the last eight years. The mess is so huge that no matter who wins the elections come November, they will be inheriting a fiscal, environmental, energy, health care and educational disaster.

Critics of Obama claim his all "fluff" and "no substance", stating that he will pander to every political interest. I beg to differ. I think Obama is the real deal and despite the unprecedented obstacles, if elected, he will restore some sense of confidence in the American dream and restore the much tarnished image of the United States around the world.

Finally, there was another phenomenal speech last night, delivered by Vice-President Al Gore, one that in my opinion, delivered more poignant blows than Obama's great speech:

So why is this election so close? Well, I know something about close elections, so let me offer you my opinion. I believe this election is close today mainly because the forces of the status quo are desperately afraid of the change Barack Obama represents.

There is no better example than the climate crisis. As I have said for many years throughout this land, were borrowing money from China to buy oil from the Persian Gulf to burn it in ways that destroy the future of human civilization. Every bit of that has to change. Oil company profits have soared to record levels, gasoline prices have gone through the roof and we are more dependent than ever on dirty and dangerous fossil fuels.

Many scientists predict that the entire north polar ice cap may be completely gone during summer months in the first term of the next president. Sea levels are rising, fires are raging, storms are stronger. Military experts warn us our national security is threatened by massive waves of climate refugees destabilizing countries around the world, and scientists tell us the very web of life is endangered by unprecedented extinctions.

We are facing a planetary emergency which, if not solved, would exceed anything we've ever experienced in the history of humankind. In spite of John McCain's past record of open mindedness on the climate crisis, he has apparently now allowed his party to browbeat him into abandoning his support of mandatory caps on global warming pollution.

And it just so happens that the climate crisis is intertwined with the other two great challenges facing our nation: reviving our economy and strengthening our national security. The solutions to all three require us to end our dependence on carbon-based fuels.

Instead of letting lobbyists and polluters control our destiny, we need to invest in American innovation. Almost a hundred years ago, Thomas Edison said, "I'd put my money on the sun and solar energy. What a source of power!"

I hope we don't have to wait until oil and coal run out before we tackle that. We already have everything we need to use the sun, the wind, geothermal power, conservation and efficiency to solve the climate crisis,everything, that is, except a president who inspires us to believe,

"Yes we can."

So how did this no-brainer become a brain-twister? Because the carbon fuels industry "big oil and coal" have a 50-year lease on the Republican Party and they are drilling it for everything it's worth. And this same industry has spent a half a billion dollars this year alone trying to convince the public they are actually solving the problem, when they are in fact making it worse every single day.

This administration and the special interests who control it lock, stock and barrel after barrel, have performed this same sleight-of-hand on issue after issue. Some of the best marketers have the worst products; and this is certainly true of today's Republican Party. The party itself has on its rolls men and women of great quality. But the last eight years demonstrate that the special interests who have come to control the Republican Party are so powerful that serving them and serving the national well-being are now irreconcilable choices.

So what can we do about it? We can carry Barack Obama's message of hope and change to every family in America. And pledge that we will be there for Barack Obama, not only in the heat of this election, but in the aftermath as we put his agenda to work for our country.

As I carefully listened to Al Gore, I couldn't help wonder "what if?", "what if the U.S. Supreme Court did not hijack the elections of 2000?" The United States (and the world) could have had a great leader back then, one who "gets it" on all the major issues.

Let's all hope the same mistakes will not be repeated in 2008.

God speed and enjoy the long weekend.

Thursday, August 28, 2008

Will Private Equity Funds Rescue the Markets?


Wall Street was in a giddy mood today. US GDP figures were revised up, right in time for the Republican National Convention next week. This will surely help bolster McCain's assertions that the economy is just fine (sure it is, especially if you lost track of how many houses you own!).

Falling oil prices also helped stocks soar as fears from Tropical Storm Gustav pushed crude oil above $120 a barrel early today, but prices later fell into negative territory as traders bet the government will tap the Strategic Petroleum Reserve if supplies are threatened.

But the GDP revisions were the big headline, sending financials soaring today. According to revised figures, the American economy was more robust in the second quarter than previously reported, as growth of gross domestic product for the period was 3.3 per cent, ahead of previous estimates of 1.9 per cent.

But before you jump to celebrate, analysts caution that much of the GDP growth was driven by the weak dollar, which boosted exports by making America's goods and services cheaper for foreign buyers. In other words, these revised figures give false recovery hope:

The impact of more than $100 billion (£54.7 billion) worth of tax rebates, made by the US Government to its citizens, also helped to offset the impact of the US housing slump and high energy costs, analysts said.

The US will benefit less in the second half of the year from exports, as the economies of Europe and Japan slow and the dollar continues to gain value.

In addition, as many of the tax rebates have been spent, the economy will not continue to benefit from the fiscal stimulus in the second half.

Lou Crandall, chief economist at Wrightson Icap, said: "The revised GDP figure is certainly not a bad thing, but it is an imprecise estimate of the true health of the economy. It is still the case that GDP could turn negative in the second half."

Brian Fabbri, chief US economist at BNP Paribas, added: "The GDP figure may not say it but this country is still in trouble. Corporate profits have fallen for four consecutive quarters, companies have fired 60,000 workers a month in the past seven months and the outlook for the economy is pretty grim."

But for today, Wall Street wanted to party and forget about the second half of the year.

The other big story that caught my eye today was this article from the Wall Street Journal stating that pension funds are closely watching the on-going Fannie and Freddie saga:

Keith Brainard, a research director for the National Association of State Retirement Administrators, which represents the directors of retirement systems with combined assets of more than $2 trillion, said, "I'd be hard pressed to believe that the decline in share values for Fannie Mae and Freddie Mac are having a material impact on" pension funds.

While some of the unrealized losses may seem large, Mr. Brainard said, they represent a small percentage of a diversified pension fund portfolio of $153 billion or more.

There was "a lot of consternation" about the millions the San Diego County Employees Retirement Association lost when hedge fund Amaranth Advisors collapsed in 2006, but the fund's results for that fiscal year were "right in the middle of the pack with other public funds," he said. "I just think it's helpful to recognize the magnitude of these funds and their long investment horizons."

It wasn't long ago that some public pension funds announced that they were buying distressed mortgage products as a value play, Mr. Brainard said. "These funds are long-term investors who are out there looking for opportunities," he said.

Pension funds are indeed looking for opportunities in all sorts of markets, including the leveraged loan market:

Leveraged loans, once a clubby arena dominated by banks and a few investment funds, exploded in the credit boom years thanks to a rise in mergers and acquisitions activity, and demand from structured products called collateralised loan obligations, which pool loans to sell on to investors.

But CLO issuance has dropped sharply and the level of takeovers has fallen. The lower demand and expectations of a rise in corporate defaults have driven loan valuations to below 90 cents on the dollar.

Ron Schmitz, chief investment officer of the Oregon Investment Council, which has invested nearly $4bn, 5 per cent of its portfolio, in vehicles dedicated to investing in loans in the past year, said: "Bank loans were a nice, stable, quiet market that didn't offer any particular bang for your buck. Now, for a variety of reasons, it does." Mr Schmitz expects returns in high-single digits even if defaults reach peaks.

A fund totaling close to $3bn that BlackRock launched last year to buy leveraged loans was taken up predominantly by pension funds inside and outside the US, said Barbara Novick, a vice-chairman at the firm.

I also read that one of the world's largest wealth funds, Norway's Government Pension Fund, is now increasing its target weight to equities from 40% to 60% and actively looking to invest in real estate.

Interestingly, the Economist published an article today discussing whether private equity funds will ride to banks' rescue:

In most financial crises private equity is part of the problem. During a typical credit cycle it is among the first to use cheap financing to buy companies. Buy-out firms gradually become trigger-happy, overpaying and loading businesses with so much debt that some of them go bust. After the crash, the industry is in disgrace and skulks away to bind its wounds. Years later it returns, penitent, wiser—but hungry once again for cheap loans.

In this financial crisis, however, private equity thinks it is part of the solution. Buy-out firms have struck lots of dodgy deals, certainly, but they are still rich and ambitious. And amid the financial wreckage of the credit collapse, private-equity partners think they have spotted a chance to make a lot of money by helping Western banks to repair their tattered balance sheets.

This strategy partly reflects private equity’s fund- raising before the credit crunch. Back then, pension and sovereign-wealth funds were not just sipping the buy-out Kool-Aid, they were swigging gallons of the stuff. As a result buy-out firms still have almost $450 billion of their cash to invest, according to Preqin, a research firm.

The boom also fed buy-out firms’ aspirations. No longer are they content to act as Wall Street’s vigilantes, picking off the weak and the stray. Most now have high fixed costs, in the form of hundreds of employees. Their ageing founders long to diversify their firms and propel them into the top ranks of the financial establishment.

So private equity has the ambition to rescue ailing banks and it has the money. But does that make it a good idea?

The article goes on to discuss the opportunities and risks of this strategy:

Yet there are risks, too. In buying LBO loans, the industry is doubling up its bet on a small pool of companies. Executives may believe in these businesses, but many of them are too indebted to cope with a downturn. Lately, the economy “has become a much higher concern” for loan traders, says Mr Taggert, which perhaps explains why loan prices have not recovered as the overhang of supply has shrunk. Most of the bank-financing packages stipulate that, if prices fall further, private-equity firms must post margin calls. And if the companies need to be recapitalised, it could lead to some toxic conflicts of interest—should debt investors be favoured over old equity investors? Can money raised for new buy-outs be used as equity to bail out old ones?

Even if LBO loans make money, they are more like a junk-food snack than a substitute for private equity’s staple diet of industrial companies. The supply of new loans is now limited, as many banks plan to keep the remaining exposures on their balance sheets. Most of the return from a typical LBO-loan deal comes from leverage. In the long run, clients are unlikely to pay high management fees for that.

The article ends off by stating:

Before private equity takes the plunge, the rules may need to be tweaked. As early as next month, the Fed is expected to offer more guidance on the grey area of the ownership thresholds, probably relaxing its stance. Private-equity firms are also lobbying for the rules to loosen, so that they can form a consortium of buy-out firms without being deemed to have formed a “concert party” that has taken control. They also want permission from both the Fed and their clients to ring-fence the funds that invest in banks, so that their wider activities are safe from banking liabilities.

Will private-equity firms ride to the rescue of banks? Buy-out firms are unlikely saviours, but private equity’s $450 billion war chest is big enough to fill Western banks’ capital shortfall. There are few other sources of ready capital. Sovereign-wealth funds have been badly burnt; banks cannot easily raise equity in public markets; and the atrophy in many of the biggest lenders leaves them in a poor state to buy the weakest.

So regulators in America and elsewhere may feel obliged to ease their ownership restrictions. Until this year private equity had stuck to form, recklessly buying industrial firms at the top of the credit cycle. But the industry’s next guise could be less familiar—and more welcome. Private equity, saviour of Western banking. Who would have thought it?

My own thoughts are that PE funds, replete with cash from global pension and sovereign wealth funds, see an opportunity to lobby governments around the world to loosen regulations so they can muscle in on the banking industry and print money at will. If they fail, no worries, the Fed will bail them out.

Of course, let's not forget, PE funds will charge egregious fees for this "active management" and pension fund managers will continue to praise their allocations into alternative investments, reaping large bonuses as they claim they're adding "significant alpha" by beating bogus benchmarks.

It sure looks like one big club to me and they are all placing their bets on a magical recovery that is unlikely to materialize. By the way, guess who will end up footing the bill if things go awry?

Welcome to the reckless new world of Moral Hazard!!!

Wednesday, August 27, 2008

300 Tough Questions To Ask Your Pension Fund Managers and Trustees


In his 2001 paper, Institutional Investment in the UK: A Review, Paul Myners highlighted the need for trustees to ensure that they are appropriately and professionally advised when making investment decisions that will affect the membership of defined benefit schemes. He wrote that "Decisions should be taken only by persons or organizations with the right skills, information and resources necessary to take them effectively."
Unless you are an investment expert, it is essential that you take professional advice when deciding on scheme investments. And decisions are becoming harder all the time as it becomes more difficult to compare different funds. As Myners said:



So-called ‘peer group’ benchmarks, directly incentivising funds to copy other funds, remain common. And risk controls for active managers are increasingly set in ways which give them little choice but to cling closely to stock market indices, making meaningful active management near impossible.

The main elements in Myner's review include:
  • Trustees should set out an overall investment objective for the fund, in terms which relate directly to the circumstances of the fund, and not to some other objective, such as the performance of other funds.
  • Trustees should normally be paid.
  • The attention devoted to asset allocation decisions should fully reflect the contribution they can make to achieving the fund’s investment objective.
  • Decision-makers should consider a full range of investment opportunities across all major asset classes, including private equity.
  • The fund should be prepared to pay sufficient fees for actuarial and investment advice to attract a broad range of kinds of potential providers.
  • Trustees should give fund managers an explicit written mandate setting out the agreement between them on issues such as the investment objective, and a clear timescale for measurement and evaluation. Fees paid to managers should include the costs of information, research or transactional services used by the manager.
  • In consultation with their investment manager, funds should explicitly consider whether the index benchmarks that they have selected are appropriate. Where they believe active management to have the potential to achieve higher returns, they should set both targets and risk controls that reflect this, allowing sufficient freedom for genuinely active management to occur.
  • Trustees should arrange to measure the performance of the fund and the effectiveness of their own decision-making, and formally to assess the performance and decision-making delegated to advisers and managers.
  • In defined contribution schemes, when selecting funds to offer as options to scheme members, trustees should consider the investment objectives, expected returns, risks and other relevant characteristics of each such fund. Where a fund is offering a default option to members through a customised combination of funds, trustees should ensure that an objective is set for the option, including expected risks and returns.
Moreover, Myners added:

The principles may seem little more than common sense. In a way they are – yet they certainly do not describe the status quo. Following them would require substantial change in decision-making behaviour and structures.

The review believes that it would be preferable for the industry to adopt the principles voluntarily, but is clear that if necessary the Government should legislate to require disclosure against them.

The review recommends that the Government should examine after two years the extent to which the proposals have been successful in changing behavior.

Taking the above into consideration, stakeholders should be asking tough questions of your pension fund managers and trustees, such as:
  • How ‘managed’ is the fund – does it simply follow the herd or track an index?
  • How often do you review the asset mix? Does it accurately reflect the current economic and financial risks and guard against disaster scenarios? Does it reflect the plan's liabilities?
  • Where did you incur losses over the last fiscal year and what measures did you undertake to mitigate against these losses?
  • Are the trustees fully cognizant of all the risks that underpin every investment activity, including the ones of private markets and absolute return strategies in public markets?
  • Did you invest in ABCP, CDOs or CDS? If so, who was responsible for these investments and how are they held accountable for the performance of these investments?
  • Is the pension plan's funding status independently verified and reported on a timely basis? Does the plan have a funding policy and is it publicly available?
  • Is there a comprehensive and integrated governance framework for the fund and the plan which clearly outlines the roles and responsibilities of government supervisors, committees, board of directors, actuaries, administrators and pension fund managers?
  • Are the performance benchmarks, including the ones for external alternative investments and internal absolute return strategies, clearly defined, explained in a public document and do they reflect the risks and beta of the underlying investment portfolio?
  • Related to the previous point, are pension fund managers properly compensated using the appropriate performance benchmarks for each investment activity making up the composite index? Is the compensation aligned with the interest of the beneficiaries?
  • How appropriate are the benchmarks to the objectives of the scheme and its members?
  • How is risk measured and more importantly, how is it monitored and managed? Are there appropriate stop losses and controls to mitigate against significant losses?
  • How exactly is risk mitigated for each investment activity, including alternative investments and absolute return strategies? How is it mitigated at the investment activity level and at the fund level?
  • Are risk-adjusted returns reported for the pension fund as a whole and each underlying investment activity?
  • How relevant is the description of risk to the beneficiaries?
  • How well governed is the pension fund? Does independence exist between those who determine performance objectives and those who manage the fund on a day-to-day basis?
  • Are there clear responsibilities and accountabilities for each investment and administrative activity governing the fund and the plan? Is there clear separation of duties between investment professionals and finance professionals that value the investments?
  • Do you have internal expertise to allocate to external fund managers, including external hedge fund managers? How does your performance rate against that of the median fund of hedge funds or multi-manager fund?
  • What are the qualifications of the person(s) in charge of allocating to external managers and what is the benchmark used to compensate this person and the team? Does this benchmark accurately reflect the risks and beta of the underlying portfolio?
  • Are all risks and benchmarks of internal and external investment activities properly documented in public documents easily accessible to all stakeholders? If not, why not?
  • Do you use external administrators to rely on valuations of external managers? If so, did you perform a due diligence on these administrators and is it properly documented?
  • Are valuations of alternative assets and complex derivatives independently verified and audited? If so, by whom and how are they accountable to stakeholders?
  • Are requests for proposals for external managers, vendors and consultants publicly available and independently verified?
  • Are all costs associated with the pension fund, including administrative fees, external manager fees and all other costs publicly reported on a timely basis?
  • Are there timely independent performance and operational audits to make sure that the trustees and fund managers are following industry best practices and are managing the funds in the best interests of the key stakeholders?
  • Are there timely fraud audits performed by independent certified fraud examiners (CFEs) to mitigate against fraud?
  • Is the fund fully transparent? In particular, are board minutes publicly available and does the fund publicly report performance of all internal and external investment activities on a timely basis?
  • Are human resource activities properly monitored and independently audited? In particular, are changes to key investment professionals public and well explained? Are turnover rates in the pension fund made public and there appropriate exit interviews for any employee or investment professional that was dismissed or who voluntarily left?
  • Does the fund take measures to foster a culture of openness withing the organization, making sure that all employees are actively engaged? Do you take genuine steps to retain your employees through competitive and fair compensation and a culture that promotes learning and personal growth?
  • Importantly, are there sound whistle-blowing policies that are independently verified by certified fraud examiners (CFEs) to ensure that employees who speak up against fraud or mismanagement are protected under the full extent of the law?
  • Finally, does the pension fund subscribe and actively implement employment equity standards for all potential candidates, including visible minorities and disabled persons? Is the fund's employee diversity independently verified in an HR audit and publicly available?
In his review, Transparency: Myners, Three Years On, Alistair Reid states the following:

Transparency was one of the key Principles outlined by Myners in parallel statements targeting both DB and DC funds. His suggestion for DC schemes, for example, was that a strengthened Statement of Investment Principles (SIP) should take into account:
  • who is taking which decisions and why this structure has been selected;
  • each fund option’s investment characteristics;
  • the default option’s investment characteristics, and why it has been selected;
  • the agreements with all advisers and managers; and
  • the nature of the fee structures in place for all advisers and managers, and why this set of structures has been selected.
Moreover, Mr. Reid adds:
Transparency means more than full disclosure by a pension scheme to its members. Just as members of a DC pension scheme need to know what their investment options are to make an informed decision, their trustees need to become aware of all of the pitfalls inherent in the modern investment landscape. 
 
For example, trustees need to fully understand that the role of custodian has outgrown its traditional function as a caretaker and facilitator of assets and now encompasses many additional services with built-in costs. Do trustees know how much their manager is invisibly charging for FX transactions? Do they know if their cash management rates are competitive? Do they know how much they are paying for investment accounting, or for performance measurement? If the answer to any of these questions is “no”, they are failing to fully address the Principle of Transparency, and in an important way they are abdicating the leadership role expected of them by their scheme members.

Finally, take the time to read Dr. Susan Mangiero's article, Pension Risk Management: The Importance of Oversight.

Dr. Mangiero states the following:

Plan trustees need to assess their comfort level with the status quo by asking questions such as: What risk factors currently affect portfolio value and returns? How is risk mitigated, if at all? And is the risk management strategy uniform across investment strategies and outside money managers?
A little later on, she adds the following:

What was the reasoning behind a particular part of the risk management process? How was the decision made to use derivatives or to forgo their use in lieu of an alternative approach?

What is the current compensation arrangement by job function and objectives and does it reward speculation? 
 
Who has the authority to change trading limits? How are money managers hired and fired as a function of their reported risk-adjusted returns? What risk metrics are deemed appropriate and why?
Process means little without comprehensive documentation that spells out answers to these and many other pertinent questions.

The current investment environment requires better pension fund governance. All stakeholders benefit when pension funds are fully transparent about their investment, operational and administrative activities and when accountabilities are properly assigned and monitored.

As I have stated before, the risks of remaining complacent on pension fund governance is too high. All stakeholders of public pension funds deserve full transparency, full accountability as well as independent performance and operational audits of their pension funds.

Stakeholders need to ask some tough questions to their pension fund managers and trustees or hire the independent consultants to ask them on their behalf (make sure they are truly independent consultants with no conflicts of interest). The above questions are among the more important ones and a good starting point for reviewing the activities of any pension fund.

Important note: I would urge those of you who want to learn more to visit the governance section on my blog by scrolling down the right-hand side. There you can find documents on industry best standards on pension fund governance, including the Clapman Report and Institutional Investments in the UK Six Years On.

Tuesday, August 26, 2008

Are We Headed Towards a Global Commercial Property Meltdown?



It's time for me to get back to the ugly reality of financial markets. This morning we got more bad news from the U.S. residential real estate market as new home prices dropped by a record amount in Q2:

The Standard & Poor's/Case-Shiller U.S. National Home Price Index tumbled a record 15.4 percent during the quarter from the same period a year ago.

The monthly indices also clocked in record declines. The 20-city index fell by 15.9 percent in June compared with a year ago, the largest drop since its inception in 2000. The 10-city index plunged 17 percent, its biggest decline in its 21-year history.

However, the rate of single-family home price declines slowed from May to June, a possible silver lining, the index creators said.

"While there is no national turnaround in residential real estate prices, it is possible that we are seeing some regions struggling to come back, which has resulted in some moderation in price declines at the national level" said David M. Blitzer, chairman of the index committee at S&P.

As tempting as it might be, I wouldn't call a bottom in residential real estate any time soon. Even worse, there are now clear signs that the commercial real estate market is set for a marked slowdown in the U.S. and across the globe.

An article in today's Globe & Mail cited a report from CB Richard Ellis which shows that Canadian commercial real estate investment is sharply lower in the first half of the year:

Investment in the sector, which includes office, retail and industrial properties, fell 24 per cent to $10-billion from $13.1-billion in record-setting 2007. The slowdown is expected to continue, with total investment for the year forecast at around $20-billion, a 40 per cent decline from the year before, and lower than in the previous two years.

That would put the overall level close to the $19.5-billion invested in the sector in 2005, but unlike that year, a big pickup in activity likely won't come in the second half of 2008, said Stefan Ciotlos, interim president of CB Richard Ellis.

“....a strong second half is unlikely to occur this year because what began as a sub-prime credit crisis in the U.S. has become a de-leveraging of all global asset classes impacting Bay and Wall Street's views of real estate in general. The U.S. is currently undergoing a very difficult investment climate, and investment sales in the U.S. were down 60 per cent at the end of June, according to Real Capital Analytics, a firm which reports on the U.S. commercial real estate market,” Mr. Ciotlos said in a statement.

Despite the slowdown, a U.S.-style downturn doesn't appear to be in the cards for the Canadian market, he said.

If you ask me, it is still too early to state that the Canadian market will escape a "U.S.-style downturn". (Our Prime Minister isn't rushing to call snap elections because he feels we are going to escape the brunt of the U.S. recession).

A couple of weeks ago, the Financial Times reported that there are ominous signs for the European CMBS market:

The number of commercial property borrowers in Europe experiencing difficulties is increasing rapidly as can be seen from a sharp rise in the number of mortgages on servicers' watchlists, according to Moody's.

Watchlists are an early indicator of potential events of default or transfer to special servicing, which sees commercial property experts move in to explore the best ways to cure a mortgage's troubles or look at options for a work-out or sale, the agency said in a report published yesterday.

The Moody's report follows analysis from Fitch, a rival ratings agency, which showed a high chance of widespread defaults in the US and UK commercial property mortgage markets if the gloomy economic predictions for those markets were true.

Moody's said there were many reasons, not all performance related, for loans to be placed on watchlists by servicers of commercial mortgage-backed securities - whose job it is to monitor loans and ensure payments are being made.

But it added that watchlists were an early indicator of "potential loan event of defaults and transfer to special servicing".

The total number of loans on watchlists in Europe sat at five or fewer until the end of 2006, but then saw a change to rise to more than 10 over the first three quarters of 2007.

That number has since leapt sharply to 68, about 10 per cent of the more than 660 European commercial mortgages that Moody's monitors in CMBS deals.

"The number of loans experiencing adverse issues is growing, as can be seen from the number of loans which have been added and have remained on servicers' watchlists over the past four quarters," says Viola Karoly, a Moody's analyst and coauthor of the report.

The analysts expect the number of loans entering special servicing to rise, although it added that the impact on the ratings of European CMBS deals would not be significant in the coming quarter.

"Given that more than 50 per cent of all loans currently on watch are in breach of coverage or loan-to-value covenants, the number of loans defaulting and/or moving into special servicing is expected to increase over the next couple of months and quarters," the report said.

Nowhere is the CMBS market wobblier than in the United States, where CMBS spreads have skyrocketed in the last few weeks. As shown above, the latest CMBX chart from Markit (AA series 5) shows spreads widening fast:

From a spread of 475bps at the end of May, it’s now coming close to 1000bp. The particularly steep rise in the spread - in mid-August - occurred after Markit announced it wouldn’t be constituting a new index - there simply wasn’t enough issuance.

The spread widening of the double-B tranche (second chart) of the CMBX is even worse, nearly 3200 bps!!!

No wonder Lehman Brothers is having trouble offloading $40 billion of CMBS assets. In fact, more and more U.S. banks are scrambling to offload troubled commercial real estate loans as that market faces serious headwinds:

Banks are scrambling to dispose of these loans, typically made to hotels, office developers and retail strips, before problems arrive.

Broader real estate indexes are already showing signs of trouble. Moody’s/REAL Commercial Property Price Index has dropped nearly 12 percent since its peak last October. A more conservative index by the National Council of Real Estate Investment Fiduciaries shows growth slowing to one-half of a percent in the second quarter, from upward of 4 percent a quarter.

Loans made for commercial real estate are typically among the safest, because a building can be used as collateral and big property developers generate income from the investment, raising the likelihood they will repay their loans.

But cracks began to emerge late last year, when Morgan Stanley reported write-downs of $400 million in commercial mortgage losses. In the first quarter, Wachovia, which had transformed itself into a leading lender in the nation’s commercial real estate market, said it would take write-downs of more than $1 billion for commercial loans for the second half of 2007. Investors had already begun balking at buying securities backed by these bonds, so banks like Wachovia were stuck with loans of diminished value.

Around the same time, the New York developer Harry Macklowe was forced to sell seven office buildings he had bought in Midtown Manhattan, as well as the General Motors Building, after he was unable to refinance the loan with his lender, Deutsche Bank.

Now, the prospect of an immense default on a commercial residential property in New York — which has not suffered as much as troubled markets like Florida — has lent new momentum to concerns over the stability of commercial real estate loans.

In this environment, it is hardly surprising that CMBS originations hit a record low:

Commercial and multifamily mortgage loan originations continued to fall on a year-over-year basis in the second quarter, according to the Mortgage Bankers Association's (MBA) Quarterly Survey of Commercial/Multifamily Mortgage Bankers Originations. Second quarter originations were sixty-three percent lower than during the same period last year. The year-over-year decrease was seen across most property types and investor groups.

Now, I ask you, do you really think we hit bottom here? Is there any light at the end of the proverbial tunnel? Anyone seeing something I missed? Anyone?

I fear that we are just entering another downturn, one that will be much more severe and widespread than the slowdown in residential real estate market. Keep in mind that global banks are much more exposed to a slowdown in commercial real estate markets and global pension funds have billions invested in commercial real estate through direct investments, fund investments, CMBS and other debt instruments.

Going forward, that means you can expect a whole new batch of writedowns as banks and pension funds scramble to clean their books of more toxic debt.

But not everyone is as gloomy on commercial real estate. Some investors see opportunities in what they call commercial real estate's lost cycle. I found this report from Wurts & Asscociates particularly balanced and informative, outlining the current fundamentals driving commercial real estate markets. It is well worth reading before jumping to any conclusions.

However, given my views that we are heading towards a prolonged period of debt deflation, I see serious headwinds facing all alternative asset classes, especially commercial real estate. CMBS spreads are providing an early indication that global commercial property markets will continue to deteriorate for the next few years.

Finally, seeing what is going on in the real estate market reminded me of why Tom Barrack, arguably the world's greatest real estate investor, cashed out back in 2005 (I had circulated this article internally at a pension fund I was working for at the time but it was ignored).

In Mr. Barrack's own words: "There's too much money chasing too few good deals, with too much debt and too few brains."

I think that sums it up well.


***Update: Comment from Michael Hudson***

Dr. Michael Hudson was kind enough to share the following comments with me:

Dear Leo,

I worry that you miss the more pessimistic side of things. Suppose global real estate prices DO turn down. The property bubble has been the only flow keeping the balance of payments of the post-Soviet countries in balance, given their structural trade deficits.

Therefore, if new mortgage lending from foreign banks slows, their currencies will buckle. This means that ON TOP OF their downturn in DOMESTIC prices, the dollarized or euro-ized real estate price index will drop even further. The entire balance of payments of trade-deficit countries has been financed only by mortgages denominated in foreign currencies (as I found in Latvia). There will be a reverberatory effect.

Good news for Russia to recapture its influence over neoliberalized countries.

Michael

Monday, August 25, 2008

Are the Clintons Planning a Coup?


The Democratic National Convention is getting ready to start today in Denver. This is suppose to be Obama's shining moment.

But some think that the Clintons have been working hard to stage a coup. Consider the arguments made in this article published in the Canadian Free Press:

  • Camp Clinton convinced Camp Obama to help liquidate her campaign debts.
  • Camp Clinton convinced Camp Obama to call for Florida and Michigan voters to be counted. It’s the right thing to do, of course. But had it already been done, Hillary would already be the nominee.
  • Camp Clinton convinces Camp Obama to agree to a floor vote at the convention when all the cameras will be rolling. What if Clinton wins on the floor?
  • Camp Clinton removes Obama supporter John Edwards from the equation, along with his scheduled convention speaking spot, on the basis that he is now a known lying cheater. But Bill Clinton (also a known lying cheater) is the headliner of the convention, and he’s not an Obama supporter at all.
  • Barockstar tanks on national TV only days before the convention and his campaign staff is sent out to do damage control, leaving the super-delegates gasping in a holy crap moment, with the sudden realization that this empty suit is in no way ready for the big show. Only a promise to make a VP announcement this week can get his failed TV appearance off the front pages.
  • Meanwhile, Camp Clinton is mobilizing millions of NObama minions and staging a convention coup in which Hillary can ride in on silver steed to save the party from complete implosion on an international stage…

Even James Carville, Dick Morris and Oliver Stone combined, could not have written this script any better. All we need is a second gunman on the grassy knoll. Howard Dean maybe?

The fact that millions of Democrat voters were intentionally disenfranchised by their own party in the primaries leaves the chosen one the prime target of too many in-house enemies. And nobody in American politics is better at organizing, mobilizing and exploiting in-house enemies than the Clintons.

Now, I'll be the first to tell you that I do not trust the Clintons, but I would be very surprised if she tries to pull off a coup at the DNC. I think she will rally her troops behind Obama (at least publicly).

Here is my reasoning:

  • Hillary knew she was not going to get the VP position. No surprise there; Obama is not going to stick her second in command because he does not trust her (that pic above is worth a thousand words).
  • Hillary's campaign is still $23 million in the hole (including $13 million she lent of her own money) and she needs Obama's key supporters to help her erase those debts.
  • Obama needed a pitbull to help him fend off the Republican smear campaign. He got Joe Biden, arguably the most feared and fearless politician in Washington. Biden can be a loose cannon, but he will make mince meat of Mitt Romney and McCain in the debates.
  • Who cares about Saddleback? I mean do you honestly think that the majority of white Evangelical Christians are going to vote for Obama? His answers to difficult moral questions were nuanced and well reasoned. The mere fact that he showed up there was a victory.
  • If Hillary attempts a coup, there will be hell to pay and she will never be forgiven. This will virtually ensure a McCain victory and will throw the Democrats off for another eight years. McCain is actually hoping that Hillary will attempt something and he is openly courting her constituents in television ads like this one that started today.
In my opinion, the Camp Clinton is acting like a bunch of sore losers. Obama is too academic and he doesn't like the dirty politics that goes on in presidential elections. But this is exactly why he chose Joe Biden as his running mate. He needs the scrapper from Scranton who isn't afraid to speak his mind.

I personally do not care much about these party conventions. They are essentially love fests and polls mean nothing after these events. The key will be the debates where I expect both Obama and Biden to shine.

Saturday, August 23, 2008

Obama Picks Joe Biden as a Running Mate


I woke up at 4:00 a.m., couldn't sleep, so I made myself a light sandwich and turned on CNN. It's now official: Barack Obama has picked Joe Biden as his running mate.

I quote the following:

Ending days of speculation, Obama announced the decision on his Web site, featuring a photo of the two.

"Barack has chosen Joe Biden to be his running mate," the announcement said. "Joe Biden brings extensive foreign policy experience, an impressive record of collaborating across party lines, and a direct approach to getting the job done."

Obama's camp also sent a text message and e-mail to supporters.

Biden, a Roman Catholic originally from the battleground state of Pennsylvania, will bring not only foreign policy expertise to the ticket but strong working-class roots.

That could help Obama connect with the blue-collar voters he has failed to attract in the run-up to the Nov. 4 election against Republican John McCain. Obama and McCain are neck and neck in opinion polls.

My own thoughts are that Biden is an excellent choice. I like his feisty style and he has the experience that Obama desperately needs to navigate in what Stratfor's George Friedman calls the Real World Order:

One of the interesting concepts of the New World Order was that all serious countries would want to participate in it and that the only threat would come from rogue states and nonstate actors such as North Korea and al Qaeda. Serious analysts argued that conflict between nation-states would not be important in the 21st century. There will certainly be rogue states and nonstate actors, but the 21st century will be no different than any other century. On Aug. 8, the Russians invited us all to the Real World Order.

Get ready for a close and heated contest between McCain and Obama. These elections are crucial not only for the United States, but for the rest of the world. After eight years of Bush/Cheney, I hope real change is finally around the corner.

Friday, August 22, 2008

ABCP and Auction-Rate Securities: A Tale of Two Justice and Regulatory Systems


Nothing makes my blood boil more than reading articles like this one from the Boston Globe. Many U.S. retail investors were wiped out and they are understandably angry that they were lied to about the safety of "auction-rate" securities:

"I didn't have a clue what an auction-rate security was,'' said Bert Davidson, a Lexington businessman who has had a large account with Fidelity for several years. But after a Fidelity representative described the securities as safe and cash-like, Davidson said, he decided to invest about $900,000 in them.

Now he can't access his money. Auction-rate securities nationwide have been frozen since February, when virtually all trading in the market shut down following a steep drop in investor demand.

And like thousands of others who bought auction-rate securities through brokerages across the country, Davidson's frustration level is mounting.

Canadian retail investors can empathize as many of them are embroiled in their own asset-backed commercial paper (ABCP) crisis.

But unlike in Canada, the legal and regulatory response in the United States has been much swifter and much harsher. An article from the LA Times this morning states that the auction-rate securities probe is expanding to cover over 40 brokerages.

I quote the following:

Regulators looking into the auction-rate securities debacle have turned their attention to nearly 40 brokerages that may have sold the paper to clients but didn't underwrite it.

Investigators from the Financial Industry Regulatory Authority plan to conduct on-site examinations at the brokerages, with the first inspections beginning Monday, to determine whether the firms were aware of the problems in the auction-rate market and adequately warned customers about the risks, according to a person familiar with the issue.

The regulatory sweep represents a major widening of auction-rate probes that until now have centered on the big investment banks that underwrote the debt and managed auctions of the securities.

On Thursday, three more Wall Street firms joined the list of companies agreeing to make amends with customers who bought auction-rate securities.

The addition of Merrill Lynch & Co., Goldman Sachs Group Inc. and Deutsche Bank brought to eight the number of companies that have reached legal settlements regarding the securities.

The eight firms -- including Citigroup Inc. and UBS -- have agreed to repurchase about $50 billion of roughly $60 billion in auction-rate debt estimated to be held by individual investors.

I am not surprised that the big Wall Street firms are in a hurry to settle now. Either they settle now or risk settling later for a lot more money.

The article goes on to state:

Auction-rate securities are long-term debt instruments that were designed to trade like short-term securities. They were issued by many municipalities and closed-end mutual funds in recent years, and were pitched by brokers to small investors as safe and easily redeemable.

When the credit crunch worsened early this year, the $300- billion auction-rate market froze, leaving investors unable to sell their holdings.
A bond-industry trade group representing regional brokerages has contended that they have no obligation to repurchase auction-rate securities, because they simply facilitated purchases at the request of clients and took no role in the creation of the securities.

However, a top lawyer in Cuomo's office sent a letter to the trade group Wednesday rebutting those claims. Benjamin Lawsky, a Cuomo special assistant, said Cuomo's probe "has already begun to uncover some disturbing facts that seem to belie the innocent picture of downstream brokerages." It seems "highly unlikely that the firms had no understanding of what was happening in the [auction-rate] market," Lawsky added.

Duh! They knew the risks but they saw a way to screw retail investors over.

The exact same thing happened here in Canada but the ABCP saga is just dragging on. It now looks like the ABCP case will head to the Supreme Court of Canada. The latest snag comes from Ivanhoe Mines Ltd., which is stuck with $70.7-million (U.S.) of ABCP and is now asking the top court to stop the planned restructuring.

I quote the following:

Ivanhoe is arguing that the restructuring is unfair because it gives all participants in the ABCP market broad immunity from lawsuits, and that the Ontario Court of Appeal ruling on Monday allowing the proposal to go ahead is flawed, said Howard Shapray, Ivanhoe's lawyer.

Purdy Crawford, head of the investor committee that created the proposal, said yesterday that the aim is still to try to complete the restructuring by Sept. 30. The plan calls for swapping the frozen notes for new bonds that trade freely.

"Ivanhoe's announced intention to seek leave to appeal does not affect our determination to complete the restructuring on our announced proposed timetable," Mr. Crawford said in an online chat on globeandmail.com, adding that "if Ivanhoe (or any other party) takes any steps to delay the completion of the restructuring pending the Supreme Court's determination, we will resist those attempts."

The Supreme Court is fresh off a momentous decision in the BCE Inc. takeover, ruling in June that the $35-billion transaction could go ahead. In the ABCP affair, billions of dollars of value would again hinge on the court's decision should it agree to hear the case.

The proponents of the restructuring say that without the legal immunity that challengers such as Ivanhoe dislike, the plan would fall apart and all investors would suffer huge losses.

With all due respect to Purdy Crawford, I believe that Ivanhoe is absolutely right to appeal the Ontario Court's decision. Other legal experts agree with this decision and see it as one that is unlikely to be successfully appealed.

But granting legal immunity to the investment banks that sold this garbage to unsuspecting retail and institutional investors is setting a dangerous precedent. Legal immunity in this case is akin to granting them a right to screw over investors in the future.

What I do not understand is why the big Canadian public pension funds did not team up with all the other investors to sue the big banks and settle out of court. Diane Urquhart recently told me that government- related entities that she knows of own 58% of the $32.1 billion Non Bank ABCP. The total marked-to-market loss on the Non Bank ABCP under CCAA is $16 billion, so the government-related entities' share of this is $9 billion.

By taking writedowns on ABCP holdings, these government-related entities, which includes large public pension funds, are effectively passing the bill off to Canadian taxpayers.

Finally, take the time to read Harry Koza's excellent article on how auction-rate securities make for more pain on Wall Street.

I quote the following:

Well, if there's investor demand for anything, whether money market paper or tulip bulbs, you can bet that the Street will quickly invent some fiendishly clever instrument to fill it. Why not get those long-term borrowers to issue debt with the same final maturity of 20 years, but with a coupon that resets every seven, 28 or 35 days? You could hold a Dutch auction (which would accept the lowest yield that can clear the amount) to reset the interest rate at the end of each period. Investment dealers would handle the auction and provide liquidity by making a secondary market in the paper.

Investors would love the stuff because it offered a little extra yield over T-bills. As for the borrowers, well, since short-term variable interest rates are much lower than 20-year fixed rates, they'd save a bundle in interest costs alone. Plus, they'd diversify their debt portfolios.

Mind you, there are risks with this kind of thing. If interest rates started to rise, issuers would have higher interest costs, which could affect their projected cash needs and debt service costs. That kind of thing could hurt their credit ratings.

No problem, said the smart guys from Wall Street, we can, at a small additional cost, add a layer of bond insurance to provide a triple-A rating, and besides, we also have a veritable cornucopia of derivative products like interest rate caps and swaps to offset any risks. We've got it all covered, nothing can go wrong.

Well, okay then, said the issuers. And the investors said, send it in, we gotta have it. And so the ARS was born. A few years on, there's $300-billion (U.S.) worth of the stuff out there. Only, it's not just municipalities and other government borrowers issuing ARS. Collateralized debt obligations (CDOs) also took advantage of low short rates to finance their long-term (subprime) assets by borrowing in the ARS market.

Then the credit bubble burst. Oops, some (many) of those CDOs had some dodgy assets on their books. Double oops, some (okay, most) of the bond insurers were leveraged at triple-digit multiples of their capital and investors rapidly lost confidence that the credit insurance was actually any good.

When the ARS reset auctions came up, suddenly there were no bids. In just one week in February, more than 1,000 ARS auctions failed. The New York/New Jersey Port Authority sold $100-million of ARS paper and the auction clearing bid was a staggering 20 per cent, up from 4.3 per cent the week before. The dealers who were to provide liquidity in the paper, alas, already reeling under their other ill-fated alphabet soup adventures (structured investment vehicles, CDOs, etc.,), were unable to do so. Distraught investors were told that the ARS market was frozen and they couldn't get their money out. Liquidity guarantees? Surely, you jest?

So, $300-billion in ARS and the market for the stuff, like the Canadian asset-backed commercial paper (ABCP) market, remains frozen. Both of these acronymic instruments are similar: both are short term; both are triple-A rated and supposedly safe as houses; both are borrowing short to finance long-term assets; and both are causing all sorts of regret and recrimination for issuers, investors and intermediaries alike.

While here in Canada the courts are upholding the notion that cleaning up the ABCP mess must necessarily exempt its perpetrators from any possibility of civil litigation, in the United States, they're making the ARS perpetrators buy it back.

UBS alone - and man, that U must stand for ubiquitous, because lately it seems every time some new credit disaster happens, there it is - has agreed to buy back $19-billion worth of the stuff. Merrill and Citigroup are, between them, buying back another $20-billion or so. It's a long way from $300-billion, but it's a start.

The Street will likely be forced to eat more of the stuff, and there will be more big writedowns ahead, so it's probably not a good idea to buy any U.S. financial stocks just yet.

Wall Street firms are taking some solace seeing some large wealth funds, like the Government of Singapore Investment Corporation (GIC), rush to their rescue with fresh capital. But when all is said and done, these wealth funds are just prolonging the inevitable. Sooner or later, they will realize that the long run may be a very long time, especially if we hit debt deflation some time in the next couple of years.

More importantly, Canadian ABCP investors are anxiously waiting to see how the Supreme Court of Canada will rule on the case. It's too bad that our justice and regulatory system have miserably failed them thus far and I fear that it's only going to get worse. When it comes to securities laws and regulatory enforcement, we could learn a lot from our neighbors down south.

Thursday, August 21, 2008

Alpha on the Cheap?


In my last post, I looked at how the hedge fund herd is mostly piling into the same trade: short financials, short U.S. dollar and long energy. While it works, it is fine, but when these trades unravel, markets become very volatile and severe market dislocations can easily degenerate into financial chaos.

But why are so many hedge funds piling into the same trade? If these so-called "alpha experts" are supposed to deliver superior risk-adjusted returns, shouldn't they be diversifying their bets and truly limiting their downside exposure? Moreover, there are now close to $2 trillion in hedge fund assets under management out there (with leverage, it's probably closer to $10 trillion or more), which means institutions are paying a 2% management fee and a 20% performance fee for what is essentially beta bets. That's billions in fees for beta bets that can be easily replicated a lot cheaper internally at a fraction of the cost.

In July 2007, the New Yorker published an article by John Cassidy, Hedge Clipping, which looked into whether or not there is a way to get above average returns on the cheap. Mr. Cassidy interviewed Harry Kat, an economist at the Cass Business School in London and an authority on cloning hedge fund strategies.

I quote the following:

It is well known that risk and return tend to go together. If you go to Atlantic City and bet your life’s savings on a roulette wheel’s coming up black, you have a good chance of earning an instant return of a hundred per cent; you also have a good chance of going broke. Playing roulette is a high-risk, high-return activity. Putting your money in a bank C.D. is a low-risk, low-return activity. Truly outstanding investors, such as Warren Buffett, somehow generate consistently high returns at low risk.

Kat decided to determine whether hedge funds met this standard; only if they did could they genuinely be said to have created alpha. In a study published in the June, 2003, issue of the Journal of Financial and Quantitative Analysis, he and a co-author, Gaurav Amin, an analyst at Schroder Investment Management, a British financial firm, compared the fee-adjusted returns of seventy-seven hedge funds between 1990 and 2000 with the returns generated by a market benchmark that had a similar risk profile. Seventy-two of the funds—more than ninety per cent—failed to outperform their benchmarks.

With the help of a graduate student, Helder Palaro, Kat also undertook a larger study, in which he examined more than nineteen hundred funds. The results, which Kat and Palaro posted online as a working paper last year, showed that only eighteen per cent of the funds outperformed their benchmarks, and returns even at the most successful funds tended to decline over time. “Our research has shown that in at least eighty per cent of cases the after-fee alpha for hedge funds is negative,” Kat told me. “They are charging more than they are adding. I’m not saying they don’t have skill; I’m just saying they don’t have enough skill to make up for two and twenty.”

In another Bloomberg article published in 2006, Kat was even more explicit:

Synthetic funds would have outperformed 82 percent of the 2,000 hedge funds and 500 funds of hedge funds studied by Kat, a former head of equity derivatives at Bank of America Corp. Most of the gains generated by hedge funds were eaten up by fees, typically 2 percent of a portfolio and 20 percent of profits, he found after studying 15 years of monthly fund results.

"In most cases, managers aren't good enough to make up for the massive fees that they charge,'' said Kat, a professor of risk management at Cass, part of London's City University, in an interview. "The combination of excessive fees and minimal opportunity in the market makes alternative investments really doubtful in terms of their value for portfolios.''

Kat is not alone in questioning hedge fund returns. Other academics like Andrew Lo have also looked into whether hedge fund returns can be replicated on the cheap.

A full discussion of hedge fund cloning strategies is beyond the scope of this post. All I can tell you is that not all cloning strategies use the same statistical techniques and that some of them are fraught with their own operational and investment issues.

Moreover, these cloning strategies are better used to screen out managers than as a standalone product. The whole point of paying for alpha is that you want to be with the top decile managers whose returns you cannot reproduce. Why replicate median returns? If you can't allocate to top managers, then don't bother allocating to these strategies (the same goes for other alternative investments).

Finally, it isn't just hedge fund returns that can replicated on the cheap. Toro's Running of the Bulls Market Blog posted an excellent entry a couple of days ago on How to Earn 40% Per Year Returns Like a Private Equity Fund.

I quote the post below (try not to laugh out loud):

Are you jealous of Blackstone? Have a hankering to be like KKR?

No problem, dear readers. We at Running of the Bulls are here to enlighten you on how to make 40% a year, just like the private equity funds, without having to pay the extortionary fees just to have the privilege of participating in a pool of capital in which you are not allowed to withdraw any money until your first born is in college.

First, one must understand how a private equity firm generates such magnificent returns.

Its easy! It goes something like this.

  1. Find a publicly traded company that has a ton of cash on its balance sheet, is magnificently free cash flow positive and is being ignored by the stock market.
  2. Offer to buy said company at 30% above the market price. The stock market - which has the attention span of a hummingbird - will be thrilled.
  3. Once you own it, gut the company of all its cash, paying yourself a ridiculously handsome dividend, using gianormous amounts of debt to pay yourself that dividend. You deserve it.
  4. Fire half the employees.
  5. A few years later, when the stock market has finally turned its attention to the industry in which the company you just hallowed out and gutted the balance sheet operates, take the company public at a higher price at which you bought it. Emphasize the efficiency gains and much higher return on equity of the company that you generously imbued your business acumen upon.
  6. Convince Congress that secretaries and hamburger flippers should be taxed at a higher rate than you.

Voila! You're a billionaire!

But since you - the average Joe who didn't go to Harvard and spend the first two years of your post-MBA career photocopying for 120 hours a week deep in the bowels of an investment bank - can't do that, here's a way for you to generate similar returns in a similar manner.

Please send me $249 for a copy of my software which will tell you how you can...

Haha! No, just kidding.

Here's how you do it.

  1. Go open a margin account.
  2. Buy one of these ultra floating ETFs which return two times the market rate, such as the ProShares Ultra S&P 500 fund, ticker SSO. Use maximum leverage.
  3. Sit back, relax and watch the money roll in.

If you are a money manager, stick the money offshore. Hire a New York valuation firm to tell you what your account should be worth. Ignore what is happening in the stock market. Charge your clients high fees.
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Satirical commentary aside, much of private equity returns come from increasing the leverage they own. The PE funds have the luxury of not marking their investment to market, thus are not bound by current market valuation as market movements are often considered transitory. They also choose when to sell their company back to the public markets. PE funds are able to exploit this "asset class structure arbitrage" quite profitably.

In our example, if one can stomach the volatility and can put up extra cash for margin calls during downdrafts, over time, one would earn similar returns. The average return of stocks has historically been 10%. Buying a double floater ETF increases the historical return to 20%. Buying the ETF on maximum margin generates average returns of 40% per year. [read more on proshare ETFs here]

Of course, even the casual investor can see the inherent dangers of such a strategy. However, initiating such a position in 1982 and removing it in 1999 would have made one very wealthy.

It goes without saying that it would be enormously stupid to do this now. Bear markets are not a good time to lever up positions in stocks with everything you have.

But you get the idea.

Oh we get the idea alright! A lot of pension funds are blindly throwing billions of dollars into alternative strategies, paying hefty fees to pooled hedge funds, private equity funds, real estate funds, infrastructure funds, commodity funds, etc., in search of alpha which is really nothing more than disguised beta. It kind of gives new meaning to the term 'alpha smoke screen'.