Monday, January 26, 2009

Global Pension Wars?


As Governor Rod Blagojevich's Illinois Senate impeachment trial started, he hit the media circuit, answering questions about Oprah Winfrey, foul language and why he won't resign.

Blagojevich told CNN's Larry King he considered approaching Winfrey for an open U.S. Senate seat, and after his arrest drew inspiration from Martin Luther King, Gandhi and Nelson Mandela.

Poor old 'Blago' is really making a fool of himself but he wants to be king for today and the media circuit is going crazy, lapping it up for ratings.

But pension fund presidents could learn a thing or two from Illinois' delusional Governor. As they get ready to report their dismal performances, they might also want to recite some poetry from Rudyard Kipling.

More fittingly, they can extol the virtues and benefits of alternative investments and recite Shakespeare's Sonnet 18:
Shall I compare thee to a summer's day?
Thou art more lovely and more temperate.
Rough winds do shake the darling buds of May,
And summer's lease hath all too short a date.
Sometime too hot the eye of heaven shines,
And often is his gold complexion dimm'd;
And every fair from fair sometime declines,
By chance or nature's changing course untrimm'd;
But thy eternal summer shall not fade
Nor lose possession of that fair thou ow'st;
Nor shall Death brag thou wander'st in his shade,
When in eternal lines to time thou grow'st:
So long as men can breathe or eyes can see,
So long lives this, and this gives life to thee.
All kidding aside, I am eager to hear how pension fund presidents will respond to some very tough questions on all asset classes, including hedge funds, private equity and real estate. Don't worry, I will prepare stakeholders well in advance of reporting season.

But that is for another day. Let me expand on yesterday's discussion on the paradox of thrift. John Hussman of Hussman Funds published his weekly comment today, Okun's Law, Ockham's Razor, and Economic Stimulus, an absolute must-read. I quote the following:

The key problems here are bank capital and mortgage foreclosures. Foreclosed mortgages are approaching about 10% of total mortgages, with an average recovery rate of only about 50% of the mortgage value when the foreclosed home is sold. The resulting loss of value, approaching 5% of the U.S. mortgage market, has thrown the economy into disarray, because the losses have been borne by highly leveraged institutions.

For many institutions, each $1 of their own capital (equity contributed by the company's own shareholders) has often supported $10, $20, or even $40 of loans, security investments and other assets. As a result, wiping out a few percent of their assets completely wipes out their own capital, leaving customers and depositors without a capital cushion and triggering withdrawals. This process started with the most egregiously leveraged companies like Bear Stearns and Lehman, and continues to put stress on enormous but capital-thin institutions like Citibank.

There is a time-honored principle called Ockham's Razor, which states that the explanation for any phenomenon should focus only on the essential and relevant elements, avoiding as many unnecessary second-order factors as possible. Albert Einstein put it this way: A theory should be a simple as possible, but no simpler.

There is certainly a wide range of important programs and objectives that the new Obama administration was elected to pursue, including investments in alternative energy, infrastructure, health care, and other programs. But from the standpoint of economic stimulus, Ockham's Razor suggests that we will fail as a nation to address the current economic crisis if we fail to address the source of that crisis. Again, this means focusing first on bank capital and mortgage foreclosures.

Although the troubled assets relief program (TARP) was originally based on an ill-considered idea to purchase distressed assets directly from financial institutions, the Treasury somewhat inadvertently discovered what we had strongly argued from the beginning that providing capital directly to financial institutions was the most effective use of TARP funds. (see You Can't Rescue the Financial System if You Can't Read A Balance Sheet). Unfortunately, neither Treasury nor Congress has made an attempt to address foreclosure abatement. Without that, financial institutions will face a continued need to replenish capital, and far more Americans than necessary will lose their homes.

Part of the problem here is that the government cannot simply forgive debt for some and not for others. If it does so, mortgage delinquencies will accelerate, as homeowners attempt to get something for nothing. Another part of the problem is a coordination failure that prevents the mortgages from being restructured because they have been cut and repackaged into more pieces than Humpty Dumpty, allowing the holder of any piece to object.

The only way to address the foreclosure problem is either to purchase whole loans at a substantial discount and then restructure them (so that the original lender, not the government, bears the loss), to accumulate all of the pieces of securitized mortgages through all or nothing auctions and then to restructure them, or to allow judges to reallocate cash flows as part of the foreclosure process itself, offering the homeowner a reduction in principal in return for the obligation to pay the balance out of subsequent property appreciation.

If there is any good news here, it may be that we have now passed the likely peak of the first wave of mortgage foreclosures. As I noted last April in Which Inning of the Mortgage Crisis are We In?, adjustable rate mortgage resets peaked in mid-2008, so that allowing for delinquency and notices of default and trustee sale, we could expect foreclosures to peak about 6 months later (and here we are). This peaking in losses is what has apparently placed renewed pressure on U.S. financial institutions in recent weeks. Unfortunately, a second wave of resets is due to arrive early next year. If we fail to address the foreclosure risk now, we can anticipate a second round of extreme economic difficulty which will cut short any nascent success of the economic stimulus plan that is now being considered.

In short, the essential problem is not insufficient aggregate demand but rather risk-aversion and anticipatory saving triggered by fear of financial instability. Ockham's razor cuts straight to bank capital and foreclosure risk. We can address a much wider range of interests in the cause of economic stimulus, but if we fail to address the central cause of the present economic crisis, the attempt to increase aggregate demand will predictably fail.

I agree with Mr.Hussman up to a certain degree. As unemployment rises, as it surely will over the next six months, then the problem of risk-aversion is compounded by insufficient aggregate demand. Moreover, in a debt deflation cycle, people put off consumption to save and pay off debts, which also depresses aggregate demand.

But Mr. Hussman is absolutely right that the foreclosure problem needs to be addressed and this will be Timothy Geithner's job now that he has been sworn in as President Obama's new Treasury of Secretary.

A few other macroeconomic tidbits for you. Jeff Rubin, Chief Economist at CIBC World Markets, wrote a research piece on reflation where he states unequivocally that quantitative easing will work this time and that the bond market isn't giving the Fed its due credit in the battle against deflation.

Silly bond market, can't they see the risks of inflation?!? With all due respect to Mr. Rubin, who was calling for oil prices to soar above $200 per barrel over the next five years, he is simply wrong again on this call.

Paul Krugman wrote a brief comment in his blog today, What's in a name?, where he states the following:

I keep seeing economics articles and blog posts that insist that we’re NOT in a liquidity trap (and, of course, that yours truly is all wrong) because the situation doesn’t meet the author’s definition of such a trap. E.g., the interest rates at which businesses can borrow aren’t zero; or there are still things the Fed could do, like buying long-term bonds or corporate debt, or something.

Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.

Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness.

Yes, there are other things the Fed could do — and it’s doing them, on an awesome scale. But they’re controversial, precisely because, unlike conventional monetary policy, they involve picking and choosing among potentially risky investments. And there’s a much stronger case for fiscal policy than in normal times, because we don’t know how well these unconventional measures will work.

So what’s the point of saying “Ha! This doesn’t fit my definition of a liquidity trap!”? If you think it says anything useful about the situation, you’ve mistaken word games for policy analysis.
So if we are in a liquidity trap and deflation sets in, there is no reason to think the bond market has got it all wrong. Moreover, I agree with Eric Roseman who writes: deflation rules, avoid most commodities (except gold).

Too bad global pension funds didn't take the risks of deleveraging/ deflation seriously. According to a Watson Wyatt report, global pension fund assets in the 11 major pension markets fell by $5 trillion in 2008 hit by volatile markets:

The study said that over 2008, global pension assets fell to $20 trillion from $25 trillion, a fall of 19 percent which took assets below 2005 levels.

Another reason for the decrease was lower government bond yields, which pushed pension liabilities further up.

Pension schemes calculate their liabilities against AA-rated corporate bond yields --if yields fall, liabilities rise and vice versa.

Watson Wyatt said it had selected government bond yields to facilitate liability comparisons across the 11 countries.

All countries in 2008 saw significant negative growth in pension assets, the study noted, except for Germany, which was protected by its high allocation to bonds.

Despite losing market share in the past 10 years the United States, Japan and the United Kingdom remained the largest pension markets in the world, accounting for 61 percent, 13 percent and 9 percent respectively of total pension global fund assets.

Australia emerged as the fastest-growing market and the country with the highest proportion of defined-contribution pension vehicles.

Assets invested in defined-contribution pension schemes, account for 45 percent of global pension assets, up from 30 percent in 1998.

Pension schemes also changed the way they invest their funds in the five years to 2008.

In the seven most-developed pension markets, which include the United Kingdom, the Netherlands and the United States, equity allocations fell to 42 percent from 51 percent in the five years to 2008, having reached a high of 60 percent in 1998.

During the same period bond allocations increased to 40 percent from 36 percent.

Alternative investments allocations like real estate, extent hedge funds, private equity and commodities, grew to 17 percent from 12 percent.

"The pensions system is being tested on every level," said Roger Urwin, global head of investment content at Watson Wyatt.

"Most notable in 2008 were the impacts on it of credit and collateral risk as well as greater issues around liquidity and volatility. These have been exacerbated by the underperformance of many investment managers relative to their benchmarks," he also said.

"We have seen some successes from diversification and hedging strategies. But overall we see an industry facing a mountainous challenge," he added.

Mountainous challenge is an understatement. What successes from diversification? Spare me the consultant's rubber stamp approval of the benefits of alternative investments.

The challenges in alternative investments aren't going to disappear anytime soon. Harvard's sale of private equity was stymied by the drop in prices:

Harvard University didn’t sell most of the $1.5 billion of stakes in private-equity funds it put on the market last year because offers were too low, said three people familiar with the matter.

The university’s $28.8 billion endowment, the richest in higher education, rejected deals as sellers, including schools and pension funds, flooded the market and pushed down prices, said the people, who asked not to be identified because the bidding is private. The Cambridge, Massachusetts university remains interested in unloading the private-equity investments.

Harvard, Duke University and Columbia University were among institutions that last year put buyout and venture capital stakes up for sale on the secondary market, where middlemen broker deals. Schools are looking to raise cash as distributions from fund managers dry up and losses on stocks and bonds mount.

As much as $40 billion in private-equity interests may go unsold this year as sellers hold out for higher prices, according to Nyppex Holdings LLC, a firm that trades stakes in buyout pools.

“The discounts were too big to get approved in the sellers’ investment committees,” said Laurence Allen, managing member of Greenwich, Connecticut-based Nyppex, which advises endowments. Endowments and other nonprofits make up 5 percent to 10 percent of secondary-market sellers, down from as much as 20 percent at the end of last year, Allen said.

And real estate's woes continue. According to a report by real estate services firm Jones Lang LaSalle Inc., sales of U.S. commercial property likely fell 70 percent in 2008 and are expected to slide another 20 to 25 percent in 2009:

Last year's sales reached just $125 billion, crippled by the global credit crisis and the U.S. recession, the firm said in its U.S. Capital Markets 2009 research report released on Monday.

The decline was most precipitous in the last part of 2008, as the commercial mortgage-backed securities (CMBS) market, the key source of funding for the real estate boom of the prior five years, virtually closed.

CMBS issuance plummeted 95 percent in 2008 to $12.1 billion. There has been no CMBS issuance since June, Jones Lang said.

"The beginning of a new presidential administration and new aggressive monetary policies should increase certainty into the debt markets by mid-2009, but the CMBS market as we knew it in 2006-2007 is gone," Bart Steinfeld, managing director of Jones Lang LaSalle's Real Estate Investment Banking practice, said in a statement.

Over the past few months, the commercial real estate industry has seen a standoff between would-be sellers who refuse to capitulate to values that are about 30 percent or more lower than they were from their highs in early 2007 and prospective buyers who will not pay prices they believe are too high, the report said.

But that standoff may finally shake loose when some owners find themselves facing foreclosure because they have no sources for new loans to replace ones that are maturing.

"It may take another three to four quarters for broad-based distress to reach the sales market, but there is no question there is capital waiting to invest in real estate once opportunities arise (estimated at $300 billion targeting U.S. real estate)," Earl Webb, chief executive of Jones Lang LaSalle Capital Markets, said in a statement.

For quality properties, first-year returns on commercial real estate investments rise above 8 percent, as measured without the use of debt, "opportunistic investors will begin to seize these once-in-a-lifetime yield opportunities," Webb said. During the commercial real estate boom, some sales commanded first-year returns of less than 4 percent. Returns and prices move in the opposite direction.

Also, as rents continue to soften and occupancy falls, property values may continue to decline. Jones Lang sees rents declining into 2010.

Remember what I told you a while back: commercial real esate lags residential real esate by roughly 18 months, so don't expect activity to pick up before 2011 at the earliest.

Back to Blagojevich. If he really cared about the State of Illinois, he'd be back in Chicago where pension wars threaten to pit the taxpayers against the city workers who provide services ranging from police and fire protection to snow removal and public school education.

And it's not just Chicago; pension battles loom across the U.S.:

A pension war is brewing, and it's likely to pit state and municipal employees against citizens who foot the bill for government pension plans with their state tax dollars.

While employees of most companies have watched their 401(k) plans, and their retirement hopes, shrivel in the bear market, public employees have been smiling. They've been promised lucrative pensions, which have increased over the years as cities and states negotiated labor contracts. Now those public employees are about to find out they are not immune from the ravages of the stock market.

The Center for Retirement Research at Boston College estimates that state pension plans have losses greater than $865 billion, a loss of nearly 40 percent in just the past year. Add those current losses to the fact that many municipalities have gotten away with under-funding those pension plans for years, and you have trouble brewing.

Now, the double-whammy of stock-market decline and lower tax revenue in this recession is causing state and local governments to take a second look at how they will fund those promises.

The options are few. Tax hikes, whether income or property or sales tax increases, will be hard to pass in this economic slowdown, as well as counterproductive. Will the voters stand for cutbacks in services, from snow removal to education funding? Or will cities ask public employees to make up the gap with a combination of benefit cutbacks or increased plan contributions?

All those choices are political dynamite, which may explain why state legislatures have been so slow to face reality.

State retirement promises: The National Bureau of Economic Research says the value of pension promises already made by U.S. state governments will grow to approximately $7.9 trillion in just 15 years.

And they're forecasting that states are unlikely to be able to keep those promises: "We conservatively predict a 50% chance of aggregate under-funding greater than $750 billion and a 25 percent chance of at least $1.75 trillion in under-funding."

They say it all adds up to a huge gap: "Insuring taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today."

Paying state pensions? The looming issue of state and local pension deficits has been buried by our national financial issues, and by state politics. But there is one Web site that is tracking the pension pile-up. It started out as a watchdog for California pension issues, and now covers state budget and pension deficits across the nation.

The site has highlighted losses in California's public pension plan (CalPERS), which invested heavily in residential real estate, a mistake that wiped out nearly a third of the state employees' pension plan. Bad planning and huge promises helped force the city of Vallejo, California, into an unusual Chapter 9 bankruptcy last spring, partly to renegotiate labor contracts and pension promises.

Illinois has a nearly $50 billion gap in its public pension funds. It's trying to sell the state lottery to raise $10 billion, so far with no takers. The legislature hasn't appropriated pension funds, perhaps not recognizing that its own pension plan was only 32% funded, and that was before the stock-market crash last fall!

Chicago has balanced its budget, but only by selling the Skyway toll road, the city's major parking garages, Midway Airport. Now Chicago is in negotiations to sell the city's parking meters! Those one-time cash infusions are a tradeoff that will make it harder to pay tomorrow's pension promises.

It's a hot issue in every state. Kentucky reports a $30 billion gap in pension funding. Connecticut and Massachusetts have highly publicized state budget woes. And the stories keep coming. One of this week's PensionTsunami headlines: "Macomb County, Michigan, faces layoffs without $10 million in cuts to pensions and health benefits!"

Accounting legerdemain: The magnitude of the state pension shortfall has been hidden by accounting rules that allow pension liabilities to be discounted based on the "expected rate of return." Obviously, the higher the expected return is set, the lower the current pension contributions required. Given recent returns, most pension plans will be even more under-funded when they report on assets in the coming months.

Pension-accounting rules add to the problem. The riskier the assets in the pension plan (stocks are considered riskier than bonds), the higher the anticipated return they can use to make the plans look solvent. That encouraged many plans to become overweight in equities in the past few years.

Paying the piper: When it comes to making good on retirement promises, states have a far different picture than the federal government or public companies. The federal government can "print" money to pay its retirement obligations, including Social Security benefits. But municipalities can only borrow the money by raising taxes or selling bonds and other IOUs, or selling assets. It's not a good market for any of those solutions.

When companies go bankrupt, the Pension Benefit Guaranty Corp. (PBGC) steps in to cover most defined-benefit pension promises. The PBGC took over 110 plans in 2007, the latest year for which figures are available, paying a maximum benefit of $51,750 a year to eligible retirees. But the PBGC does not cover municipal or state retirement plans.

The little-known Chapter 9 of the bankruptcy code allows cities to reorganize and renegotiate all contracts and promises. Chicago attorney James Spiotto of Chapman and Cutler says the law can be murky: "There are varying levels of protection, ranging from strict constitutional rights to general statutory provisions, that might allow for some renegotiation of benefit levels in light of adverse conditions affecting the pension fund."

In other words, if a government body attempts to renege on pension promises, there will be a huge court battle.

The stage is set. If the generous state and local pension promises negotiated by unions are to be kept, it will be up to taxpayers to come up with the money, either through higher tax levies or lower service levels. That debate is coming soon to a taxing body near you! And that's the Savage Truth!

Yes, and here is another savage truth. Pension battles loom across the world, including in Australia, Ireland, England, the Netherlands, Canada, and in most other countries (except in Turkey and South Korea - they got it right investing mostly in government bonds).

So get ready for some 'Blago theatrics' from the presidents of your pension funds as they try to reassure you that they are on top of things and get ready for some tough political battles between unions and taxpayers as pension wars erupt across the globe.

And that's the Savage Truth!

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