Wednesday, January 28, 2009

Nowhere to Hide?

The U.S. House passed President Barack Obama’s $819 billion stimulus package, aimed at lifting the economy out of recession through tax cuts and more than a half-trillion dollars in new spending.

For its part, the Federal Reserve left the benchmark interest rate as low as zero, said it’s prepared to purchase Treasury securities to resuscitate lending and warned inflation may recede too quickly.

Let me quote the following from the Fed's monetary policy statement:

The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly.

Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level.

The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant.

The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

For those of you who still feel bonds are in a bubble and inflation will roar back, I invite you to listen to Charles Collyns, Deputy Director, Research Department at the IMF.

After listening to his presentation, take the time to read the IMF's World Economic Outlook that came out today, Global Economic Slump Challenges Policies. I quote the following:

A pernicious feedback loop between the real and financial sectors is taking its toll.

Global output and trade plummeted in the final months of 2008 (Figure 2, view: Data Figure 2). The continuation of the financial crisis, as policies failed to dispel uncertainty, has caused asset values to fall sharply across advanced and emerging economies, decreasing household wealth and thereby putting downward pressure on consumer demand. In addition, the associated high level of uncertainty has prompted households and businesses to postpone expenditures, reducing demand for consumer and capital goods. At the same time, widespread disruptions in credit are constraining household spending and curtailing production and trade.

At the bottom of the page, there are two documents that you must print and read, Gauging Risks for Deflation and Fiscal Policy for the Crisis.

I quote the following from the first paper, which is more important for pension funds:

  • An index of deflation vulnerability developed by Kumar and others (2003) covering countries accounting for roughly 80 percent of world output suggests that deflationary tendencies in the global economy are now somewhat higher than during the 2002–03 deflation scare. A key difference between then and now is the weakness in many housing markets, and the financial crisis. Neither are fully captured by the vulnerability indicator. Considering this, risks for sustained deflation are appreciably greater than in 2002–03, particularly in several G-7 economies. Nonetheless, the most likely outcome is that sustained deflation will be avoided, as was the case in2002–03.
  • A model-based analysis for the G-3 economies (United States, euro area, and Japan) also suggests that, on the assumption that the financial distress is gradually resolved, the most likely outcome is that the global economy will stay clear of sustained deflation. However, if financial sector problems are not remedied or further shocks add to current stresses, there is a significant probability of more negative deflationary outcomes, with a deeper and more prolonged recession.
  • Policymakers should err on the side of acting too soon rather than too late in countering deflationary shocks. Very low inflation and inflation expectations can create a problem for monetary policy even before a sustained deflation sets in. Key considerations are that the lower inflation and inflation expectations are, the smaller the scope for central banks to stimulate activity with interest rate cuts; notwithstanding the recent experience of relatively high global inflation, slumping aggregate demand can quickly lead to expectations of falling prices in large parts of the world because in these parts inflation expectations are not very persistent; and monetary policy takes one to two years to exert its full effect on activity.

In plain English, the deflation psychology can wreak havoc before actual deflation sets in. And once deflation sets in, good luck trying to get out. This is why you are seeing unprecedented fiscal and monetary policy as well as quantitative easing. Anything to avoid deflation.

Against this backdrop, it's not surprising to see gloom is deepening among business leaders and economists, casting a pall over this year’s World Economic Forum in Davos, Switzerland:

“The crisis is getting worse,” Rupert Murdoch, chief executive officer of News Corp., said at a press conference to kick off the five-day event today. “It’s going to take very drastic action to turn that around, if it can be turned around, quickly. I believe it will take quite a long time.”

Concerns over the economic outlook are virulent as executives from JPMorgan Chase & Co.’s Jamie Dimon to Stephen Green of HSBC Holdings Plc join more than 2,500 counterparts, academics and policy makers in the ski resort for five days of soul-searching and deal-making.

“You have to realize the size of the problem confronting us today is significantly larger than in the ‘30s,” George Soros, the billionaire hedge-fund owner and philanthropist, said today. “The situation will continue to deteriorate.”

Just one in five of 1,124 chief executives in 50 nations said they were very confident about prospects for revenue growth in 2009, down from half last year, and more than a quarter said they were pessimistic, a survey by PricewaterhouseCoopers LLP showed. The sentiment was the worst since the accounting and consulting firm began tracking the CEO outlook in 2003.

The global economy will slow close to a halt this year as more than $2 trillion of bad assets in the U.S. help sink economies from Russia to the U.K., the International Monetary Fund said today.

‘Pretty Grim’

“The outlook is pretty grim,” said Howard Davies, director of the London School of Economics and a former Bank of England policy maker who is in Davos. “Things are not good and business surveys are coming out showing they’re getting even worse.”

What began as a financial meltdown 17 months ago has morphed into an economic calamity unseen since the Great Depression.

In the past year, Lehman Brothers Holdings Inc. and Bear Stearns Cos. have collapsed and officials around the world have committed trillions to prevent more from toppling. The Standard & Poor’s 500 Index is still falling after its worst year since 1937 as the U.S., Japan and Europe sink into their first simultaneous recession since World War II.

World Bank Chief Economist Justin Lin said today the world was in a “protracted recession” and that injecting capital into banks won’t revive it. “We need to have coordinated fiscal stimulus that’s large enough,” he said.


It’s “delusional” to expect the U.S. fiscal stimulus plan crafted by President Barack Obama to “jump start” the economy, Stephen Roach, Morgan Stanley Asia’s chairman, told a panel in Davos today.

The executives polled by PricewaterhouseCoopers survey don’t see a turnaround soon.

Only about a third were very confident about growth in the next three years, down from 42 percent last year. Almost seven in 10 said their companies will be affected by the credit crisis, and 70 percent of those said they will delay planned investments as a result.

Just 13 percent of U.S. executives said they were “very confident” about revenue growth in the next 12 months, compared with 36 percent last year, while 15 percent in Western Europe expressed the same sentiment, down from 44 percent. Among developed economies, French executives were the most skittish, with just 5 percent calling themselves very optimistic.

Emerging Markets

Business leaders in emerging markets were more confident. Seven in 10 Indian executives expressed optimism about their company’s growth, as did about three in 10 of those in Brazil, Russia and China.

One further bright spot: Only about a quarter of the business chiefs said they plan to cut payrolls in the coming year, while 35 percent said they intended to maintain staffing levels. That would be welcome news to workers as unemployment accelerates around the world with Home Depot Inc., Caterpillar Inc. and ING Groep NV among those axing positions this week.

So why are these people so gloomy? I think a significant problem was identified by the FT's Martin Wolf in his article, Why dealing with the huge debt overhang is so hard:

How much debt is too much? Nobody knows. But the governments of highly indebted high-income economies – such as the US and UK – think they know the answer: more than today. They want even more credit to flow to their struggling private sectors. Is that an attainable ambition and, if so, how might it be achieved?

Let us start with some facts. The ratio of US public and private debt to gross domestic product reached 358 per cent in the third quarter of 2008. This was much the highest in US history (see charts). The previous peak of 300 per cent was reached in 1933, during the Great Depression.

Nearly all of this debt is private. That reached an all-time high of 294 per cent of GDP in 2007, a rise of 105 percentage points over the previous decade. The same thing happened to the UK, on a yet more impressive scale. This has been a gigantic debt and credit expansion.

Particularly remarkable is the composition of the increased debt. In the early 1930s, most US private debt was owed by non-financial companies: so balance-sheet deflation occurred in companies, as was also the case in Japan in the 1990s. This time, however, the big increase in debt was in the financial and household sectors.

Over the past three decades the debt of the US financial sector grew six times faster than nominal GDP. The consequent increases in its scale and leverage explain why, at the peak, the financial sector allegedly generated 40 per cent of US corporate profits. Something decidedly unhealthy was going on: instead of being a servant, finance had become the economy’s master. In a superb brief account of today’s calamity, Lord Turner, chairman of the UK’s Financial Services Authority, refers explicitly to “illusory profits”*.

Moreover, household debt – much of it associated with housing – also rose rapidly: from 66 per cent of US GDP in 1997 to 100 per cent in 2007. A slightly bigger jump in household indebtedness can be seen in the UK.

What do such rises in indebtedness portend? The answer might be: nothing. After all, over the world, debt nets to zero. In principle, the ability to transfer purchasing power from lenders to borrowers is highly desirable: as a British advertising campaign once claimed, credit “takes the waiting out of wanting”. Yet people can also make big mistakes, particularly if they confuse bubbles with permanently high prices. The financial sector is particularly prone to such blunders. As Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard comment: “Systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike”**.

Once such asset bubbles burst, it becomes hard to find borrowers and lenders who are either willing or creditworthy. The over-indebted start paying down their debts, instead, as now. Desired savings also soar. Realised savings may not rise, however: incomes may collapse, instead. This is what John Maynard Keynes called “the paradox of thrift”. The result will be a slump caused by balance sheet collapse rather than attempts to control high inflation.

What then might be done?

Some recommend a “liquidation”. A chain of bankruptcy would indeed eliminate a debt overhang, as happened in the 1930s. But, with much of the economy enmeshed in bankruptcy and the financial sector imploding, a depression would result. To choose that option must be insane.

Less unappealing is organised mass bankruptcy. Proposals for an organised debt-for-equity swap in failed or enfeebled financial institutions fall into this category. So, too, does allowing courts to modify mortgage contracts. Executed efficiently and expeditiously, such ideas are attractive. Costs would fall on shareholders and creditors, not taxpayers, and so sustain the principle of private responsibility.

An opposite approach is to sustain existing levels of debt, by slashing its cost to borrowers and trying to grow out of it over many years. This is what current monetary policies seek to achieve. It is a good idea, however unpleasant to creditors. But this would not generate much additional borrowing or fresh spending; it would not stop the indebted from trying to lower their debt; and it would not restore the financial sector to health.

Yet another approach is to replace private debt with public debt. That is what recapitalisation of banks now means. Over time, private-sector debt should fall, while public-sector debt, explicit and implicit, rises. Socialising debt increases the chances of growing out of it. That has happened before, notably in the case of UK public debt over the course of the 19th century.

Finally, there is inflation. If central banks and governments are aggressive enough, they can generate inflation, which will lower the debt burden. But they will imperil – if not terminate – the experiment with unbacked fiat (or man-made) money that started in 1971.

So which is the best approach?

At the overall level, it must largely be to grow out of the debt overhang, with socialisation of a part of it an essential element. Relapse into inflation would be a huge policy failure. A plan is also needed to deal with the plight of many households and with the overextended and undercapitalised financial sector.

The financial sector, as a whole, cannot deleverage by selling assets. It would be helpful if claims of global financial institutions could be netted out, instead, though that would require international co-operation. The Obama administration must also soon launch a recapitalisation of US banking, but not by buying the “toxic assets” at above-market prices. A debt-equity swap would be preferable. If that is politically impossible or too destabilising, publicly financed recapitalisation is inevitable. Just do not dare to call it nationalisation.

Whatever is done, one compelling truth cannot be evaded. It is going to be very hard to generate substantial net borrowing by households and non-financial corporations in the high-income countries with high internal debt. It is unimaginable that they will return to levels of private-sector borrowing, spending and increases in debt that characterised these countries for so long. Countries with large current account surpluses have long demanded an end to the profligate borrowing and spending of the customers upon whom they depended. They should have been careful what they wished for: they have now got it. Enjoy!

What does all this mean for pensions? It means that it will take a very long time before they recoup the losses of 2008 - possible a decade or longer.

Pension fund managers should listen to Nouriel Roubini who sees 'nowhere to hide' from the global slowdown:

“There is nowhere to hide,” Roubini, an economics professor at NYU’s Stern School of Business who predicted the financial crisis, said from Zurich in an interview with Bloomberg Television. “We have for the first time in decades a global synchronized recession. Markets have become perfectly correlated and economies are also becoming perfectly correlated. This is not your kind of traditional minor recession.”

Roubini said the U.S. government should nationalize the biggest banks because losses will exceed assets, threatening to push them into bankruptcy. The banks could be privatized again in two or three years, Roubini said. The professor reiterated his prediction that U.S. financial losses will more than triple to $3.6 trillion and that global equities will fall 20 percent this year from current levels.

‘Zombie Banks’

“Nobody’s in favor of long-term ownership of the U.S. banking system by the government, but if you don’t do it this way, you end up like Japan where you kept alive for a decade zombie banks that were never restructured,” he said. “That’s going to be much worse. It’s better to clean it up, nationalize it and sell it to the private sector.”

Japanese policy makers hesitated in addressing a banking crisis in the 1990s and then struggled to revive growth and fight deflation in what is known as the “Lost Decade.”

Roubini recommended holding cash or short-term government debt and said high-yield bonds are cheap relative to U.S. stocks.

[Note: Stick to high quality corproate bonds (AAA). According to S&P, default rate for issuers of U.S. corporate junk bonds — bonds that Standard & Poor’s rates BB+ and below — is expected to “catapult” to an all-time high of 13.9% by December.]

But pensions followed Harvard (and Yale) into alternative investments and now they are going to suffer the same fate as the world's biggest endowment who may have lost more than it previously stated:

Harvard Management Co., which runs the world's largest endowment fund, has had until recently an incredible record. Over the past six years, it succeeded in more than doubling the notional value of Harvard's endowment to $36.9 billion in fiscal 2008 (which ended on June 30) even after paying for about one-third of Harvard's operating expenses.

So its recent loss of $8.1 billion from July 1 to Oct. 31, 2008, came as a stunning blow. Yet this huge loss, as staggering as it sounds, might be only the tip of the iceberg of illiquid investments. According to a source close to the Harvard Management Co., the damage, if the fund's illiquid investments are realistically appraised, may be closer to $18 billion—or more than twice the amount previously reported. (This is in line with a report, released today, showing an average 22.5 percent drop in endowments in North America.)

The lack of clarity says a lot about how exotic Harvard's finances have become. Its team of highly incentivized money managers—who themselves earned $26.8 million in 2008—adopted a strategy aimed at taking maximum advantage of an inflationary global boom in the early 2000s by shifting the lion's share of Harvard's money from conventional endowment assets—such as bonds, preferred stocks, Treasury bills, and cash—into more esoteric investments that would presumably rise as more money chased after scarcer goods. They bought, for example, oil in storage tanks, timber forests, and farmlands. As the proliferation of trillions of dollars worth of subprime mortgages further expanded the bubble, driving up the price of oil, lumber, and land, the notional value of Harvard's portfolio soared.

The price of oil, for example, which Harvard and other speculators were storing, more than quadrupled to $153 a barrel on commodity exchanges, allowing Harvard to hugely appreciate the notional value of its portfolio. So between fiscal 2003 and 2008, Harvard's "real assets" showed a gain of nearly 25 percent annually. But even after the subprime mortgage crisis began to unfold and a number of financial institutions had collapsed, Harvard's money managers persisted in pursuing this risky course.

Consequently, as late as June 2008, the fund kept almost no reserve of cash or Treasury bills and allocated a mere 6 percent of its money to fixed-interest bonds. It also borrowed more than $1 billion to amplify the returns on its less conventional investments. So by the time the bubble burst in the fall of 2008, only a small fraction of the endowment fund investment was even under the jurisdiction of the SEC. According to the November 7th 13F holding report it filed with the SEC for the quarter ending September 30th, 2008, Harvard had only $2.88 billion of its funds in exchange-listed stocks, options, or other derivatives. What of the more than $35 billion it had allocated to investments at the start of fiscal 2009 (i.e., July 2008)?

Most of the balance had been allocated to investments, which if not totally illiquid could not be valued by market activity. The breakdown that follows illuminates how far HMC had strayed from the path of traditional endowment investing in the last decade.

More than one-quarter of Harvard's funds were still sunk in "real assets": about 8 percent in stockpiled oil, about 9 percent in timber and other agricultural land, and 9 percent in real estate participation. Then came the financial crises, and prices plunged. Oil fell to less than $40 a barrel. Lumber suffered almost as badly. And, with the drying up of bank lending, the value of Harvard's real estate holdings—which remain opaque—became at best problematic.

One indication of how steep the loss may be is that CalPERS, the giant pension fund of the California Public Employees' Retirement System, which owned even more real estate acreage than Harvard, reported in this period a 103 percent loss on real estate deals in which, like Harvard, it had borrowed to amplify its profits.

Another huge portion of Harvard's endowment had been farmed out to hedge funds (18 percent) and private equity funds (13 percent). While these funds provided some diversification, many of them also impose restrictions on withdrawals, including ones, like Citadel, that suffered substantial losses.

To get back its money under such circumstance, it was often necessary to sell at a steep discount to a "secondary" hedge fund. One major player in the private equity business tells me that Harvard had tried this fall to sell its private equity stakes at 30 percent to 35 percent discounts but could find no buyers even at those prices. It's also possible that Harvard will have to meet "capital calls" on its private equity investments that would sap even more capital.

Harvard also allocated nearly $4 billion, or 11 percent of its fund, to volatile emerging markets, such as Brazil, Mexico, and Russia. Here its money managers bet both that the stocks would go up and that the local currencies would at least hold steady against the dollar, but they lost on both counts.

First, the thin local stock markets, which had little liquidity, collapsed in the financial crises. For example, Russian stocks lost almost 80 percent of their value in a matter of days last fall. Then, as banks and hedge funds got out of their currency trades, the local currencies in many of these countries also lost heavily against the dollar. The Brazilian real, for example, fell about 40 percent last year. So presumably the endowment fund took a double hit. Aside from emerging markets, Harvard had invested another 11 percent if its portfolio in more established foreign economies, as those of Britain, Germany, France, Italy, Australia, and Japan. But here the stock markets declined and, with the exception of the Japanese yen, so did their currencies.

Given the true cost of getting its money out of the hedge funds and other illiquid investments, my knowledgeable source finds the claim by Harvard's money managers that the fund lost only 22 percent at best "purely Pollyannaish." (A Harvard University press representative declined to comment for this story.)

But while Harvard's money managers may chose to look through rose-colored glasses at the value of their portfolio, Harvard University, which relies on the interest from distribution from its endowment to fund one-third of its operating budget, needs to be more realistic. As its president, Drew Faust, noted in an e-mail to the Harvard community, "We need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint."

Harvard is hardly alone in moving from traditional investments to more exotic instruments. Yale's endowment fund, which with $22.5 billion in assets in 2008 was second only to Harvard's, followed a similar strategy of finding alternate investments including hedge funds, private equity funds, physical commodities, and emerging markets.

Its longtime manager, David Swensen, indeed makes the argument in his book Pioneering Portfolio Management that diversifications of this kind are safer than just investing in traditional stocks and bonds. And during the decade preceding the present financial crises, his fund actually outperformed Harvard's. But despite his efforts at diversification, Yale lost at least 25 percent of its fund in the fall of 2008 if one takes into account the plunging value of its illiquid assets. Columbia University, too, is seeing losses.

So institutions of higher education, like other speculators seeking enormous profits in what is essentially a zero-sum game, learned the sad lesson that playing for high stakes in the casino economy inexorably entailed the risk of catastrophic losses.

After reading tonight's comment, I hope you get a deeper understanding of the seriousness of the problem at hand.

This isn't just another market downturn - it's a catastrophe and taxpayers are going to be called upon once again to bail out the incompetent and reckless decisions that pension fund managers and their boards of directors undertook over the last decade.

As pension fund consultants get busy firing and hiring money managers in coming months, I wonder how many more billions of losses before senior pension fund managers get axed?

Then again, unlike the hard working members they invest for, senior pension fund managers have golden parachutes to cover themselves in case they get fired. All upside, no downside. No wonder they take excessive risks with other people's money.

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