Wednesday, January 14, 2009

Pension Pandemic: Part II

This is the second part to the pension pandemic comment I wrote about yesterday. As you will read below, there is a reason why I chose the word "pandemic" to describe the global pension crisis.

But first, a few sobering articles for you to read and think about. In mid December, Global Europe Anticipation Bulletin (GEAB) published an article, Global systemic crisis – New tipping-point in March 2009: "When the world becomes aware that this crisis is worse than the 1930s crisis":
LEAP/E2020 anticipates than the unfolding global systemic crisis will experience in March 2009 a new tipping point of similar magnitude to the September 2008 one. According to our team, at that period of the year, the general public will become aware of three major destabilizing processes at work in the global economy, i.e.:

• the length of the crisis
• the explosion of unemployment worldwide
• the risk of sudden collapse of all capital-based pension systems

A whole range of psychological factors will contribute to this tipping point: general awareness in Europe, America and Asia that the crisis has escaped from the control of every public authority, whether national or international; that it is severely affecting all regions of the world, even if some are more affected than others (see GEAB N°28); that it is directly hitting hundreds of millions of people in the “developed” world; and that it is only worsening as its consequences reveal throughout the real economy.

National governments and international institutions only have three months left to prepare themselves to the next blow, one that could go along severe risks of social chaos. The countries which are not properly equipped to cope with a surge in unemployment and major risks on pensions will be seriously destabilized by this new public awareness.

In this 30th issue of the GEAB, the LEAP/E2020 team describes these three destabilizing processes (two of them are described in this public announcement) and gives recommendations to cope with the surge in risks. In addition, this issue also provides the opportunity to make an objective assessment of the reliability of LEAP/E2020's anticipations and specifies a number of methodological aspects of the analytical process used. In 2008, LEAP/E2020's success rate reaches 80%, and even 86% when it comes to strictly socio-economic anticipations. In a year of major upheavals, our team ise altogether quite proud of this result.

The crisis will last at least until the end of 2010

Evolution of the US money base and indications of related major US crisis periods (1910 – 2008) - Source: Federal Reserve Bank of Saint Louis / Mish’s Global Economic Analysis
Evolution of the US money base and indications of related major US crisis periods (1910 – 2008) - Source: Federal Reserve Bank of Saint Louis / Mish’s Global Economic Analysis

As we already explained in GEAB N°28, the crisis will affect in different ways the different regions of the world. However, and LEAP/E2020 wishes to be very clear on that aspect, contrary to the dominant stance today (coming from those experts who denied the fact that a crisis was coming up three years ago, who denied that it was global two years ago, and who denied the fact that it was systemic six months ago), we anticipate that the minimum duration of the decanting phase of the crisis is 3 years (1).

It shall be finished neither in spring 2009, nor in summer 2009, nor at the beginning of 2010. It is only towards the end of 2010 that the situation will start stabilizing again and improving a little in some regions of the world, i.e. Asia and the Eurozone, as well as in countries producing energy, mineral and food commodities (2).

Elsewhere, it will continue; in particular in the US and UK, and in all the countries depending on their economy, were the duration could approximate a decade. In fact these countries should not expect any real return to growth before 2018.

Moreover no one should imagine that the improvement at the end of 2010 will correspond to a return of high growth. The recovery will take long. For instance, stock markets will take a decade to return to levels comparable to 2007, if they ever return to that. Remember that it took twenty years before Wall Street resumed its 1920 levels.

Well, according to LEAP/E2020, the present crisis is deeper and longer than in the 1930s. The general public will gradually become aware of the long-term aspect of this crisis in the coming three months and this situation will immediately trigger two tendencies carrying with them social-economic instability: fear of the future and enhanced criticism towards leaders.

The risk of sudden collapse of all capital-based pension systems

Finally, among the various consequences of the crisis for dozens of millions of people in the US, Canada, UK, Japan, Netherlands and Denmark in particular (3), there is the fact that, from the end of the year 2008 onward, news about major losses on the part of the organizations in charge of managing the financial assets supposed to finance pensions will multiply.

The OECD anticipates that pension funds will lose 4,000 billion USD in 2008 only (4). In the Netherlands (5) as well as in the United Kingdom (6), monitoring organizations recently blew the whistle asking for an emergency contribution reappraisal and a State intervention.

In the United States, growing numbers of announcements call for contribution increases and benefit reductions (7), knowing that it is only in a few weeks time that most of these funds will start calculating their total losses (8).

Most of them are still deluding themselves about their capacity to build up again their capital after the markets turn around.

In March 2009, when pension fund managers, pensioners and governments will become simultaneously aware of the fact that the crisis is there to last, that it coincides with the « baby-boomer » generation’s age of retirement and that the markets will not resume their 2007 levels until many long years (9), chaos will flood this sector and governments will reach the moment when they will be compelled to nationalize all these funds. And Argentina, who took this decision a few months ago already, will appear a pioneer.

All the trends described above are already at work. Their combination and the public becoming aware of the consequences they could entail, will result in the great collective psychological trauma of Spring 2009, when everyone will realize that we are all trapped into a crisis worse than in the 1930s and that there is no possible way out in the short-term.

The impact on the world’s collective mentalities of people and policy-makers will be decisive and modify significantly the course of the crisis in its next stage. Based on greater disillusion and fewer beliefs, social and political instability will settle down worldwide.

Finally, this GEAB N°30 presents a series of 13 questions & answers designed to enhance savers'/investors'/decision-makers' capacity to understand and anticipate the next stages of the global systemic crisis:

1. Is this crisis different from the previous crises which affected capitalism?
2. Is this crisis different from the 1930s crisis?
3. Is the crisis as serious in Europe or Asia as in the USA?
4. Are the current actions undertaken by public authorities worldwide sufficient to curb the crisis?
5. What are the major risks still weighting on the world financial system? And are all savings equal in front of the crisis?
6. Is the Eurozone a true protection shield against the worst aspects of the crisis and what should the Eurozone do to improve its protection status?
7. Is the Bretton Woods system (in its 1970s last version) currently collapsing? Should the Euro take the place of the Dollar?
8. What can be expected from the next G20 meeting in London?
9. Do you think that deflation is right now the biggest threat to economies worldwide?
10. Do you think that the Obama administration will be able to prevent the USA from sinking into what you called the ‘Very Great US Depression’?
11. In terms of currencies, beyond your anticipation of the Dollar resuming its collapse in the very next months, do you think that the UK Pound and the Swiss Franc are still currencies with an international status?
12. Do you think that the CDS market is about to implode in the coming months? And what could be the consequences of such a phenomenon?
13. Is there a ‘US Treasury Bonds Bubble” about to burst?

(1) It can be useful to read on this crisis a very interesting contribution by Robert Guttmann published in the 2nd half of 2008 on the website, supported by the Maison des Sciences de l'Homme Paris-Nord.

(2) As a matter of fact, commodities have already started contributing to boost the market of international sea transport. Source: Financial Times, 12/14/2008

(3) It is in those countries that capital-based pension systems were most developed (see GEAB N°23) but is also the case of Ireland. Source: Independent, 11/30/2008

(4) Source: OECD, 11/12/2008

(5) Source: NU.NL, 12/15/2008

(6) Source: BBC, 12/09/2008

(7) Sources: WallStreetJournal, 11/17/2008; Phillyburbs, 11/25/2008; RockyMountainNews, 11/19/2008

(8) Source: CNBC, 12/05/2008

(9) Not to mention the effect of an explosion of the US T-Bond bubble on pension funds. See Q&A, GEAB N°30.

I have already discussed the so-called 'bond bubble' and as far as CDS, keep an eye on what is going on with Citigroup (C) and Bank of America, which some think is the next Citigroup, because there will be some serious aftershocks in the credit markets if either of them collapse.

Another sobering analysis you should read is Hoisington Investment Management's Quarterly Review - Fourth Quarter 2008.

I quote the following:
The debt level of the U.S. has reached unprecedented proportions (Chart 1). More important than the level, however, is the fact that for the last few years the debt was improperly loaned and financed. In the words of the late economists Minsky and Kindelberger, this type of lending activity implies there is little likelihood of repayment of principal and interest.

Stock prices have plunged, and with home prices plummeting, and commercial and industrial properties losing value, a deflation of assets has clearly begun while the underlying debt remains constant. Will this deflation overwhelm the best efforts of the Federal Reserve, invalidate Friedman’s theory and prove Fisher correct? Most naturally feel and hope that the superiority of unbridled monetary and fiscal stimulus will overwhelm incipient price declines and stem the expanding cyclical downturn in economic growth.

Our judgment is that the power of monetary policy revolves around the ability to initiate a new borrowing and lending cycle. This can only happen if lenders are willing to lend and borrowers are wanting and able to borrow. Presently, neither are so inclined (Chart 2). If price declines in assets continue, then Shakespeare’s admonition of “neither a borrower nor a lender be” will become the economic mantra, meaning that a period of very low nominal growth will likely extend for a decade.

Moreover, fiscal policy actions may not be helpful either and could produce unintended negative consequences. Conventional wisdom is that the current economic contraction is nothing more than a typical post war recession. In the ensuing paragraphs we intend to frame an argument that is contrary to this conventional wisdom.

here to read the full quarterly review, it is excellent)
Now that I got your attention, let me share with you my "insider's view" of how I foresaw this financial and economic crisis.

President Bush may be wildly unpopular now - and with good reason - but I do think he was very unlucky that the financial meltdown happened on his watch. Moreover, he was absolutely right on the money when he said "Wall Street got drunk".

The problem is that pension funds got drunk too as they tangoed with Wall Street for many years, shoveling billions into alternative investments like real estate, private equity, hedge fund and commodities. Some pension funds even bought auction-rate securities, asset-backed commercial paper (ABCP here in Canada), CDOs and sold CDS!!!

I had a bird's eye view of all this nonsense. As a senior investment analyst, I was responsible for researching, writing, and presenting documents to the Board of Directors on many of these asset classes. I also invested in hedge funds, met some exceptional managers and a ton of mediocre managers too.

At one point I wrote a paper where I was looking into commodity futures and I was simply not convinced of the so-called "diversification" benefits of investing in long-only commodity futures. Some of the world's biggest pension funds were investing in commodity futures, but I was very skeptical of this "asset class" (not to mention we have enough commodity exposure here in Canada through our public equities).

The speculative frenzy fueling oil price swings was recently covered by CBS's 60 Minutes, but the truth is most pension funds got in there late in the game. Still, pensions shoved billions into long-only commodity futures indexes and even commodity CDOs and CDO-squared and cubed that the investment bankers were peddling, effectively adding leverage upon leverage. It was ridiculous and I see pension funds have not learned their lesson as they continue to pump more into commodity futures.

Equally ridiculous was watching pension fund managers at hedge fund conferences or private equity conferences touting the benefits of alternative investments without properly understanding the risks of these investments. They were being wooed by managers that were feeding them sophisticated "bullshit" and they funelled billions into the alternative investment pension Ponzi scheme (it's so easy acting like a big shot with other people's money!).

And now the music has stopped, pension funds are scrambling to regain their senses. According to the FT, a handful of high-profile public pension schemes in the US are slashing their investments in portable alpha – an aggressive strategy they say has failed to live up to expectations amid the market turmoil:
It is a disappointing setback for managers offering the product; some had expected portable alpha to be one of the most popular and lucrative product lines in 2008.

“People are not as interested as before,” says Keith Black, associate at consultant Ennis Knupp. “People thought these portable alpha products were absolute return products that wouldn’t lose money. So a lot of people got into them without knowing what the risks are on the alpha side.”

Portable alpha is a vaguely defined strategy that can differ from firm to firm. Some consultants say investors looking for ways to reduce risk are cutting portable alpha because they did not understand it in the first place.

Broadly speaking, the strategy combines leveraged exposure to an index with investments in a high-returning asset or strategy uncorrelated to that index. The former provides the beta, the latter is supposed to deliver outperformance, or alpha.

For example: An investor has $100. She invests $3 of it in an index under a derivative contract with a $100 notional value. This leaves her with $97 that she invests in assets or strategies uncorrelated to the index.

In July 2008, JP Morgan Asset Management predicted that many institutional investors of all kinds would buy into that idea. In an alternative investment survey, the firm said 31 per cent of pensions, foundations and endowments already used portable alpha, with another 15 per cent planning to implement a programme shortly.

But interest since then has chilled. Consultants say the strategy will continue to bleed investors as the down market squashes areas to gain beta exposure.

Among those paring down their involvement is the Pennsylvania State Employees’ Retirement System, which started its portable alpha programme in 2002. The pension fund had to meet a margin call for $1.5bn (£987m, €1.1bn) late last year when the strategy performed worse than expected. The fund’s programme uses hedge funds of funds, and faces more margin calls as additional contracts mature. In December, that came to an additional $1bn.

The system is cutting its beta exposure from almost $9bn two years ago to under $2bn, by letting contracts expire unrenewed. The alpha component was reduced in 2007 when the system shifted about $3bn in portable alpha hedge funds of funds to the absolute return folder. The system currently has $1.9bn left in its portable alpha programme and about $30bn in the total portfolio.

“With the markets in such turmoil, we deemed it to be the most prudent thing to do,” says Robert Gentzel at the fund. “The swaps did what they were designed to do, produce the market return, but the funds of funds were not able to produce positive returns in what, admittedly, was a difficult environment.”

He says the system will reassess the programme when markets recover.

The South Carolina Retirement System is pulling back too, reportedly reducing the beta component of the programme to between 10 per cent and 15 per cent, down from 20 per cent of the total $20bn portfolio. Robert Borden, chief investment officer, did not return phone calls for comment.

Consultants say they expect more to abandon portable alpha. Some, they say, will realise that they didn’t fully understand how the product worked or the pitfalls involved.

Understanding that the product is levered is the most important component, says Mr Black at Ennis Knupp. He urged investors to demand better education about portable alpha before investing in it – and to assume more realistic return assumptions.

“I think some people got into portable alpha products because whoever they were working with gave them the idea there was this risk-free product out there. The people who have the lowest risk perception are the ones that are the most worried,” he says.

Andy Turner, managing director at venture capital firm Northern Lights Ventures, agrees, predicting investors “will be spooked”.

“The strategy might be working fine, and either the responsible parties for the funds might become uncomfortable or the trustees might become uncomfortable,” says Mr Turner. “There are always a few people who get into a strategy who may not understand it completely. If you think about the real genesis of a portable alpha strategy, it makes sense.”

Portable alpha does have its champions. At the Pension Reserves Investment Management Board of Massachusetts, executive director Michael Travaglini says he plans to hold on to the programme, despite losses.

“Heading for the hills after what’s essentially been three months of bad performance? That’s just not how we make decisions around here,” says Mr Travaglini. The pension’s portable alpha programme comprises about 6 per cent of the $40bn portfolio and is used to add value to its domestic equity portfolio instead of active managers.

“We knew a year like 2008 was possible. We’re trying to remind people 2008 is not going to be the rule.”

Mr Travaglini expects the programme will consistently generate returns in excess of the Russell 3000 after at least three years. “The toughest thing for a fiduciary is to not follow the crowd.”

The toughest thing for a fiduciary is not to follow the crowd? Huh? What about the crowd who blindly bought into "portable alpha" the investment bankers were peddling them, swapping into indexes and then shoving billions into funds of hedge funds that were charging them an extra layer of fees?

Boy, that crowd must feel great paying funds of hedge funds extra fees after hedge funds got clobbered in 2008 and are now bracing for more pain in 2009.

And it's not just in hedge funds. Funds of real estate funds and funds of private equity funds have also performed dismally. As the smoke clears around private equity, PE insiders are expecting write-downs of at least 20-30 percent as buyout firms revalue assets in a new world where unemployment is rising and consumer spending has fallen off a cliff.

The same can be said about commercial real estate which is the next in line to fall as CRE loan distress levels are escalating rapidly. Commercial real estate market stakeholders are pushing lawmakers to devote at least $20 billion of financial rescue funds to a new Federal Reserve facility aimed at unfreezing lending to the sector. The same thing is happening in Britain where the largest commercial-property firms need to raise as much as $20 billion this year to restore their balance sheets at a time when financing is scarce.

The great alternative investments debacle recently prompted David Swensen, chief investment officer of Yale’s $17bn endowment, to warn that efforts to emulate Yale’s investment strategy would fail if other institutions use consultants and funds of funds to make investment decisions, instead of hiring a team of in-house professionals:

The head of the Yale’s $17 billion endowment believes that funds of funds and consultants are bad for the investment community and “facilitate the flow of ignorant capital”.

“Fund[s] of funds are a cancer on the institutional-investor world,” David Swensen, chief investment officer for Yale’s endowment, told The Wall Street Journal today. “The best managers don’t want fund of funds money because it is unreliable.”

Consultants, he said, “make money by giving advice to as many people as possible. But you outperform by finding inefficiencies most of the market has not yet uncovered. So consultants ultimately end up doing a disservice to investors”.

Swensen decried other institutional investors’ attempts to mimic Yale’s investment approach, which

pioneered a focus on private equity, hedge funds and oil and gas.

“Most endowments use fund[s] of funds and consultants, rather than making their own well-informed decisions,” Swensen said. “If you’re going to invest in alternatives, you should be all in, and do it the way Yale does it – with 20 to 25 investment professionals who devote their careers to looking for investment opportunities.”

Yale has struggled in the financial turmoil of the past year, with its endowment declining by 25 percent since the end of June, when it was valued at $22.9 billion. The endowment stands at $17 billion.

The endowment’s investments had a negative 13.4 percent return from July through October, Yale’s president Richard Levin said in a letter to alumni in December. Levin said he expected the endowment to remain flat through the 2009-2010 academic year and resume growth after 30 June, 2010.

Yale has committed 18.7 percent of its investment portfolio to private equity, with a target of 19 percent, according to the university’s most recent annual report, published in June 2007.

Harvard’s endowment also took a loss of $8 billion, or 22 percent, in the six months from the end of June, when its portfolio was valued at $36.9 billion. The school expects losses to climb to 30 percent once it has fully updated valuations for private equity and real estate.

Well, most pension funds tried Yale's yardstick and now they are feeling Harvard's horror. They caught the "alternative investment bug" and now we are all going to suffer from a full-blown pension pandemic.

Mike Shedlock is right, a massive taxpayer backlash over the pension crisis is coming. But it's too late, the damage is already done and all those pension fund presidents who will tell you 2008 was a "fluke" or "statistical outlier" are deluding themselves or just bullshitting their stakeholders to save their jobs.

I did promise to discuss some solutions to this pension crisis, but it is getting late and I am becoming more pessimistic with each passing day as I read the latest news on Pension Tsunami.

I think pension funds should go back to the basics, keeping it simple. I have discussed some of the broader investment themes I am looking at in my Outlook 2009 comment. As far as stocks, pick your themes and sectors, focusing on structural growth areas and companies with strong balance sheets. The same advice holds with corporate bonds where default rates are on the rise.

If you must invest in hedge funds, stay away from complicated, highly leveraged strategies that are illiquid and difficult to understand. If you can, inquire about the benefits of segregated accounts that offer transparency and liquidity. Most importantly, make sure you are paying fees for alpha, not disguised beta (talk to the folks at Bridgewater about this).

In private equity and real estate, hunker down and stick with the best distressed funds. Unless you see clear indications that the U.S. housing market has bottomed and is recovering, there is no rush to buy private equity and real estate funds.

I happen to believe that it's only a matter of time before all hedge funds and private equity funds are legislated to become fully transparent. PE firms recently came under fire after a report revealed the industry failed to comply with its code of conduct on transparency.

Watch as the new era of diminished expectations, deleveraging, deflation, and re-regulation dawns upon us, transforming capital markets and capitalism. Are pension funds ready? Have they begun to prepare for the long road ahead?

More importantly, what are world leaders doing to address the pension pandemic? Time is running out and delaying the inevitable will only ensure a catastrophe for millions of hard working people who will never be able to retire with dignity.

***Update: Chinese central banker warns of second wave***

The world may encounter a second wave of the financial crisis in the mid-term due to rising sour loans as real economies sink into recession, a senior Chinese banker warned in remarks published on Thursday:

Zhu Min, vice president of Bank of China, said in the official China Securities Journal that the current global financial market turbulence would last a while.

"The property market will continue its correction, the share prices of financial institutions will still see big swings, liquidity will remain tight and the foreign exchange market will continue to fluctuate due to reallocation of funds in the world," he said.

He also warned that some big firms that have already been bailed out by governments might be in trouble again and more financial institutions could face bankruptcy as they have not yet completely written off their losses.

"In the next one or two years, more small- and medium-sized banks will go bankrupt, a great deal of hedge funds will close and many insurers will suffer serious losses," he said.

Again, I urge world leaders to take immediate steps to address the pension pandemic before it's too late. Hoping for some miracle will only ensure a catastrophe on a scale that we have never seen before.

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