Wednesday, January 7, 2009

Who Stripped Them of Their Pensions?

As a follow-up to yesterday's comment questioning the bond bubble, I urge you to read John Mauldin's latest Outside the Box comment by Bennet Sedacca, Setting the Bull Trap.

I quote the summary:

As I have mentioned many times, markets are clearly driven by fear and greed. At Atlantic Advisors we operate without regard to market benchmarks. To guide our investing, we don't begin by looking at the construction of market benchmarks, instead we ask ourselves, "in the absence of a benchmark, what would you buy?"

This leads into buying only securities that we believe have the best risk/reward profile and away from those that are not attractive, even if they are part of the benchmark.

Most money managers are driven by "beating the benchmark"; no matter how imprudent it may be to do so. Like Kenny Rogers sang in "The Gambler", "you have to know when to hold 'em and know when to fold 'em." Knowing when to fold 'em or play it close to the vest, while everyone around you is partying is perhaps the most difficult task we face as investors. I am fully aware of the Fed's goal to both "save the system" and "force everyone out on the risk spectrum", but I have seen this play before.

I believe very strongly that investors who believe that they must be invested in risky assets at the expense of prudence will rue the day that they did so. As it relates to stocks, when I consider the risk/reward ratio with equities at 22 times earnings (using 931 S&P 500 and $42 in earnings in 2009), I cringe when I hear people say that stocks are cheap.

What about municipal bonds? Pundits are declaring municipals cheap relative to Treasury bonds. Treasuries are not a good barometer as they are being manipulated lower in yield. With the insurers like MBIA and AMBAC gone, and little if any research available on the nearly 50,000 issuers out there, and downgrades coming like Noah's Flood, I cringe to think that they are attractive as well.

When I consider junk bonds, with new issuance at zero (a whopping one new issue was completed in the 4th quarter of 2008), they may seem cheap relative to Treasuries, but with the window for new money issuance closed, and money scarce, who will the buyers be? Expect a record high default rate in junk bonds in 2009-2010.

As for preferred stocks, I am cautious there as well as I wouldn't be surprised to see Uncle Sam exercise his muscle and step in to tell banks that they CANNOT pay common OR preferred dividends. Such is the life of Socialism.

In sum, I think many investors are being forced into taking risk so as to avoid a zero return when they actually would rather play it safe.

Again, we remain conservatively invested with a trading attitude towards the best of breed companies and sectors, those that do not need Federal assistance to stay in existence.

Once last thing - please check out the chart below to see what the government has purchased for our national portfolio. Lovely. Just Lovely.

Lovely indeed, almost as lovely as what pension funds have been heavily buying these last six years. And now it's time to face the music and tally up the losses.

According to the FT, private equity firms will in the next few weeks send their investors grim letters telling them just how much – or little – the companies they invested in are worth today, with many executives saying the reported fall in value will be 20-30%:

According to regulations that are applied this year for the first time, private equity firms are required to value their companies at what they would be worth in the market today rather than merely disclose the original cost of the investment.

By some calculations, the actual losses could far exceed 30 per cent, since many of these companies were bought and taken private at the peak of the financial frenzy. In many deals – particularly ones struck in 2006 and 2007 – private equity firms paid a 25 per cent premium to public market levels to take their targets private.

They then put massive amounts of debt money into their companies, suggesting the drop in value should be more like 60 per cent, some industry experts estimate.

With public markets down about 40 per cent, the equity may well be worthless today – save for the fact that the private equity firms have years to try to restructure and restore value to their companies.

Once year-end figures are known, many cash strapped investors, themselves reeling from losses, are likely to put more pressure on private equity firms to refrain from doing deals that would require them to write more big cheques.

These investors are also expected to dump more of their private equity holdings in the secondary market.

In the past, private equity firms had the luxury of valuing the companies they bought at cost until they sold them years later. But today the buy-out firms have been forced to adopt more rigorous accounting.

At the same time though, valuations still appear somewhat subjective, with each firm applying the rules with varying degrees of rigour.

“While the end-of-year markdowns are sure to reflect their current thinking and are believed to be conservative, as the effects of the downturn continue, the marks will get worse,” said Alan Pardee, chief operating officer of Merrill Lynch Private Equity Funds Group. “It will take four to six quarters for the [private equity firms] to embrace the new valuations.”

In a letter to investors on December 23, Jonathan Nelson, founder of Providence Equity Partners, noted that all the active Providence funds experienced valuation declines in the third quarter, as a result of declining public market values and what the firm referred to as “softening financial performance”.

Providence wrote down values in its latest fund by 19 per cent for the period ending September 30. The fourth quarter is expected to be even more brutal.

For example, Providence wrote down its stake in Univision to 50 per cent of cost at the end of the third quarter. But other firms are carrying Univision at higher valuations, according to the financial sponsors groups at the banks.

At the same time, Clayton Dubilier & Rice marked down nothing as of the end of September, although its December 18 letter to investors warns that at the end of the year it will mark down its investment in Home Depot Supply “to reflect a more severe decline in revenues and profit as well as more diminished market prospects”.

Home Depot Supply has been reeling from the downturn in the housing market last year. Other investors in that deal have already marked down their equity.

No doubt, Providence is breathing easier now that they got out of the BCE mega buyout deal which they partnered up with Ontario Teachers' Pension Plan. Now they and Teachers' are getting sued by Bell Canada for the $1.2 billion break-up fee.

Where else will losses come from? Yesterday I referred to an article from the Washington Post stating that 2009 will be tough for commercial real estate and today Marcus & Millichap Real Estate Investment Services released the results of the industry’s largest investor survey, in which participants revealed the lowest confidence level observed in five years:

Of the 1,129 private and institutional real estate investors surveyed nationwide, 51 percent plan to increase commercial real estate allocations in 2009, compared to 62 percent a year ago and a high of 74 percent in 2005.

“Despite the significant drop-off in acquisition plans from the peak in 2005, it is interesting to observe that slightly more than half of investors are still planning to increase their commercial real estate holdings,” says Harvey E. Green, president and CEO.

“This speaks to the opportunity that many investors expect as prices adjust.” Indicating a lack of “panic” in the market, only 11 percent plan to reduce their real estate portfolios in 2009, according to the survey results.

The majority of investors polled expect commercial real estate values to decline further in 2009, with 67 percent expecting price corrections of at least 10 percent on average, and 32 percent predicting price declines of 15 percent or more. “Prices are adjusting; however, there is a wide gap between top-tier properties in primary markets and lower-quality assets in secondary and tertiary locations,” according to Hessam Nadji, managing director of research services.

The highlights of this year’s survey include:

The top concerns of commercial real estate investors are availability of financing (60 percent), creditworthiness of tenants (29 percent) and rising vacancy rates (28 percent).

Overall, 22 percent of investors believe this is the right time to buy; 64 percent believe it is the right time to hold; and 14 percent believe this is the right time to sell commercial real estate.

59 percent of respondents do not need to refinance any part of their portfolios in 2009, and only 12 percent indicate the need to refinance 20 percent or more of their holdings.

59 percent of respondents expect all-in mortgage rates to be higher a year from now, and 74 percent believe financing will be as difficult or more difficult to obtain.

Investors are most bullish on apartments, with 34 percent indicating now is the time to buy, and 48 percent expect apartment rents to grow in 2009. This was followed by 23 percent who believe this is the right time to buy land, and 16 percent for buying industrial. Fourteen percent of investors believe this is the right time to buy CBD office product, and 11 percent believe this is the right time to buy suburban office. Retail scored the lowest on the acquisition scale, with 5 percent believing this is the right time to buy mall properties.

49 percent of respondents indicated that their acquisitions in the past year were less than they had planned, primarily because prices had not adjusted enough, lack of available financing and uncertainty with future values.

Respondents expect a slow economic rebound (31 percent expect the economy to be weaker in 12 months, 30 percent expect it to be the same, and 33 percent expect it to be stronger) and anticipate softer real estate fundamentals (for most property types, a larger percentage expect a decrease in effective rents and property values than an increase).

60 percent of respondents expect a full recovery of the CMBS market eventually, but it could take at least two years.

60 percent of investors expect a change with capital gains tax as result of change in administration, while 49 percent expect increase government oversight of financial markets.

Respondents to the survey have been in the industry an average 19 years and have an average $32 million in commercial real estate assets. In response to the turmoil in the financial markets, an additional 352 commercial real estate professionals were surveyed between September 15 and 19, and an additional 562 commercial real estate professionals were surveyed between October 6 and 10.

For a full copy of the survey, visit

I believe next year's survey will be considerably more gloomy. It still has not sunk in that commercial real estate is going to experience its worst crisis since the late eighties and it will be a long crisis. And if you think CMBS will come back in two years, you are in for one nasty surprise.

Then there are hedge funds. Apart from the superstar managers like John Paulson who stuck their necks out and bet big against the herd, making a fortune in the process, the majority of hedge funds, including past superstars like Citadel Investment Group, are reeling following their dismal 2008 performance:

Citadel Investment Group's main hedge fund lost 53% for 2008, according to a person familiar with Citadel's preliminary estimates.

The $10 billion Kensington and Wellington funds lost about 9% during the first 24 days of December, punctuating the toughest year yet for Citadel founder Ken Griffin. That came after a 13% loss in November. In 2007, the fund was up 30%.

A bright spot this year was Citadel's $3 billion market-making family of funds, which ended 2008 up about 43%, according to preliminary estimates.

Citadel has weathered the downturn better than some fund managers thanks to its financial flexibility and its size, at a time when the industry is contracting and many smaller funds are forced to close down.

Chicago-based Citadel last month barred investors from withdrawing money from the Kensington and Wellington funds until at least March. That has helped liquidity, as has the firm's ability to move money around among its individual hedge funds and its tight relationships with lenders, which include big banks such as Goldman Sachs Group Inc. (GS).

[Note: it helped their liquidity for now but it pissed off their investors who wanted to get out to shore up their liquidity.]

For the industry in general, smaller funds that have had performance similar to Citadel could have trouble surviving, simply because they have to regain their "high-water mark" before they can start earning management fees again. For a firm with billions, like Citadel, there's enough money to continue operations and pay employees.

[Note: Hedge fund managers and PE managers continue to collect the 2% management fee when they lose money; it's the 20% performance fee that does not kick in until they regain their high-water mark. That is why a lot of hedge funds close and reopen under a different name because they know they will never recoup those losses.]

But for smaller fund managers that haven't been around that long, the money earned from management fees is crucial to keeping the fund going.

David Friedland, president of hedge fund of funds Magnum Investments and the Hedge Fund Association, said the industry saw contraction after 1998's Long Term Capital Management collapse, but the industry was smaller then.

"This is obviously much more severe than that and something the industry didn't foresee," Friedland said. While he doesn't think that every small hedge fund will disappear, he does think the contraction could continue.

The average hedge fund was down more than 20% in 2008, a year that saw industry-wide assets most likely dip below $2 trillion after hitting more than $ 2.5 trillion earlier in the year, according to most estimates.

While large funds are better-positioned to survive the turmoil, several have nonetheless been stung significantly.

Publicly traded hedge-fund manager Och-Ziff Capital Management LLC (OZM) said in a regulatory filing Monday that its assets under management dropped to about $22.1 billion from more than $33 billion.

And New York-based Marathon Asset Management, which manages more than $10 billion, has had trouble in many of its funds. According to investors, two of its bigger funds - the Marathon Special Opportunities fund and Marathon Overseas fund - were down 28.5% and 31.5% year-to-date, respectively, through Dec. 19.

All this spells big trouble for pension funds. They were overexposed to equities and they bet big on alternative investments thinking that they will continue to deliver absolute returns.

The collapse of the stock market last year left corporate pension plans at the largest companies underfunded by $409 billion, reversing a $60 billion pension surplus at the end of 2007, according to a study released yesterday:

Shoring up the plans could cause further pain for workers, businesses and the struggling economy at a time when they can least afford it, pension specialists said.

"The chaos that has been observed in the world's financial markets over the last 12 months has had a major adverse impact on pension plan funding and will negatively impact corporate earnings," the Mercer consulting firm reported yesterday. "Moreover, the trend in recent months has been one of alarming deterioration," Mercer said.

As Mercer and other pension specialists described it, the pension problem illustrates how the recession and the meltdown in the financial markets can become self-reinforcing.

Ballooning pension deficits will leave some companies with diminished profits, weaker credit ratings and higher borrowing costs, which can translate into lower stock prices, said Mercer principal Adrian Hartshorn.

The need to cover pension shortfalls could prompt businesses to reduce spending on items as varied as equipment that boosts productivity and dividends that deliver income for shareholders.

Though shoring up pension funds is supposed to increase employees' financial security, it could involve such tradeoffs as reductions in wages, benefits and jobs, said Mark J. Warshawsky, director of retirement research at consulting firm Watson Wyatt Worldwide.

In a further irony, it could also prompt companies to freeze the amount of pension benefits employees can accrue, Warshawsky said.

But the overall economic effects may be more complicated, pension specialists said. Filling the gaps will force companies to boost their pension investments, contributing to demand for stocks and bonds.

Mercer's monthly snapshot of corporate pension plans focuses on those offered by employers in the Standard and Poor's index of 1500 big corporations, and it uses the accounting methods companies must follow when they prepare their financial statements.

Mercer estimated that the S&P 1500 pension plans held enough assets overall to cover only 75 percent of their obligations, down from 104 percent at the end of 2007. Precise figures won't be available until companies issue their annual reports for 2008 in the coming months.

Pension deficits are far from unprecedented. As recently as March 2003, the funding level for plans in Mercer's study was 73.2 percent.

When pension plans are underfunded, companies are required to plow enough additional money into the funds each year to correct the imbalance, a process than can take several years.

This year, Mercer estimates that the companies in its study will end up reporting about $70 billion of pension expenses, up from about $10 billion in 2008. That would equate to an 8 percent reduction in annual profits compared to 2007, the most recent year for which companies have reported full annual results, Mercer said.

Watson Wyatt looked at the issue from a different angle but found a similar trend. It tried to assess in aggregate the condition of all pension plans sponsored by individual corporations in the United States, and it used a different set of measures -- the rules that govern the actual amount of cash companies must put into their pension funds.

Watson Wyatt estimates that corporate pension plans began 2009 with $1.63 trillion in assets and $2.12 trillion in liabilities, Warshawsky said. The firm estimates that companies will have to more than double their contributions to pension plans this year, to $111.2 billion from $50.5 billion in 2008, he said.

Both Mercer and Watson Wyatt advise companies on employee benefits.

Some business groups have been calling for relief from the federal law that would force them to boost pension fund contributions in the short run, and the government has already eased some requirements. Relaxing the requirements could entail another compromise -- the health of the pension plans.

Even before the current recession, traditional pension plans that promise fixed retirement benefits were an endangered species for workers in the private sector. "As U.S. manufacturing and the U.S. organized labor footprint have contracted, the defined benefit plan has contracted," said the Brookings Institution's J. Mark Iwry, a former pension system regulator.

Pensions have largely been supplanted by 401(k) plans, which offer no guaranteed payouts.

Like pension funds, Americans' 401(k) accounts have generally plummeted over the past year, and some companies have added to the strain by cutting matching contributions.

Whether the responsibility rests with corporate pension fund managers or individual employees managing their own accounts, the nation's ability to convert relatively low savings rates into comfortable retirements depends on investments not merely outstripping inflation but delivering strong and stable returns over the long run. That proposition has been sorely tested of late.

Keith Ambachtsheer, an adviser to pension funds, says the nation may be in store for "a radical rethinking of how we deliver pensions to private-sector workers."

Increasingly, the burden may fall to taxpayers, as it has with other aspects of the nation's financial troubles, said Kent Smetters, an associate professor at the University of Pennsylvania's Wharton School.

When companies go bankrupt and are unable to shoulder their pension obligations, the federally chartered Pension Benefit Guaranty Corporation steps in and covers the shortfall, subject to legal limits that would leave many higher-paid workers with smaller pensions than they had been promised.

The PBGC is funded through insurance premiums paid by employer-sponsored pension funds, but Smetters predicted that the PBGC eventually will need a federal bailout.

As of Sept. 30, when its last fiscal year ended, the PBGC reported a deficit of $11.15 billion.

And it's not just corporate plans that are underfunded, public pension plans are underfunded too. According to NBER researchers Robert Novy-Marx and Joshua Rauh, the extent to which public pensions are underfunded has been obscured by governmental accounting rules, which allow pension liabilities to be discounted at expected rates of return on pension assets:

  • They report that over the next 15 years state pensions are expected to grow to a total of about $7.9 trillion.
  • But they conservatively estimate a 50 percent chance that the system will be underfunded by more than $750 billion at that time, and a 25 percent chance of a shortfall of at least $1.75 trillion (in 2005 dollars).
  • Adjusting for risk, the true intergenerational transfer is substantially larger, they note. Insuring both taxpayers against funding deficits and plan participants against benefit reductions would cost almost $2 trillion today, even though governments portray state pensions as almost fully funded.

States back pensions with stocks, bonds, cash, private equity, real estate, and hedge fund exposure. But the typical investment strategies, in conjunction with accounting rules, make the pension funding situation look much better than it actually is.

Under the government accounting logic, states always could eliminate their underfunding, no matter how large, simply by investing in sufficiently risky assets.

In fact, investing in riskier assets may raise expected returns, but it also increases the probability of a severe underfunding. Under current investment strategies and a standard equity premium of 6.5 percent, there is a two-thirds chance that state pension plans will realize a shortfall in 15 years. The expected conditional shortfall is almost $1.5 trillion in 2005 dollars.

Source: "The Intergenerational Transfer of Public Pension Promises," National Bureau of Economic Research, September 2008, and Robert Novy-Marx and Joshua D. Rauh, "The Intergenerational Transfer of Public Pension Promises," National Bureau of Economic Research, Working Paper 14343, September 2008.

For text:

For study:

There you have it folks. The pension promise is broken, you've been stripped of your pensions and future generations will pay for the costly mistakes of the current generation.

I've said it before, it is time we impose clawbacks on those those huge bonuses we handed out to senior pension fund managers who conned us into believing they were aligning their interests with those of their stakeholders.

The only thing they were lining were their pockets (with other people's hard earned money) by beating bogus benchmarks in an elaborate alternative investment pension Ponzi scheme.

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