Tuesday, February 24, 2009

Coping With "Reverse Affluenza"?


In his first speech to a joint session of Congress, President Obama outlined an ambitious agenda to revive the economy, saying it's time to act boldly "to build a new foundation for lasting prosperity":

President Obama says the United States will overcome its current economic struggles.

Obama focused on the three priorities of the budget he will present to Congress later this week: energy, health care and education.

The president said he sees his budget as a "vision for America -- as a blueprint for our future," but not something that will solve every problem or address every issue.

Obama said his administration already has identified $2 trillion in government spending cuts that can be made over the next decade.

Obama said he would cut spending considered wasteful, and invest in programs that will help the economy recover.

The president touted the $787 billion stimulus plan he signed into law last week, saying it will invest in areas critical to the country's economic recovery.

The United States has "fallen behind" other countries when it comes to producing clean energy, he said, but thanks to the stimulus, he said the United States will double its supply of renewable energy in the next three years.

Obama asked Congress to send him legislation that places a market-based cap on carbon pollution and drives the production of more renewable energy in America.

He said to support that innovation, the country will invest $15 billion a year to develop new technologies.

Saying the United States can no longer afford to put health care reform on hold, Obama said his budget proposal will include a "historic commitment" to it.

Obama said he will be assembling representatives of business, labor, doctors and health care providers next week to begin discussing the reforms.

Obama also called for all Americans to commit to at least one year of higher education or career training.

"This can be community college or a four-year school; vocational training or an apprenticeship," he said.

"But whatever the training may be, every American will need to get more than a high school diploma."

He pointed to the billions for education -- from early childhood education expansion to college-loan programs -- in his recently approved economic stimulus package and set a goal of having the highest college graduation rate in the world by 2020.

Obama opened his speech by telling the nation "we will rebuild, we will recover, and the United States of America will emerge stronger than before."

Obama urged Americans to "confront boldly the challenges we face," saying that the answers to the country's problems "don't lie beyond our reach."

"They exist in our laboratories and our universities; in our fields and our factories; in the imaginations of our entrepreneurs and the pride of the hardest-working people on Earth," he said.

Obama described the nation's financial woes as a "reckoning" for poor decisions made by both government and individuals.

"A surplus became an excuse to transfer wealth to the wealthy instead of an opportunity to invest in our future," Obama said.

"Regulations were gutted for the sake of a quick profit at the expense of a healthy market.

"People bought homes they knew they couldn't afford from banks and lenders who pushed those bad loans anyway. And all the while, critical debates and difficult decisions were put off for some other time on some other day."

"Now is the time to act boldly and wisely to not only revive this economy, but to build a new foundation for lasting prosperity," Obama said.

Obama also sought to assure people that their money is safe in the banks.

"Your insurance is secure; and you can rely on the continued operation of our financial system. That is not the source of concern," he said.

Instead, the source of concern is that "if we do not re-start lending in this country, our recovery will be choked off before it even begins," he said.

Making sure the nation's lending industry is strong is crucial to jump-starting its economy, Obama said, even as he acknowledged anger over the government banking bailout Congress approved last year.

"I know how unpopular it is to be seen as helping banks right now, especially when everyone is suffering in part from their bad decisions. I promise you -- I get it," Obama said.

[Note: I am not sure he "gets it" because his Treasury Secretary is trying to kick-start securitization, the very process that got us into this mess! There is one guy in Washington who actually gets it.]

"But I also know that in a time of crisis, we cannot afford to govern out of anger, or yield to the politics of the moment."

He said he plans a new lending fund to provide college, auto and small-business loans and a housing plan that will help struggling families refinance and pay smaller mortgages. He said he wants to continue propping up the nation's largest banks when they're in danger, but will hold them accountable for how the money is spent.

"This time, CEOs won't be able to use taxpayer money to pad their paychecks or buy fancy drapes or disappear on a private jet," Obama said. "Those days are over."

Those days are over. Just ask investment bankers and hedge fund managers who have seen their riches dwindle as the global economic crisis has taken grip and are now turning to professional counselors to cope:

Mayfair-based investment consultancy Allenbridge, which offers a psychologist service for young people who inherit wealth, has instead found itself facing a growing demand for the service from struggling hedge fund managers and investment bankers.

Anthony Yadgaroff, chairman of the wealth management firm, told financial publishing group Citywire that "a couple of hedge fund managers have problems and we are expecting to see more come in".

"The last person we had in to the service was a hedge fund manager who was dealing with having had so much and losing it," Mr Yadgaroff said.

The development follows a disastrous year for the hedge fund sector, with the decimation in value of many funds prompting a flood of redemption notices, while thousands of investment banking positions have fallen victim to the global slowdown.

Citywire investment editor Charlie Parker said City bankers had been "the fastest growing group of wealthy people in Britain and now they are the fastest shrinking".

"Many were financing hugely expensive lifestyles through taking on large amounts of debt intended to get them through the year, in the hope that their bonus, when it came, would pay off the debt," Mr Parker said.

"As bonuses have collapsed they have been forced to radically reappraise their lifestyles and I would imagine it would require a pretty dramatic change in mindset."

Most clients of the Allenbridge service, which has been dubbed "Affluenza and Wealth" and is headed by Los Angeles-based psychologist Dr Ronit Lamit, are wealthy families. Mr Yadgaroff said a "Reverse Affluenza" service was emerging for bankers and hedge fund managers who lost their wealth or jobs.

Forgive me a minute as I digress. My father is a 77 year old psychiatrist who still works ten hours a day helping patients from all socioeconomic backgrounds suffering from serious mental illness.

I do not want to minimize nor ridicule the plight of these investment bankers and hedge fund managers, but take it from a 37 year old who has battled a serious illness for over a decade, there are more important things in life than money, fame and status.

Nobody has ever died from "Reverse Affluenza" and you will learn the beauty of keeping your life simple, never living beyond your means. In fact, a lot of people - not just investment bankers and hedge fund managers - need to get a grip and reevaluate their priorities in life. Bigger houses, bigger cars, big spending trips will invariably lead you to big headaches.

[Note: Take the time to carefully listen to CBC Radio's interview with Richard Florida on how the recession will reset the way we live.]

Now, getting back on topic, with the drumbeat for hedge fund regulation getting louder, from Berlin to Washington to Connecticut, the industry is going on the defensive:

Hedge funds are already “rigorously regulated” in Europe, the Alternative Investment Management Association said, a week after European leaders agreed on the need for additional oversight of the industry as part of a far-reaching set of proposals to change the global financial system. AIMA’s statement sought to downplay the need for additional regulation, and to combat the image of hedge funds as freewheeling and unsupervised.

“It is important to stress that hedge fund managers in Europe are currently rigorously regulated at both national and European levels,” Andrew Baker, CEO of AIMA, said. “The industry is also subject to a whole range of European directives. It is part of the solution, not part of the problem.”

Hedge funds are seeking to deflect the threat of tougher regulation:

“It is important to stress that hedge fund managers in Europe are currently rigorously regulated at both national and European levels,” Andrew Baker, the chief executive of the Alternative Investment Management Association (AIMA), said. “The industry is also subject to a whole range of European directives. It is part of the solution, not part of the problem.”

Hedge funds, already hurt as falling markets, dwindling lending and redemptions from their investors erode their profitability and drive many to close, have been fighting politicians to try to stave off regulation. Last month, some of the industry’s top luminaries, including TCI’s Chris Hohn and Paul Marshall, the co-founder of Marshall Wace, faced a grilling from British MPs over their role in the financial crisis.

The funds have historically made their money by looking around for niches to invest in, such as derivatives, where other financial institutions do not trade, and the fear is that excessive regulation could curb the industry’s strength, built on such flexibility.

The AIMA statement came as reg-ulators and central bankers across the developed world push for a global regulatory framework in the wake of the financial meltdown that has shaken the planet in the last year and a half. Hedge funds, credit rating agencies and all other important market players should be subject to this global approach, the European Central Bank’s president, Jean-Claude Trichet, said at a conference yesterday.

“The current crisis is a loud and clear call for extending regulation and oversight to all systemically important institutions – notably hedge funds and credit rating agencies – as well as all systemically important markets – in particular, the OTC [over the counter] derivatives market,” M. Trichet said. “What is currently under discussion is the precise way in which these elements should be integrated within an overall regulatory framework,” he said.

The UK’s Financial Service Authority has said it wants a global framework. Global regulatory reform tops the agenda for a summit of the Group of 20 rich and big emerging economies in London in April.

Antonio Borges, the chairman of the Hedge Funds Standards Board, a voluntary UK body, said hedge funds had behaved responsibly, proven their value with lower losses than elsewhere in the market and had a better understanding of risk than almost anybody. “We have to conclude the hedge fund model will remain quite powerful. It has very low leveraging,” Mr Borges said.

And they are open to disclosing more to regulators:

The leading trade body, whose members manage more than 75pc of hedge fund assets across 43 countries, proposed that hedge funds would disclose all significant trading positions to global regulators, including short positions.

AIMA also said it would support the supervision of managers based on a model proposed by the Financial Services Authority and a new regulatory code based on proposals from various international bodies.

On Monday, European Central Bank President Jean-Claude Trichet said the financial crisis was a loud and clear call for extending regulation to all systemically important institutions, notably hedge funds and credit rating agencies. But AIMA hopes its pre-emptive concessions will be enough to divert bank-like rules which it claims would damage funds' ability to make money.

AIMA chief executive Andrew Baker said: "We want to dispel once and for all this misconception that the hedge fund industry is opaque and uncooperative. That's why we are declaring our support for the principle of full transparency of systemically significant positions and risk exposures by hedge fund managers to their national regulators."

Let me qualify that statement by Mr. Borges. The very best hedge funds have behaved responsibly and do have a better understanding of risk, but the majority of hedge funds are mediocre funds that charge alpha fees for "disguised beta."

How do I know this? Because I use to allocate to hedge funds and I saw all sorts of hedge fund managers peddling their "investment skills" to get a big allocation. I can't blame them for trying - who wouldn't want to collect a 2% management fee and a 20% performance fee for delivering beta?

Among the worst offenders were Long-Short equity managers who were typically long small cap stocks and short large cap stocks. This is why small caps are expected to benefit the most when hedge funds put cash back to work.

The problem was that very few managers knew how to make money in down markets. They all talked a big game but very few delivered the merchandise when you needed it the most.

As for the equity market neutral and arbitrage funds, they took a lot of leverage (often in illiquid securities) to deliver their returns and when systemic risk hit, most of them got slaughtered.

The global credit crisis is also hitting private equity funds, which are now learning to play a different tune as default risk rises:

As Guy Hands can no doubt attest, the problems facing private equity have certain parallels with the music business.

Customers of the two industries have suddenly stopped paying for services that for years they happily stumped up cash to receive.

As the founder of the Terra Firma buy-out house and owner of the EMI music group, Mr Hands will be familiar with the issues.

In the music industry, a new generation of consumers are downloading songs from the internet for free rather than paying for CDs.

In private equity's case, cash-strapped investors (the industry's equivalent of customers) are finding themselves short of money to meet the commitments they have made to buy-out funds.

When a private equity group raises a fund, investors make binding commitments, promising to provide the money when the group finds deal opportunities.

However, because the flow of returns from private equity has slowed to a trickle and investors are nursing big losses across their portfolios, it is becoming harder for some to honour commitments.

Different private equity groups have already come up with various ways to deal with the fact that some of their investors risk defaulting on future commitments.

Permira was first to grasp the nettle, agreeing to return undrawn commitments to its investors who could struggle to meet them in return for financial penalties, shrinking its fund from €11.1bn (£9.9bn) to €9.6bn.

TPG Capital followed, offering to return 10 per cent of the $20bn fund it raised last year to investors after losing money on one of its first investments in Washington Mutual, a US savings and loan group.

More recently, Candover unveiled plans to hand back much of the €3bn it raised from investors for its latest buy-out fund.

Mr Hands has developed an unusual technique of his own.

The 49-year-old buy-out boss and karaoke fan approached all 170 investors in Terra Firma Capital Partners III, the €5.4bn fund he raised in 2007, to ask if they faced liquidity problems that could prevent them meeting future uncalled commitments.

He found at least three that said yes and were willing to discuss a highly unusual deal to sell their commitments back to Terra Firma's management company, which is tightly controlled by Mr Hands.

The Terra Firma boss offered the investors, or limited partners, relatively attractive terms compared with what they would have received from more stingy secondary investors, who operate in the murky market for second-hand private equity interests.

It is an advantage for Mr Hands to keep the investors from selling to a less reliable party, who may not contribute to future fundraisings or object to proposed deals.

It also means Mr Hands - already one of the four biggest investors in his own fund with €200m committed - has even more riding on his latest fund, which has half its capital still to invest. This should be a reassuring sign for remaining investors.

Terra Firma refused to say what price it paid to buy the three investors out of their €50m interests in its latest fund, which leaves Mr Hands and other top executives at the buy-out firm liable for their €25m of undrawn commitments.

But people familiar with the transaction said it was done at a significant discount to the carrying net asset value of the €25m already invested in deals, such as its €3.2bn buy-out of EMI, whose artists include Lily Allen, the Beastie Boys and Coldplay.

As Terra Firma's latest fund, which also includes the merged AWAS and Pegasus aircraft leasing business, has already written down the value of some investments, this means the three investors received small beer for their holdings.

The EMI deal accounts for 30 per cent of Terra Firma's last two funds. Concerns that Terra Firma overpaid for the music group at the top of the market and used too much debt in the deal have weighed on the price that its investors receive for their interests in the secondary market.

But those investors sticking by Mr Hands will be pleased to see he is still prepared to put his money where his mouth is.

The shakeout in hedge funds and private equity has spawned a new sale platform:

Cash-strapped investors have put more than $540m (€420m) of private equity and hedge fund stakes up for sale on a new platform launched Tuesday, aiming to draw out possible buyers for the otherwise illiquid holdings.

The platform introduced by newcomers SecondMarket is a bold move to break the log-jam in markets for second-hand private equity and hedge fund stakes, where prices have plunged to record lows as sellers have far outweighed buyers.

Hundreds of pension funds, endowments, banks, insurance companies, and wealthy individuals are looking to sell their private equity and hedge fund holdings to cover losses elsewhere in their investment portfolios.

SecondMarket, which describes itself as the world’s largest marketplace for illiquid assets, said its trading platform would trade limited partnership (LP) interests in private equity, venture capital, hedge funds, and funds of funds.

The move was greeted with scepticism by specialist secondary investors, who said the idea had been tried before and failed because of the need for strict confidentiality in selling LP interests and the heavy restrictions placed on selling the assets.

However, Barry Silbert, chief executive of SecondMarket, said that, since it started advertising plans to launch the new platform last month, more than $500m of LP interests had been listed for sale on the website. He said $40m of new LP interests were put up for sale only Tuesday. More than 150 of SecondMarket’s 2,000 pre-qualified participants have registered their interest in bidding for some of the LP interests.

“There is billions of dollars of this stuff coming up for sale,” said Mr Silbert. “But it is a bit of a Wild West at the moment in the way it gets sold. We aim to formalise it.”

More than $130bn of private equity interests are expected to be put up for sale in the next two years, according to the specialist secondary investor Paul Capital. But there is only about $30bn of capacity among specialist secondary buyers. Because of the supply-demand imbalance, sellers of private equity assets have been receiving less than 50 cents in the dollar of the face value of their assets, according to a recent report from Cogent Partners, a secondary markets adviser.

SecondMarket has already traded more than $1bn of assets since its launch in 2005, including restricted and illiquid blocks of public equities, auction rate securities, and bankruptcy claims, such as those pending against Lehman Brothers.

It remains to be seen whether this SecondMarket will provide investors with the liquidity they are looking for their illiquid fund stakes. I am skeptical but at least we can get a sense of where these funds are trading on the secondary market.

And finally, there is commercial real estate, the next crisis. According to the Moody's/REAL National All Property Type Aggregate Index, commercial property prices fell almost 15% in 2008 amid the credit storm:
The benchmark measures investment activity and property sales trends in U.S. commercial real estate. "The market has not seen this price level since 2005, erasing three years of gains," said Neal Elkin, president of Real Estate Analytics LLC
Commercial real estate is in deep trouble. All you have to do is look at the stock price of Office Depot (ODP), which is back to its historic lows.

[There is an idea for pension funds. Instead of buying some illiquid real estate fund, just buy Office Depot shares and sit on them waiting for the economy to recover. I would just wait because the Feds are probing Office Depot right now.]

All this spells trouble for pension funds where losses in alternative investments are shaking up pension thinking:

An increasing number of employees are getting concerned that their pension benefits are in jeopardy, in some cases because plan managers took on alternative investments that were too risky.

In the United States, many plans fell victim to Bernard Madoff's hedge fund, an apparent Ponzi scheme that lost $50 billion US for investors.

And in Canada we had the Caisse de Depot pension plan, expected to have lost $38 billion last year due in part to investment in ill-fated asset-backed commercial paper. That has prompted calls for a change in the risk models used by Canadian plans to channel investments.

"Perhaps the only positive aspect to come out of this is that it's really shone the spotlight on risk, and managing that risk within defined-benefit pension plans," said Brad Bondy of Aon Consulting, during a recent address to the Northern Alberta chapter of the Canadian Pension and Benefits Institute.

Defined-benefit plans invest contributions and define expected benefits, but the percentage in Canada not fully solvent or able to pay all maturing obligations has risen from 64% in 2007 to 94%.

Some people leaving defined-benefit plans are getting only 65% of the commuted value of their pensions, with hopes of the rest later.

The federal government announced in November a proposal to extend the time that federally funded plans have to return their solvency to health from five to 10 years.

"I believe this will improve things, and that over the longer term equities are going to generate some decent returns. But I don't know when," Bondy said in an interview afterwards.

But pension money managers are caught in the trap facing all investors -- how do you recoup losses when equities are volatile or preserve capital when bond rates are low?

"I think there is a lot of interest in liability-driven investing, which means holding more long-term bonds and less equities. I think people are hesitant to make that move now, because interest rates are so low.

"But I think one of the things we need going forward is a transition plan, without basically locking in the horrendous returns we've had in equities, but gradually transitioning to a lower-risk strategy going forward."

He had some intriguing charts comparing three portfolios -- one of 100 per cent cash in T-bills, one of the traditional pension mix of 40% bonds and 60% equities, and one of 100% equities.

As expected, over one-year periods dating back to 1934, cash was the least volatile and equities the most. However, when you go to 20 year periods during that same time-span, equities actually were the least volatile.

Furthermore, a goal of generating annual returns of four per cent plus inflation each year was achieved by the T-bill portfolio 20% of the time and by the bonds-stocks mix 70% of the time.

What happens, though, is that when the S&P/TSX composite index turns in double-digit returns four straight years as it did from 2003 through 2006, pension money managers feel some pressure to increase returns, and look at alternative investments. Those include things like hedge funds, currency, infrastructure, private equity and real estate.

But if deflation sets in, more alternative investments will lead to more misery for pension funds. And alternative investment managers will find it hard to cope with "Reverse Affluenza".

The alternative investment party is over and those who were "hooked on debt" will hurt the most. In the new era of deleveraging, deflation, transparency and regulation, the new paradigm will be "small is beautiful."

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