Wednesday, February 18, 2009

Inside the Pension Meltdown

Bruce Friesen of Global Investment Solutions sent me an email this morning telling me about PBS's Frontline special, Inside the Meltdown. If you didn't see it, take the time to watch the entire program by clicking here. It's an excellent account of what went wrong on Wall Street.

Who would have imagined that troubles at Bear Stearns would spark an unprecedented wave of deleveraging that would send shockwaves throughout the global financial system?

[Note: Some of us saw the common denominator of failure.]

Speaking of deleveraging, I spoke with a senior pension fund manager this afternoon. There are a handful of people out there that understand hedge funds and the markets as well as this person. When he talks, I listen.

We both agree that deleveraging will continue in 2009 and the economy will get worse before it gets better. "I see a long U-shaped recovery and it's going to get ugly in 2009. We can't talk about a meaningful recovery before 2011 and even then, it will be a slow recovery".

[Note: The U.S. Federal Reserve cut its outlook for the performance of the battered U.S. economy on Wednesday, saying it now expects a contraction of between 0.5 and 1.3 per cent this year.]

We talked about the U.S. financial stability plan and he told me that "all they are doing is throwing liquidity at a problem to slow it down, but the underlying asset values will not gain value."

He told me that the weak hands got exposed first: "highly levered, distressed and illiquid assets got clobbered first". We both agreed that real estate and private equity woes will continue in the next few years.

I then told him that to my dismay, pension funds are still throwing billions into alternative investments like hedge funds, private equity and real estate. I also told him that even the Pension Benefit Guarantee Corporation (PBGC) - the U.S. government entity that insures corporate pensions - is diversifying into alternatives.

His immediate response: "That is a huge mistake." He added: "...the hedge fund model is broken and so are the models of private equity and real estate funds."

Importantly, he stated exactly what I was thinking: "The real opportunities are going to first come in the liquid markets. Why pay 2 and 20 to some hedge fund when all they'll deliver is beta? Why tie up your capital with some illiquid private equity fund when liquid markets will be the first to recover?"

As far as the bottom, he stated that "nobody knows where the stock market will bottom, but I see the S&P reaching 650" As far as illiquid leveraged loans, "people that tried to time the bottom got creamed and will continue to get creamed."

On the banking crisis, he told me that European banks hold 70% of all emerging market debt. "It's a mess in Europe and because they can't fire people as easily as in the U.S., costs will hit operating earnings hard."

Finally, he told me once real yields start rising, there will be an opening for pensions to get out of this mess. He also sees opportunities in emerging markets longer term where the secular growth story will continue once the global economy recovers.

But just like the economy, the pension meltdown will get worse before it gets better. Even if asset values pick up, falling yields will increase future pension liabilities, putting more pressure on pension deficits.

Importantly, it's not just the hedge fund model that is broken; the pension model is also broken. And remember, taxpayers are on the hook if public pension funds are unable to meet their liabilities.

So what is the solution? More real esate and private equity? Nope, they lag the economy so don't expect these asset classes to offer you the required return.

What about hedge funds? By some estimates, their assets under management declined by $700 billion or 34% from 2007 levels. And hedge funds will come under siege in 2009:

As the economic crisis of credit and confidence reshapes the global financial landscape, mergers and acquisition activity in the asset management industry in 2009 will be powered primarily by need and the availability of capital, rather than strategic dealmaking, according to a new survey.

Jefferies Putnam Lovell expects that private equity firms will be active buyers of asset managers, in some cases partnering with strategic buyers to gobble up failing firms as leverage becomes available.

Deals in the alternatives space will be driven primarily by sellers that otherwise run the risk of folding, unable to generate a profit on (shrinking) management fees alone. Jefferies also believes that funds of hedge funds will “remain relevant”, and strategic buyers will look to acquire these firms once the broader markets and asset levels stabilize.

“Pure-play asset managers, acting alone and in concert with private equity firms, will increasingly take advantage of this unique situation as commercial banks and insurance companies shed non-core investment businesses to raise capital,” said Aaron Dorr, a New York-based managing director at Jefferies Putnam.

“In asset servicing, we see a wave of consolidation looming, as undercapitalized companies look to divest operations, while small- and mid-sized independents seek shelter within better-capitalized partners.”

The survey also says that traditional long-only asset classes will gain inflows at the expense of alternatives, which will continue to play an important role, particularly among institutional investors. The alternatives universe will be reshaped in 2009 as investors reconsider fee levels, demand more flexible capital lock-up periods, and insist on greater transparency. Increased regulatory oversight will raise the cost of doing business for hedge funds.

Also, the initial public offering window will remain closed in 2009 for asset managers and those that still find going public appealing will wait for the multiples of listed asset managers to normalize before even considering a flotation.

Moreover, according to the FT, hedge funds face new woes in 2009:

Hedge funds are facing a second round of redemptions after several big investors hit by Bernard Madoff's alleged $50bn fraud began liquidating portfolios, according to some of the world's biggest hedge fund managers.

The scale of the redemptions is not as bad as the heavy withdrawals that hammered the industry in October and November, but is significant enough to create problems for managers still struggling with the hangover of last year's withdrawal requests, they said.

"For those hedge fund managers who were wiping their brow and saying they're through the redemptions, Madoff is a new blow," said the head of one large US hedge fund. "It is another wave, for a different reason."

Hedge funds were hit by redemptions estimated by Morgan Stanley at 20 per cent - close to $400bn - in the second half of last year, with another 10-20 per cent to come by the summer. This forced managers to dump shares, bonds and derivatives to raise cash and contributed to the wild swings in some assets popular with hedge funds over the past few months.

"The people who have been touched by Madoff will in some cases have horrendous redemptions," said Bruce Hamilton, an analyst at Morgan Stanley.

The big redemption requests being put in by funds of hedge funds and private banks hit by Madoff appear to be to raise cash in preparation for major withdrawals by the end clients, hedge fund managers said.

The most extreme action is being taken by Optimal Investment Services, the Geneva fund manager of Spanish bank Santander, which is liquidating seven funds specialising in hedge fund investment after its use of Madoff as a manager hurt its image.

But other major investors hurt by Madoff - mostly based in or around Geneva - also rushed to put in withdrawal notices to the hedge funds they hold after Mr Madoff was arrested in December, managers said. Because of the long time lag for withdrawals from hedge funds - with quarterly payouts common - many will not get their money back until the end of March.

"Those that have been hurt badly have taken the whole lot out," said the founder of a large London hedge fund. "It is brutal."

Another big London fund said it was assuming that all or almost all the money put in by those hard-hit by Madoff would be withdrawn.

Even private banks that avoided Madoff said client confidence in hedge funds had been badly shaken by the alleged fraud.

Clearly deleveraging doldrums that started last summer are far from over. And the brutal shakeout in the hedge fund industy will continue to wreak havoc on asset prices.

[Ok Mr. Hedgie, I feel sorry for you, so here are a couple of ideas: 1) short volatility in 2009 and 2) short life insurers and anyone else who is long alternative investments!]

But wait a minute, aren't most pension funds long alternative investments too? Weren't alternative investments suppose to offer years of unfettered absolute returns?

That is what most pension fund managers believed but they all got a rude awakening in 2009. The alternative investment dream has become an alternative investment nightmare, exacerbating the pension meltdown.

Who is to blame for all this? Watch that PBS video above and remember all those "geniuses" on Wall Street who originated those toxic assets had to find dumb money to buy them. And boy did they find it, in droves, sparing no expense to woo global pension fund managers in search of higher yields.

The pension meltdown is still underway but when PBS, 60 Minutes or other investigative journalists decide to explore it more detail, I will be more than happy to offer my views on the biggest public policy scandal of our era - one that threatens the financial security of millions of workers and retirees.

I will offer them an inside account of the great pension con job that exacerbated the pension meltdown and I will tell them that nothing has really changed at most public pension funds where it's still business as usual.

No comments:

Post a Comment