Sunday, March 1, 2009

Will Pension Funds Plug the Credit Gap?

The Financial Times reports that large pension schemes are starting to make direct loans to credit-starved companies, potentially plugging the gap in the debt markets caused by the rapid contraction of the global banking sector:

The banks’ retreat has pushed up the cost of borrowing, enhancing the returns pensions schemes are able to generate from lending to even highly rated companies at a time when returns from mainstream assets have been poor.

As a result, a slice of the $22,000bn (£15,523bn, €17,410bn) sitting in the world’s pension schemes could now be lent to the corporate sector.

“The whole market is crying out for liquidity. Banks don’t have any, corporates don’t have any, but pension funds are sitting on loads. This is, hopefully, a one-off opportunity for pension funds to put their money into something that will be for the greater good,” said James Trask, partner at Lane Clark & Peacock, a consultancy.

“There is talk of major pension funds loaning directly or joining forces to create large pools and effectively do what the banks would do if they were able to lend, loaning tens or hundreds of millions of pounds to large corporates.”

Sian Hurrell, head of European pensions and insurance solutions advisory at Royal Bank of Scotland, said a number of pension funds had taken the plunge.

“We have had interest from some of the larger pension schemes in the provision of loans direct to corporates. They might be working in conjunction with a bank that has the appetite to loan 50 per cent. The pension fund may come in and do the other 50 per cent.

“That is probably the preferred route and some of the larger schemes have made investments in that way.”

Asset managers are also exploring the possibility of creating funds that would aggregate pension fund money, allowing greater diversification.

M&G is planning to launch a UK Companies Financing Fund that would lend tranches of up to £100m to mid-size UK companies. The fund will go ahead if M&G can raise at least £1.5bn from pension funds to add to £500m of seed money from Prudential, its insurance company parent. It is targeting returns of 4-6 per cent above Libor.

M&G, which has been in discussions with pension funds since November, said a number of funds “have expressed interest”. Other asset managers are believed to be looking at following suit, potentially creating a market in which banks are disintermediated from the corporate lending process.

Although bank loan funds have existed for some time, this structure differs in that pension funds are providing the loan principal, rather than merely buying tranches of loans made by banks.

The concept appears to be gaining initial traction in the UK but other countries with large defined benefit pension industries such as the US, Canada and the Netherlands are also seen as well placed to follow suit.

Compared with corporate bonds, pension funds’ traditional means of accessing the credit markets, loans rank higher in the capital structure in the event of a bankruptcy.

Mr Trask also believed some borrowers were willing to offer “sweeteners”, such as seniority and equity warrants to scheme lenders.

However, there are potential drawbacks. Ms Hurrell argued lack of liquidity for corporate loans meant investors would probably have to hold them until maturity, typically five to seven years, while many funds’ statements of investment principles would prevent them from initiating loans.

Alasdair Macdonald, senior investment consultant at Watson Wyatt, said: “There are hurdles. Banks were invented for a reason, they have the ability, specialist resources and an aggregation role as a wholesaler of risk, and it’s difficult to replicate. A pension fund won’t have the in-house skills to know who they want to lend to and how much to charge.”

It is an interesting idea that is being bounced around here. I have written about pension funds rescuing banks and banking with hedge funds, but this is a novel approach because pension funds would be making direct loans to corporations.

As far as having the "in-house" expertise, pension funds can start hiring all those bankers that lost their jobs and develop the in-house expertise. If done properly, with a focus on risk management and governance, this idea can help ease the credit crisis.

If you are skeptical, watch Fareed Zakaria's interview with the Financial Time's Martin Wolf. Mr. Wolf says that the economic situation has deteriorated so fast that the stimulus package is simply not enough to address the downturn. He fears a long period of stagnation as consumers save to pay off debts and companies stop investing because demand has dried up and they can't borrow from banks to invest.

As far as the bank bailout, Mr. Wolf thinks that the banking sector is grossly undercapitalized, if not insolvent. He does not like the term "nationalization", preferring to call it "restructuring". He fears that the measures will lead to Japanese "zombie banks" where the banks do not lend but just use public money to bolster their balance sheets. He advocates a restructuring where you get rid of senior managers who caused this crisis.

If "zombie banks" are the product of these incomplete stimulus programs, then pension funds can play an important role by providing fresh capital to cash-starved corporations.

But reading Pension Tsunami every day, I see that corporations have their own pension bombs to deal with. Exxon Mobil Corp's pension deficit, which was the highest among U.S. blue chip companies in 2007, more than doubled in 2008 to above $15 billion.

Exploding pension fund shortfalls are blowing billion-dollar holes in the balance sheets of some of the Chicago area's biggest companies, forcing them to make huge contributions to retirement plans at a time when cash flow and credit are already under stress:

Boeing Co.'s shareholder equity is now $1.2 billion in the hole thanks to an $8.4-billion gap between its pension assets and the projected cost of its obligations for 2008. At the end of 2007, Boeing had a $4.7-billion pension surplus. If its investments don't turn around, the Chicago-based aerospace giant will have to quadruple annual contributions to its plan to about $2 billion by 2011.

Stock market losses also pounded pension funds at Abbott Laboratories Inc., Caterpillar Inc. and Exelon Corp., with others sure to emerge as companies file their annual financial reports with the Securities and Exchange Commission in coming weeks.

The pension gaps underscore a growing conundrum. Unfunded pension liabilities have to be subtracted from shareholder equity, weakening balance sheets at a time when it's already tough to borrow money. Barring a reprieve from Congress, companies may be forced to make more layoffs or curb capital investments to divert cash to shore up pensions.

"There are companies out there faced with paying their pension plan or staying in business," says Mark Ugoretz, president and CEO of the ERISA Industry Committee, a Washington, D.C., lobbying group. ERISA refers to the Employee Retirement Income Security Act of 1974, which sets standards to ensure pension plans are sufficiently funded.

The Chicago companies are symptomatic of nationwide woes. Last year, the 100 largest corporate pension funds in the U.S. saw their net assets decline by 21%, while liabilities increased 1.2%. Applying those averages to any of the region's top funds puts almost all of them into the red by at least $1 billion.

The situation is far worse at companies that entered 2008 with plans already in poor shape. They are now even harder-pressed to come up with huge increases in pension fund contributions to erase the gap in seven years, as federal law requires.

A Boeing spokesman says the pension deficit is "clearly a situation we don't like," but adds that the company's credit rating hasn't been affected.

Stricter federal pension-funding requirements, enacted when the stock market was riding high, threaten to undermine the economy further. Business interests are lobbying for more time to close the gaps, but with lawmakers focused on the housing and banking crises, the issue hasn't gained much traction in Washington.

As a result, "many of the country's largest employers are being forced to make short-term trade-offs between maintaining employment and funding long-term obligations," Sears Holdings Corp. Chairman Edward Lampert wrote in a note to shareholders last week.

Hoffman Estates-based Sears, which announced the closings of 24 stores this year, expects its pension expense to soar as high as $175 million this year from $1 million last year due to the markets' decline.

Underfunded pensions also are forcing borrowing costs higher for some companies.

At Peoria-based Caterpillar, shareholder equity dropped more than 25% from the previous year after the company booked a $5.8-billion pension shortfall and its plan went from 93% funded to 61% funded.

That means Cat has to pay an additional 1.5 percentage points of interest to keep its untapped credit lines intact, according to SEC filings. Its pension assets sank 30% last year, and this year's contribution will more than double to about $1 billion. A Cat spokesman declines to comment.

A decline in interest rates last year also fueled widening pension liabilities, says Lynn Dudley, senior vice-president of policy for the American Benefits Council, another Washington, D.C., group lobbying for more time to fund plans.

Generally, the current value of a future obligation goes up when interest rates come down. In essence, last year's drop in stock prices and interest rates was a double whammy for pension funds, Ms. Dudley says.

"The law kind of slams you. In extreme markets, it's really unpredictable," she says. Absent relief from Congress, she says, "there have been some layoffs, and there are going to be more layoffs" to save cash for pension contributions.

The most notable Chicago-area exception is Moline-based Deere & Co., which began 2008 with a plan that was 17%, or $1.5 billion, overfunded.

Deere may have escaped the worst of the 21% average decline in assets. The company's fiscal year ended Sept. 30, before the worst of the stock downturn hit, and only 27% of its fund — far less than most — was in equities. A Deere spokesman declines to comment.

Meanwhile, GM's pension spending is under scrutiny:
A drastic decline in General Motors Corp.'s U.S. pension funds during a year-long period was due, in part, to questionable spending practices, experts say.

Pension Research Council Executive Director Olivia Mitchell said spending on employee buyout programs and benefit increases dropped the company's pension funds from $20 billion in late 2007 to a $12.4 billion deficit a year later, the Detroit Free Press reported Sunday.

"To the extent it is consistent with the law, the question is: Is it really consistent with the promise?" Mitchell said regarding the spending.

"Workers deferred part of their compensation to get a pension later, and to the extent that salary deferral is going to somebody else, it's going to be a big disappointment."

The Pension Benefit Guaranty Corp. has also questioned GM's pension spending and losses, which included a $11.3 billion drop blamed on investment losses.

The federal group charged with insuring retirement plans opposed using pension funds to pay for employee-reduction programs and buyouts, the Free Press reported.

Will pension funds plug the credit gap? There is a rationale for pension funds to fill the credit void as "zombie banks" stop loans to corporations.

But many public pension funds are underfunded and few have the expertise to get into direct lending to corporations, many of whom are also struggling with soaring pension deficits.

The idea has tremendous potential but once again, transparency, accountability and risk management need to be the cornerstone of the governance framework that sees pension funds plugging the credit gap.

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