Wednesday, April 1, 2009

Pensions Face Severe, Synchronized Downturn


Reuters reports that the OECD sees a bleak global outlook and soaring job losses:
The world economy will shrink at a far faster pace than originally expected this year, sending unemployment soaring and highlighting the need for extra steps to halt the crisis, the OECD said on Tuesday.

The 30-nation Organization for Economic Co-Operation and Development (OECD) said member economies would contract -4.3 percent this year. That was sharply down from its last forecast of -0.4 percent, made in November.

"The world economy is in the midst of its deepest and most synchronized recession in our lifetime caused by a global financial crisis and deepened by a collapse in world trade," the OECD said in its interim economic outlook.

[Note: Click on chart above to enlarge. It was taken from the OECD's latest Economic Outlook.]

"We anticipate that the ongoing contraction in economic activity will worsen this year before a policy-induced recovery gradually builds momentum through 2010."

International trade was set to fall by 13.2 percent in 2009 dragging export-reliant economies like Germany and Japan down sharply, the report said.

It said the downturn would continue into 2010, with the OECD area seen contracting by another 0.1 percent next year and only Canada and Germany of the rich G7 nations expected to show any growth.

All of those forecasts were much more pessimistic than those by the World Bank, whose President Robert Zoellick said on Tuesday it expected a 1.7 percent contraction of the world economy and 6 percent decline in trade this year.

OECD chief economist Klaus Schmidt-Hebbel said jobless numbers in the Group of Seven rich nations would nearly double to almost 36 million and would rise by 25 million across the OECD as a whole by late 2010.

"The impact of the recession on societies will be very substantial," he said, noting that unemployment rates would reach double digit levels in most countries for the first time since the early 1990s.

DOWNSIDE RISKS

As leaders of the G20 group of rich and emerging countries begin to arrive in London for a summit to address the crisis, the report said "risks remain firmly tilted to the downside."

It said the largest danger was that the weakening economy might further undermine the health of financial institutions, forcing them to curtail lending beyond what is anticipated.

Ahead of the summit on Thursday, the report included a special focus on economic policies needed for a recovery.

"An essential step to arrest the 'economic hemorrhaging' that is ongoing is to devise and implement without delay a coherent strategy that squarely tackles the mess in financial markets," the report said.

This included decisive measures for dealing with impaired assets and restoring confidence in markets. "Additional macroeconomic stimulus is also critical to cushion the fall in aggregate demand," it said.

The United States has pushed for Europe to take more stimulus action ahead of the summit. The OECD said some countries, including Germany, Canada, and Australia, appeared to have more fiscal room and urged those that could afford it to make a special effort in 2010.

Policy makers should, however, make sure they can lay out a plan for scaling back stimulus as the recovery gathers pace, to persuade markets the plans are sustainable and prevent upward pressure on bond yields from worries over growing debt.

MORE RATE CUTS

The OECD praised the "vigorous" action of central banks with both conventional and unconventional measures.

But it urged the European Central Bank to cut its main policy rate further from 1.5 percent and said it should commit to the quantitative easing hinted at by the bank's policymakers in recent days.

"The grim outlook for economic activity in the euro area and widespread evidence of falling inflation call for exhausting the remaining scope for further cuts," the OECD said.

"With the bleak economic outlook, quantitative easing should be used to support demand," the report said on the ECB.

The Bank of England should keep its policy rate as close to zero as possible until the end of 2010, it said.

The Bank of Japan has used its limited scope for maneuver to cut rates to 0.1 percent and the outlook points to maintaining that rate, the OECD said.

"The Bank of Japan should keep the policy interest rate close to zero and continue measures to increase liquidity until there is a definitive end to deflation," it added.

It also said the U.S. Federal Reserve must be wary of inflation expectations when the recovery takes hold.

"Once economic recovery is well underway and financial conditions are normalized, the Fed will need to start raising interest policy rates ... to keep inflation expectations well anchored, something expected to happen beyond 2010," it said.
Reuters also reports that world leaders will pledge to regulate major hedge funds for the first time and set up a new oversight board to monitor the global financial system, according to a draft of the G20 communique:

The draft, obtained by Reuters from delegation officials at the G20 summit, also said leaders would vow to cooperate over economic policies to restore global growth and "refrain from competitive devaluation of our currencies."

Leaders of the world's largest industrialized and emerging economies are due to finalize their plan for reviving growth and stabilizing the financial system at a summit here in London on Thursday.

Missing was toughened language on tax havens, which France and Germany have sought where locations would be named and bank assets there revealed.

The draft communique would strengthen the authority of the International Monetary Fund, giving it more responsibility for overseeing the world economy and making sure that crises do not erupt in the future.

New resources would be made available to bolster the IMF's war chest and its quasi-currency called Special Drawing Rights would be expanded. But specific figures were not included in the draft.

The outlines of a new global financial architecture were there, with a new Financial Stability Board to replace the Financial Stability Forum, which would work with the IMF on overseeing the world economy and financial system.

The communique made five pledges -- to restore growth and jobs; repair banks and lending; strengthen global financial institutions to deal with the crisis and prevent future ones; to promote global trade; and to build a sustainable recovery.

"By acting together to fulfill these pledges we will bring the world economy out of recession and prevent a crisis from recurring in the future," according to the draft.

It all sounds impressive, but as always, the devil is in the details. Notice how the communique does not refer to the global pension crisis? Also, how can the G20 regulate hedge funds and private equity funds without better regulating the pension funds that allocate billions to them?

Importantly, the G20 needs to find a way to regulate the so-called "shadow banking system" which is made up of investment banks, hedge funds, private equity funds, insurance companies and pension funds.

In a speech given last weekend to the University of Alberta business School, Mark Carney, Governor of the Bank of Canada asked What Are Banks Really For?

I quote the following:
The global financial crisis exposed the fundamental incentive problems that can occur with securitization. In the originate-to-distribute model, the incentives of the originating institution were no longer aligned with those of the risk-holders. Once that relationship was severed, the standards for new loans and their ongoing monitoring were adversely affected. However, pricing and risk management did not reflect these changes until they were abruptly adjusted, helping to trigger the onset of the crisis.

Third, many retail and commercial banks expanded into investment banking. This allowed banks to package traditional lending with higher value-added agency business, market-making activities and, increasingly proprietary trading. Banks’ push into markets helped spur the proliferation of over-the-counter derivative products, which created counterparty and investment risks that were difficult to identify and control.

Incentive problems also plagued this transition. In many banks, a culture that rewarded innovation and opacity over risk management and transparency eventually undermined its creators. Senior managers and shareholders of banks discovered that actual risks were much greater than originally thought. By that time, the more junior traders who had assumed the risks had already been paid, largely in cash. Many large, complex institutions learned too late that there can be principal-agent problems within firms, as well as between firms and their shareholders.

Just as banks began doing what markets traditionally did best, there was an explosion in highly specialized products that required monitoring and continuous access to funding liquidity. More and more of the traditional functions of banks – including maturity transformation and credit intermediation – were conducted through a broader range of intermediaries and investment vehicles, which have been collectively referred to as the “shadow banking” system. Shadow banks included investment banks (in other countries), mortgage brokers, finance companies, structured investment vehicles (SIVs), hedge funds, and other private asset pools.

The scale of these developments was remarkable. During this decade, banking assets grew enormously, to anywhere from one and a half times to six times national GDP in Canada, the United States, the United Kingdom, and Europe. In all countries besides Canada, much of this growth was financed by increased leverage.3 In the final years of the boom, when complacency about access to liquidity reached its zenith, the scale of the shadow banking system exploded.

The value of SIVs, for example, tripled in the three years to 2007. The growth in financial activity and the increasingly complex array of financial players have prompted a dramatic increase in claims within the financial system, as opposed to between the financial system and the real economy, which created risks that were difficult to identify and evaluate.

Financial institutions, including many banks, came to rely on high levels of liquidity in markets. In the United States, the total value of commercial paper rose by more than 60 per cent and the ABCP market by more than 80 per cent in the three years before the crisis.

In essence, the shadow banking system practiced maturity transformation without a safety net – that is, it was wholly reliant on the continuous availability of funding markets. The collapse in market liquidity that began in August 2007 crystallized these risks.

The regulatory system neither appreciated the scale of this activity nor adequately adapted to the new risks created by it. The shadow banking system was not supported, regulated, or monitored in the same fashion as the banking system. With hindsight, the shift towards the shadow banking system that emerged in other countries was allowed to go too far for too long.

Financial Deleveraging

The financial crisis is now reversing the decades-long transition from bank-based, relationship-oriented finance towards market-based, transaction-oriented finance. Banks are playing a larger role in the ongoing extension of credit. However, this transition carries enormous risks. Banks alone cannot support the same level of economic activity as the entire system did before, particularly since many need to delever. Moreover, the financial system as a whole is more robust when both banks and markets are strong, healthy, and liquid.

Financial deleveraging is now one of the dominant forces in the global economy. After a decade during which household debt, leverage in the financial sector, and cross-border capital flows all rose rapidly, all have slowed or are now falling. The duration and orderliness of these shifts will help to determine the severity of the global recession.

Financial institutions around the world must bring their leverage down to more sustainable levels by shrinking assets and raising more capital. Considerable, albeit disruptive, progress has been made in the shadow banking system, where SIVs and other conduits have been largely wound up. Hedge fund assets under management have been cut in half to about US$1 trillion, and the leverage applied to these assets has been substantially reduced.

As liquidity in many funding markets has dried up, so has embedded leverage in many pension funds. However, there has been less progress in the regulated banking sector. This is a large task. We estimate that to bring leverage ratios down to Canadian levels by raising capital alone, global banks would need more than US$1 trillion in new capital, before any additional writedowns on assets.

The deleveraging process has contributed to a dramatic reversal in cross-border capital flows. Many of the largest global banks have dramatically curtailed their international activities. Hedge funds have similarly retreated to their home countries in anticipation of redemptions and over concerns for cross-border liquidity. The Institute of International Finance (IIF) estimates that net flows from private creditors to emerging markets, which topped US$630 billion in 2007, will be negative this year.

Once the crisis passes, the scale of cross-border financial transactions is unlikely to return to pre-crisis levels. This reflects both the re-emergence of home bias amongst investors and the impact of measures to support domestic institutions. This financial protectionism, if not checked, could permanently impair cross-border capital flows and could be a serious setback for the global economy.
As mentioned above, the global economy is teetering on the edge. While I agree with many of the points the Governor of the Bank of Canada raised in his speech, I believe that the embedded leverage in most pension funds remains too high.

To be sure, risk is being cut across the board as asset allocation shifts towards more bonds. Moreover, Hedge Funds Review reports that the Dutch pension fund ABP has increased its exposure weightings to hedge funds by 1% in an attempt to cut its investment risk profile over the next five years:

A spokesperson for the fund said in the long term a modest allocation to hedge funds was expected to lower the value fluctuations of the total investment portfolio of a pension fund. "It is also expected to decrease the risk that future assets are not sufficient to cover future liabilities," he added.

As part of its plan ABP has also increased its exposure weightings to convertible bonds and infrastructure by 3%. Its weight for stock investments has been decreased by 3 percentage points to 29%.

According to a statement from ABP, recovery from under-funding should be achieved in approximately four years.

ABP is the world's third-biggest state pension fund managed with $231 billion in assets at 31 December 2008.

I expect ABP's shift in asset allocation will be followed by other pension funds. I still believe that highly leveraged illiquid strategies are dead, so pension funds should proceed cautiously in the hedge fund space.

Moreover, the FT reports that the number of hedge funds managing more than $1bn fell by more than 40 per cent globally last year, according to a survey that reveals the extent of the damage inflicted on the world's largest funds by volatile markets and tight funding conditions.

As far as other alternative investments, they continue to struggle. The Independent reports that private equity firms' fundraising falls to the lowest level since 2003:

The number of private equity firms that are giving up on plans to raise money from investors is also on the rise, according to research published by data provider Private Equity Intelligence.

A total of $45.9bn (£32bn) was raised for 71 private equity funds in the first quarter of the year, according to Preqin. This is the lowest figure since the final three months of 2003, when $34bn was raised as the global economy emerged from the slowdown resulting from the implosion of the dot.com boom.

The total compares with $125bn raised in the fourth quarter of last year. Funds focusing on the US saw the most money contributed by investors, with $23bn raised across 39 funds, making them the biggest group in terms of number and value. Seventeen European funds brought in $20.2bn, while the same number targeting investments in the rest of the world raised $2.7bn.

"Many of the fund managers we have been speaking with have indicated that they are going to be postponing the final closing of their current vehicles as a result of falling investor appetite," Tim Friedman, a spokesman for Prequin, said. "Banks' unwillingness to lend since the financial meltdown started late last year has dealt a hammer-blow to the private equity industry.

More than half of buyout firm returns on investments came from leverage in the boom times, the British industry body had revealed a few months ago.

Buyout firms typically buy a business, hold on to it for up to five years then sell it on to a buyer or via an initial public offering, aiming for high returns of typically 25 to 30 per cent a year.

Using a lot of debt in the acquisition allows them to magnify the returns on their own cash invested in the deal.

Some buyout firms such as Candover have been so hurt by the slowdown they are now in talks with their lenders as they seek to survive. Many portfolio companies such as the estate agent Foxtons, which is owned by Cinven, have breached banking covenants and will need to be restructured due to the amount of debt used in their acquisition.

And what about commercial real estate? According to this recent presentation by Richard Parkus, Head of CMBS Research at Deutsche Bank, it's going through a meltdown.

This is why Andy Hochberg argues that in the new world of commercial real estate, you need location, liquidity and luck.

Finally, these trends in alternative investments means that the global financial crisis is wreaking havoc on pension funds across the world. Moreover, the threat of bankruptcy haunts autoworkers and on Wednesday, Canada's Transport Minister John Baird said the Canadian government is looking at the pension situation at Air Canada very closely.

All this to say that in the midst of the most severe, synchronized downturn in post-war history, the G20 leaders have their work cut out for them. Let's all hope they don't drop the ball and make a terrible situation even worse.

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