Saturday, January 31, 2009

Here Comes the BARF?


I got a kick yesterday listening to an angry Senator Claire McCaskill lambaste Wall Street executives for doling out huge bonuses while they accepted TARP handouts:
"We have a bunch of idiots on Wall Street that are kicking sand in the face of the American taxpayer," an enraged McCaskill said on the floor of the Senate. "They don't get it. These people are idiots. You can't use taxpayer money to pay out $18 billion in bonuses."

Sen. McCaskill, D-Missouri, introduced a bill stating that no employee would be allowed to make more than the president of the United States.

Of course, her bill will not pass, but she made her point. The problem is that the bonuses are no luxury for some Wall Street employees.

But guys like John Thain, the now disgraced CEO of Merrill Lynch, should be prosecuted for criminal negligence and prosecutors should demand clawbacks on their outrages bonuses. Lock up all these guys for a long time and I will show you how fast Wall Street will change its stupid behavior.

Speaking of Wall Street, as President Obama gets ready to outline the economic strategy, the 'Bad Bank' is seen as crucial to the recovery:

As the Obama administration mulls the next phase of the bank bailout, Wall Street is increasingly calling for a return to its original intention: buying toxic securities that continue to riddle the sector's collective balance sheet.

Sen. Christopher Dodd (D., Conn.) on Tuesday said he was open to using funds from the Troubled Asset Relief Program (TARP) to establish a "bad bank" that would hold financial firms' debt securities, thereby boosting boost their capital levels and restoring confidence in the sector.

Treasury Secretary Timothy Geithner has said that the Obama administration was exploring the "bad bank" idea, but provided few details. A report by Bloomberg indicated Wednesday that the Federal Deposit Insurance Corp. may be lining up to manage the program.

But news broke out yesterday that the "Bad Bank" may be put on hold:

Policy-makers have yet to reach a consensus on how a U.S. government-run bad bank would work and the idea may not move forward, CNBC television reported on Friday, citing unnamed sources.

"The government-run bad bank idea that was being floated ... apparently has hit a snag, it might not happen," a CNBC anchor said recapping an earlier report. "Charlie (Gasparino) says the government has no consensus right now on how the bad bank would work, the issue is pricing."

"Making that thing work right now from what I understand is proving to be very difficult," CNBC's Gasparino said in his report.

Gasparino said the Treasury Department has been talking with the chief executives at the biggest Wall Street banks on how to proceed and may shelve the idea of an aggregator bank and instead provide across-the-board guarantees for the troubled assets clogging up banks' balance sheets.

"The aggregator bank is been put on hold indefinitely," he said. "They may do a hybrid: aggregator bank-guarantees. This thing right now has hit a major snag."

Another issue plaguing the proceeding on how to purchase the assets from the banks is the lack of senior staffing under Treasury Secretary Timothy Geithner

Geithner was meeting on Friday with Federal Reserve Chairman Ben Bernanke, Federal Deposit Insurance Corp Chairman Sheila Bair and Comptroller of the Currency John Dugan, with the Treasury saying it was "to discuss financial and regulatory reform."

Then, late last night, news broke that a selective suspension of fair value accounting is one idea being floated as U.S. policymakers wrestle with how to price bad assets the government might buy from the distressed banking industry:

The accounting fix suggested by a bank industry group could prevent banks from having to broadly mark down all assets to the prices a government-run "bad bank" might pay.

The Obama administration is discussing setting up a government-run "bad bank" that could soak up mortgage securities and other distressed investments that have become virtually impossible to sell in the markets.

But pricing remains a thorny issue.

If the government values the assets too high, the taxpayer would be unduly burdened. If they are priced too low, an accounting tsunami would be set off as other banks are forced to write down assets on their own books.

Scott Talbott, chief of government affairs for the Financial Services Roundtable, said the U.S. Securities and Exchange Commission could send a letter to the industry, informing banks that sales involving the bad bank do not constitute a market price for accounting purposes.

"Otherwise it could trigger losses that all banks have to pick up, which is exactly opposite of what the government is trying to do," Talbott told Reuters.

There is precedent for bank-specific accounting fixes.

In October, the SEC and Financial Accounting Standards Board (FASB) sent a letter saying banks could treat warrants as permanent equity instead of liabilities in certain circumstances.

It cleared the way for banks to participate in the Treasury Department's $250 billion (172.8 billion pound) capital injection plan, in which banks received federal cash in exchange for preferred shares and warrants.

Asked whether the SEC would be willing to amend aspects of fair value accounting, an agency spokesman indicated the agency was not closed to improving aspects of the requirement also known as mark-to-market accounting.

"While the SEC does not recommend suspending existing fair value standards, our recent report to Congress makes several recommendations to improve fair value's application, including a reassessment by FASB of current impairment accounting models for financial instruments," the spokesman told Reuters.

The Obama administration has not yet consulted the SEC on fair value accounting changes, according to a source familiar with the communication between the two groups.

Accounting tweaks were also used during the savings and loan crisis in the 1980s.

Regulators encouraged investors and healthy institutions to take over failing thrifts by changing an accounting rule related to acquisitions to let buyers circumvent normal capital requirements. The change was later reversed.

Mark-to-market accounting rules have been a hot topic of discussion in recent months, as they have been blamed by some U.S. banks and lawmakers for billions of dollars in write-downs.

Fair value accounting took full effect last year in the United States and was designed to let investors truly see what is on the balance sheet and to help them understand which assets are under stress.

It requires assets such as mortgage-backed securities to be valued at market prices, but the rules have been difficult to apply in current market conditions when there is little to no market for such assets.

And the financial industry worries government purchases of illiquid assets could only amplify fair value accounting's damaging effects.

"There is concern that if the government buys massive amounts of this stuff, you reinforce the markdowns and you kind of lock them in, and banks are sitting with massive capital losses," said Bert Ely, a banking industry consultant in Alexandria, Virginia.

However, proponents of fair value accounting say temporarily suspending the rules for transactions involving a government-run bad bank would only temporarily suspend the truth of what assets are worth.

"When accounting diverges from economic reality, that's where you run into problems," said Hal Schroeder, director of relative value arbitrage at Carlson Capital.

Let be clear on something, temporarily suspending fair value accounting will do nothing to cure the cancer plaguing the financial services industry and pension funds that are loaded up with toxic illiquid securities.

Go back to read the FT article on the Swedish model for western banks which I referred to earlier this week:

Under this model banks were nationalised, fully aligning the interests of the institution with that of the taxpayer, while the depositor was fully protected. In the process shareholders were in effect wiped out, as they should be, and incumbent management was replaced, as it should be.

This left none of the massive conflicts of interest, as well as perverse unintended consequences, caused by the present anomalous situation in the west where too many banks are being rewarded for failure – leading, incidentally, to a massive competitive disadvantage for those banks that managed their affairs more prudently.

A crucial principle of the Swedish model is that banks were forced to write down their assets to market and take the hit to their equity before the recapitalisation began. This is of course precisely what has not happened in either the US or Britain, where too many policy measures seek to delay asset price clearing and only add public sector debt on top of existing private sector debt.

This is why the current approach in the west to the banking crisis can be compared more accurately with Japanese policy in the 1990s, and that clearly did not work. The outcome, as then, is increasingly zombie-like banks.

The ultimate endgame in countries such as the US and Britain is still likely to be full-scale nationalisation of most of the banking system, as the logic of such action finally becomes overwhelming.

But it would be much better if this were done proactively rather than reactively, since it would accelerate resolution of the financial crisis. This is why nationalising the banks would also be bullish for stock markets, if not for the specific bank stocks themselves – although, obviously, there are powerful vested interests wanting to prevent such an ultimate course of action.

Instead of implementing this logical approach, here comes the BARF:

First there was TARP. Get ready for BARF.

They haven't named it that yet, but calling a federal "bad bank" to soak up toxic assets the Bad Asset Repository Fund would be truth in advertising at least. Despite Washington's renewed enthusiasm for the idea, there is a strong case to be made against it.

The problem boils down to bank profitability, which is depleted, and the industry's ability and willingness to lend. Offloading the worst assets into an aggregator fund would still leave banks with loan books under pressure from rising defaults. Banks would still be forced to build reserves at a time when their earnings power is reduced, and that earnings power would only shrink more with a smaller asset base.

And there is no way a "bad bank" will induce banks to lend. "Lending standards have tightened dramatically and there is an unavoidable restructuring of risk taking place," says Meredith Whitney, the Oppenheimer & Co. analyst who was among the first to point out the looming bank crisis. "Such causes money to come out of the system and lending to contract, with or without this 'bad bank' structure."

But facing a mounting banking crisis, federal regulators and the new Obama administration have returned to the original idea of the Troubled Asset Relief Program as one way to solve the credit crisis. New Treasury Secretary Timothy Geithner said this week that a new plan is expected to be announced soon.

One idea is for the government to buy assets that banks have classified as "available for sale" and create a guarantee program for assets classified "held to maturity."

The latter category avoids the need to mark the assets to market, and in recent months banks have moved "massive" amounts of assets from the "available for sale" category to "held to maturity" for this reason, says Joshua Rosner at Graham Fisher.

That would create an incentive for banks to avoid the pain of marking down values of assets sold to a bad bank, Rosner notes. They could simply shift the assets to the category destined for the guarantee program, "delaying the day of reckoning."

Last fall, as Lehman Brothers failed and other banks scrambled for safety, thoughts turned to the revival of an idea from the last real estate lending crisis. The Resolution Trust Corp. came to life in 1989 after the failure of the Federal Savings and Loan Insurance Corp., then the thrift industry's version of the Federal Deposit Insurance Corp. (FDIC). In the thick of the savings and loan debacle, FSLIC was swamped by the collapse of 296 thrifts in a short span of time. It too failed.

So Congress put together the RTC, funded it with $50 billion, and tasked it with taking on the assets of failed thrifts and working them off. The RTC lasted until 1995 and required additional injections of capital, ultimately totaling more than $100 billion.

It did serve its purpose, however expensive. In its six-year lifespan, the RTC worked with 727 failed thrifts, totaling some $394 billion of assets.

Last fall, former Treasury Secretary Henry Paulson convinced Congress to approve the $700 billion rescue program for the banking system with a similar plan in mind. But that part of the TARP never got off the ground, mainly because the government couldn't figure out how to price the assets it was buying. Price them too low, and banks had no incentive to participate. Price them too high, and taxpayers wind up with socialized losses while banks benefit with private gains.

Paulson decided to use $250 billion of TARP funds to take direct equity stakes in banks instead.

Some don't think a new RTC-like structure is needed. The FDIC already functions as a buyer of troubled bank assets. During the savings and loan crisis, the FDIC handled the failure of 1,911 banks, totaling $703 billion of assets, and didn't succumb to failure like the FSLIC.

Concerns that the FDIC will run out of insurance funds to cover deposits are overblown, many say. For starters, the insurance fund isn't a separate account, as many imagine it to be. It is part of the Treasury Department's general fund, meaning it can be expanded to how ever big it needs to be.

Analysts at Keefe Bruyette & Woods estimated in recent days that for a new or improved TARP to really be effective, the government would have to take on roughly 25% of the banking industry's assets, or $3.5 trillion.

An alternative to selling their loans at distressed prices to a bad bank structure is selling "crown jewel" assets, Whitney from Oppenheimer notes. Citigroup, which has taken $45 billion from the TARP in two installments and needed the government to back $300 billion of its assets, agreed to sell 51% its Smith Barney brokerage to a joint venture with Morgan Stanley for $2.7 billion.

"Private capital will readily invest in businesses that make money and grow," says Whitney. "The banks do not fit this description."

Even George Soros thinks the 'Bad Bank' is a bad idea:

Billionaire financier George Soros told CNBC he disagrees with plans to create a new government entity to buy up troubled bank loans and believes former Treasury Secretary Henry Paulson mis-managed the first rescue attempt of financial institutions.

"That (the "bad bank" proposal) will help relieve the situation, but it will not be sufficient to turn it around," Soros said during a live interview at the Davos economic conference in Switzerland.

Instead, Soros said he would create a "good bank" and re-capitalize the good assets. He admitted his alternative plan is not likely to get support because it too closely approaches nationalization. "The political will to do that is not there," he said.

As to Paulson's handling of the first half of the $700 billion Wall Street bailout fund known as TARP, Soros said the money was used "capriciously and haphazardly." He said half of it has now been wasted, and the rest will need to be used to plug holes.

Although Soros saw trouble ahead, he stresses he did not foresee how bad it was going to get after the "life-changing event" of the Lehman Brothers bankruptcy.

"The storm that started in the financial system has now spread, in a very big way, to the real economy," he said. "It has fallen off the cliff following the Lehman thing."

He believes still more must be done to turn the slowing of decline into real economic growth, including the reorganization of the mortgage system, and skillful handling of the international repercussions.

Finally, please take the time to read Dr. Michael Hudson's latest counterpunch article on Obama's new bank giveaway:

First, here’s the silhouette of the giveaway, as outlined Thursday in the New York Times:

“Treasury Secretary Timothy F. Geithner said Wednesday the administration is working on a comprehensive plan to “repair the financial system.” … bank stocks surged on hopes the government was moving toward creating a “bad bank” to purge toxic assets from balance sheets that are rapidly deteriorating as the economy worsens… administration officials believe that trillions of dollars more may be needed to buy the majority of bad assets from banks. …

“The concept of a bad bank has gained momentum in the financial industry as the economy deteriorates, slashing the value of risky assets on banks’ books and increasing the need for banks to hold capital against those losses. Shares in Citigroup and Bank of America, which both recently received a second taxpayer lifeline, surged 19 percent and 14 percent respectively as the stock market rose on optimism that the administration would relieve banks of money-losing assets.”

“Geithner Says Plan for Banks Is in the Works”, By Stephen Labaton and Edmund L. Andrews, The New York Times, January 29, 2009.

After (1) threatening for eight years that the prospect of a trillion-dollar deficit spread over a generation or so is sufficient reason to stiff Social Security recipients and abolish debts to the nation’s retirees, and (2) after the Bush administration provided $8 trillion over the past three months in cash-for-trash swaps of good Treasury bonds for Wall Street junk derivatives, the Obama Administration is now speaking of (3) some $2 to $4 trillion more to be given in just the next week or so.

Not a single Republican Congressman went along, just as Rep. Boehmer refused to support the Bush bailout on that fatal Friday when Mr. McCain and Mr. Obama debated each other over marginal issues not touching on the giveaway, which both candidates passionately supported. The Party of Wealth sees the political handwriting on the wall, for which the Party of Labor seems happy to take all responsibility. This probably is the only place where I’d like to see “bipartisanship.” Watch the campaign contributions flow for an index of how well this will pay off for the Democrats!

How many families would like a “give-back” on every bad investment they’ve ever made? It’s like a parent coming to a child who has just broken a toy, saying “That’s all right. We’ll just go out and buy you a new one.” This from the apostles of “responsibility” for poverty, for mortgage debtors owing more than they can afford to pay, for people who get sick and can’t afford medical care, and for states and cities now left high and dry by the fiscal wipe-out that the Bush-Obama “cleanup” has foisted onto the economy. No do-over for anyone but the hundred or so billionaires who have just been endowed with enough free money to become America’s ruling elite for the rest of the 21st century.

After spending a lifetime denouncing socialism as inherently unfair, Wall Street is now doing a hideous parody – as if “socialism for the rich” were not an oxymoron in the first place. Certainly the banks are not being “nationalized.” Giving away the largest sum of spendable securities in history without direct managerial power that goes with ownership is not “nationalization.” Ask Lenin.

Now that the details of the new, larger but definitely not improved bank giveaway of between $2 and $4 trillion more have been leaked out in time for Wall Street’s Davos attendees to celebrate, we may ask whether, financially speaking, the Obama Administration should best be thought of as Bush-3 – or indeed, whether it is still on a pro-creditor trend that may better be traced as Clinton-5, or perhaps even Reagan-8. Since 1980 the financial sector has made a sustained money grab at the expense of labor and “taxpayers.” More accurately, it has been a debt grab, on the opposite side of the balance sheet from assets.

Backed by Larry Summers, Boris Yeltsin’s Harvard Boys transferred trillions of dollars of Russian mineral wealth and public enterprises into the hands of kleptocrats. That was an asset transfer, pure and simple. In 1997, to be sure, the IMF gave Russia a loan that immediately disappeared into the kleptocrats’ bank accounts, to be paid out of subsequent oil-export proceeds. But assets were the name of the game. Today’s U.S. giveaway has a new twist.

The analogy is the “watered stocks” and bonds of yesteryear that railroad magnates and Wall Street emperors of finance gave themselves and their political mouthpieces, simply adding the interest coupons and dividends onto the prices charged the public as if they were real “costs.” Today’s version – “watered Treasury bonds” – are being created on the public sector’s balance sheet. “Taxpayers” must pay bear the interest charges – leaving less for the infrastructure investment that Mr. Obama suggests we may need.

The Bush-Obama bailout bore “small print” stipulations that have already given Wall Street a decade’s tax-free status by letting it count its financial losses against its tax liability. So not only has there been a great fiscal giveaway, there has been a tax shift off finance onto labor and industry. States and localities already have begun to announce plans to sell off roads and airports, land and other public assets to the financial sector in order to finance their looming budget deficits (which localities are not allowed to run under present legislation). No federal funding has been granted to finance the cities as their tax receipts plunge.

There has been a token amount to relieve some low-income families saddled with junk mortgages. But this does not involve actually giving them a spendable money “bonus.” Their role is simply to be trotted out like widows and orphans used to be, as justification to bail out banks for their bad gambles on currency, interest rates and bond derivative gambles. Insolvent debtors are merely passive vehicles to get a book-credit of mortgage relief that the government will turn over in their name to their bankers to make these institutions whole.

Whole, and then some! Chris Matthews just reported his statistic of the day (January 29): $18.4 billion in Wall Street bonuses, paid for out of the government giveaway.

This is called “saving the economy.” That is as much an oxymoron as “socializing the losses.” Socializing the losses would mean wiping the mortgages and other bank loans of debtors off the books. These giveaways are to keep the debts on the books, but for the government to buy them and make the creditors whole – while a quarter of real estate has fallen into Negative Equity as its debts are not being bailed out but kept on the books. The economy’s “toxic waste” remains. But a matching volume of new waste is being created and given to a few hundred families. No wonder the stock market soared by 200 points on Wednesday, led by bank stocks!

In the seemingly frenetic ten days since Obama took office, it is beginning to look as if his good political decisions regarding Guantanamo, Iraq, employee rights to sue for employer wrongdoing, are sugar coating for the giveaway to Wall Street, a quid pro quo to avert opposition from his Democratic Party constituency. At least this seems to be their effect. To accuse Obama of a giveaway would seem at first glance to contradict the basic thrust of his actions – or would be if one did not take into account his appointments of Larry Summers at the White House and the conspicuous leadership role in the bailout played by Barney Frank in the House and Chuck Schumer in the Senate.

There is a simple way to think about what has happened – and why it won’t help the economy, but will hurt it. Suppose the new $4 trillion “bad bank” works. The government shell will give away Treasury bonds for bad bank loans and derivatives gambles, without the government “marking to market.” (So much for the pretense that giving Wall Street credit is “free market” policy. But the alternative to free markets does not turn out to be “socialism” at all, even if “socialism for the rich.” There are worse words for it, which I won’t use here.)

The real question is what the Wall Street elite will do with the money. From Chuck Schumer and Barney Frank through Larry Summers, the Obama administration hopes that the banks will lend it out to Americans. Borrowers are to take on yet more debt – enough to start re-inflating house prices and making homes yet more unaffordable, requiring buyers to take on yet larger mortgages. Larger mortgages at rising prices are supposed to help the banks rebuild their balance sheets – to earn enough to compensate for their gambling losses.

But this neglects the fact that today’s looming depression is caused by debt deflation. Families, businesses and government having to spend more wage income, profits and tax revenues on debt service instead of buying goods and services. So why is the solution to this debt overhead held to be yet MORE debt? Is there not something crazy here?

The government’s solution, placed in its hands by the financial lobbyists, is to bail out the bankers and Wall Street while leaving the “real” economy even more highly indebted. All this talk about “more credit” being needed, all this begging of banks to lend more money and then extract yet more interest and amortization from the economy, is leading it even deeper into the debt hole. It is not helping families repay their debts. And indeed, homeowners whose mortgages already exceed the market price of their property are not going to be able to borrow more.

It would take only $1 trillion or so – or simply to let “the market” work its magic in the context of renewed debtor-oriented bankruptcy laws – to cure the debt problem. But that obviously is not what the government aims to solve at all. It simply wants to make creditors whole – creditors who are, after all, the largest political campaign contributors and lobbyists these days.

The most important thing to understand about the present economic crisis is that it was not necessary technologically, politically or fiscally.

Government at the state, local and federal levels are strapped for funds – but only because the natural source of taxation, land rent and monopoly rent and the user fees from public enterprise have been financialized. That is, whereas property taxes used to finance about three-quarters of state and local budgets back in 1930, today they supply only about a sixth. The shrinkage has not been passed on to homeowners and renters or commercial users. Prices for homes and office buildings are set by the marketplace. The rise in market price has been pledged to bankers as mortgage interest. The financial sector thus has replaced government as recipient of the economic surplus – leaving the public sector starved of cash.

The financial sector also has replaced the government as economic planner. This role has followed from its monopoly in credit creation, which turns out to be the key to resource allocation.

Bank credit is created freely. Governments could do the same. Indeed, this is what the U.S. Treasury did during America’s Civil War, when it issued greenback credit.

If today’s looming economic depression is a manmade (that is, lobbyist-financed) phenomenon, then what policy is needed as a remedy?

So there you have it, a tour of opinions on the 'Bad Bank' idea being proposed by the new administration.

I sure hope President Obama and his team get this right because if they don't we are going to need a 'Mega Bad Pension Fund' to deal with all those pensions funds who blindly followed the advice of bad banks and are now teetering on collapse.

Thursday, January 29, 2009

Vive la Révolution!


Tonight we begin in France where huge crowds took to the streets to protest over the handling of the economic crisis:

Unions said 2.5m workers had rallied to demand action to protect wages and jobs. Police put the total at 1m.

President Nicolas Sarkozy said concerns over the crisis were legitimate and the government had to listen and act.

He will meet union and business leaders next month to discuss what programme of reforms to follow this year, he said.

Overall, the government estimated that a quarter of the country's public sector workers had joined the action, which was called by eight major French unions. The unions put the figure higher.

A spokesman for the CGT union told AFP that 2.5m people across the country had taken part in the day's protests. French police put the number at just over 1m.

CGT leader Bernard Thibault called on Mr Sarkozy to recognise the gravity of the situation and "reassess his measures" to deal with the economic crisis.

In Paris, police said some 65,000 demonstrators had joined a march from the Place de la Bastille towards the centre of the city.

There were reports of violent outbreaks on the outskirts of the protest as it reached central Paris, with dozens of youths throwing bottles and lighting fires in a main shopping street.

Police in riot gear charged the youths, pushing them back on to the Place de l'Opera where the crowds were gathering, but the situation remained volatile.

There were repeated baton charges, and after fires were lit on some of Paris' best-known boulevards, police used tear gas on the minority of protesters who were violent.

Earlier, some 25,000 to 30,000 people rallied in the city of Lyon, according to organisers and police.

In Marseille, organizers and the authorities disagreed, with the former putting the number of demonstrators at 300,000 but the police estimating 24,000 had taken part.

The protests are against the worsening economic climate in France and at what people believe to be the government's poor handling of the crisis.

Opposition Socialist Party leader Martine Aubry said people were out in the streets "to express what worries them: the fact that they work and yet cannot make ends meet, retired people who just can't make it [financially], the fear of redundancies, and a president of the Republic and a government that just don't want to change policy".

French President Nicolas Sarkozy faces his biggest challenge yet:

The nation’s eight largest unions joined forces in the strike, saying Sarkozy’s 26 billion-euro ($34.4 billion) economic-stimulus package is inadequate. They want the government do more to counter rising unemployment and weakening purchasing power as the French economy enters its first recession in 16 years.

“The target is won, thanks to the massive presence of private sector workers,” Francois Chereque, head of Confederation Francaise Democratique du Travail, France’s biggest union, said at the end of the Paris demonstration, adding that today “is the biggest workers’ action day in about 20 years,” according to his press office.

The strike resulted in train delays, closed schools and jammed roads as more than a million public sector workers and thousands of others from companies including France Telecom SA and Renault SA took part in the work stoppage.

Bank of France

Participation in the strike today ranged from 25 percent at the Bank of France to more than 60 percent in primary schools. The Public Service Ministry reported that 26 percent of its staff walked out, or about 900,000 people. That’s more than the 20 percent strikers in November 2007.

“This crisis imposes the government a duty to listen, to engage in dialogue,” Sarkozy said in an e-mailed statement in response to the day’s events. “The concern is legitimate” as citizens “are losing their jobs” he said, adding that he plans to meet with labor unions and employers next month to discuss reforms planned for 2009.

The Paris march ended with violence at the Garnier opera square. Riot police fired tear gas as protesters burned trash bins. CGT said 300,000 walked in the capital city and authorities reported 65,000 demonstrators.

While France has a history of street protests, the global financial crisis has sparked similar demonstrations and unrest in countries from China and Greece to Iceland. France’s most disruptive transport strike in over a decade in November 2007 cost as much as 400 million euros a day, according to finance ministry estimates.

Other protests are already being organized in Europe. Spanish unions on Thursday called for regional protests against layoffs at big firms and lending restrictions by banks after the global crisis sent Spain's unemployment rate to the highest in the European Union.

Meanwhile, throughout Europe the pension crisis is growing. In France, the Fonds de réserve pour les retraites (FRR) reported its preliminary results today:

At the Supervisory Board meeting on January 29, 2009, the preliminary results of the financial management of the FRR for the year just ended were presented and analyzed. In addition, the overall situation was subject to a thorough review.

On December 31, 2008, the assets of the FRR were valued at 27.7 billion euros. The annualized performance2 of the FRR since inception (June 2004) remains slightly positive (+0.3%). At year-end 2007, it was +8.8%. This sudden deterioration is the direct consequence of the global crisis in the capital markets, in particular that of the world’s equity markets which declined by 42% over the last year. With this background, the performance of the FRR’s portfolio for the year 2008 was -24.8%.

These results do not reflect any losses related to securitized vehicles, structured products or hedge funds, in which the Fund has made no investments. The losses are attributable to the strategic asset allocation, which led to a predominance of equity investments in the portfolio (60%), made in 2003 and in 2006, consistent with the usual level of exposure to the markets for a very long-term investor with no liquidity constraint prior to 2020 and therefore able to benefit from the outperformance of equities over a sufficiently long time frame. This position is one shared by all of the FRR’s foreign counterparts.

In light of the turn for the worse that the crisis took in late September, and following the guidelines decided on as of October, the exposure of the FRR’s portfolio to equities was substantially cut back (to 49% from 64.5% at year end 2007). Correlatively, the percentage of assets held in treasury (14%, versus 1.2% at year end 2007) and invested in bonds (36%, versus 33.5%) was increased.

The Supervisory Board unanimously considered that, in light of the current market environment, this conservative management strategy had to be maintained for the foreseeable future.

As indicated in October 2008, the task of reviewing the strategic asset allocation has begun and should be completed by May 2009.

By the way, it isn't just the FRR that has decided to scale back on equities. ABP and two other top Dutch pension funds lost an average of 11.6 percent of their value in the last three months of 2008 due to the credit crisis and for now are sticking to a lower weighting for stock investments:

ABP, the world's third-biggest state pension fund after Japan's and Norway's, said in a statement on Thursday the value of its assets fell to 173 billion euros ($226 billion) from 195 billion euros in the fourth quarter last year.

ABP and the number three and four Dutch funds PMT and PME said the relative weight of stock investments had fallen due to share price declines, and ABP and PME said they had not increased those weightings again in order to cut investment risks.

Dutch pension funds, which in total managed 736 billion euros in September, usually buy extra stocks when equity markets go down to keep up the weight of share investments relative to other asset classes, Dutch central bank data has shown.

But metal workers fund PME, which managed 18.7 billion euros at the end of December, will keep its weight for stocks at 20 percent of total assets for 2009 from a 38 percent target in 2008.

"This means that there will be more investments in fixed-interest rate assets in 2009. Due to the change from stocks to fixed-income assets the risks of our investments is lowered," metal workers fund PME said in a statement.

ABP, which is closely watched by investors worldwide for its investment policy, let the relative weight of non-fixed income assets, which include stocks, private equity, property and other assets, fall to 55.2 percent from 59.6 end-September.

An ABP spokesman declined to say whether the civil servants fund would buy stocks again this year because it was working on a plan to recover from a deficit as the value of assets had fallen below the fund's liabilities based on net present value.

In May, ABP said it had bought stocks for nearly 10 billion euros on the view the worst of the global financial crisis was over and said in July it planned to cut down on debt investments to switch to assets that offered a better inflation hedge.

Over the fourth quarter, ABP reported a 23 percent negative return on investments in non-fixed income assets, due primarily to sharp declines in the value of its investments in stocks, real estate and private equity.

Due to the fall in oil prices, ABP also reported a 47.5 percent negative return on commodities, which it includes among its non-fixed income assets.

The Dutch pension fund said its investments in fixed-income assets showed a positive return of 1 percent.

Dutch PFZW, the second largest Dutch fund and Europe's third-largest pension fund with 71.5 billion euros in assets, continues to add stocks to its portfolio to have about 40 percent of assets invested in listed shares, a PFZW spokesman said.

"PFZW rebalances, meaning we keep a certain part invested in stocks. Share price declines result in buying additional stocks to maintain holdings at a certain weight," the spokesman said.

PFZW said in a statement it booked a negative return of 13.1 percent in the fourth quarter, making it the largest negative return among the four Dutch funds.

Many Dutch pension funds have fallen into deficits due to the credit crisis and are working to file recovery plans with the regulator, the Dutch central bank (DNB), which gives them three years time to reach a surplus again.

The Dutch organisation for sector pension funds, VB, asked for flexibility from the DNB so funds would not have to take far-reaching measures such as sell off assets, cut pension payments or raise pension premiums because such actions could exacerbate the economic downturn.
Three years to reach surplus? There is no way that they will be able to recover in three years now that there is nowhere to hide. Also, ABP was a big proponent of commodities, investing billions into the Goldman Sachs Commodities Index (GSCI) which has taken a huge hit this past year as oil prices plummeted.

ABP also invests billions in alternative investments like hedge funds, private equity and real estate. If you've been reading my blog, you know the hot air has come out of these alternative investments.

The bloodbath in hedge funds will continue in 2009 except perhaps in distressed debt and global macro. One thing is for sure, the days of 2 and 20 are over and as hedgies stick their heads in the noose, they'd better get used to tougher regulations.

In private equity, leveraged buyout firms that use debt to pay for takeovers face a lending drought as governments bail out banks and bolster lending oversight. Moreover, I agree with Sam Jones, mark to myth has been exposed:

In recognition of the extreme volatility in the markets, the Group has undertaken a special exercise to value its largest investments at 31 December 2008… For those assets valued on an earnings basis at both 30 September 2008 and 31 December 2008, there was a negative total value movement of £(214)

That par from 3i’s trading statement, out yesterday. A negative revaluation of a couple hundred million is not much really, considering 3i has a portfolio of more than £5bn. Still, the private equity group’s share price has taken a hammering today. It was down 24 per cent at one point this morning on rumours that the group was going to have to go to the market for a cash call.

3i share price

How long can the private equity delusion last? Surely these businesses are not performing this well. 3i’s somnolent shareholders seem to have woken up to that today anyway.

[My note: It isn't just 3i. Allied Capital (ALD) shares slumped 47% on Wednesday after the small-business lender warned that it may default on its debt.]

Given the performance of stock markets as a whole (down 40-50% +), is it really much of a stretch to imagine big writedowns for private equity’s formerly public holdings?

In the current climate, with unemployment beginning to spike and a true macroeconomic downturn only just beginning to bite, modeling companies’ worth based on (inflated) projected earnings is a fools game.

Here’s Nassim Nicholas Taleb’s take anyway:

Banks are being bailed out, and private-equity firms are going to go next. These people in a bull market look like geniuses. And now they don’t look that intelligent, and it’s going to get a lot worse for them. If the S&P goes down 20 percent from here, what will happen to private equity firms? They’re all under water.

Private equity is probably the ultimate leverage-based operation: everyone “looked like geniuses” in the bull market as Taleb says, because there was so much leverage around: any company that private equity touched escalated in value. Private equity giants know the power of leverage, too:

[Davos] Mr. Schwarzman is already making a splash. At a discussion panel on Wednesday, he hopped off his stool during a debate moderated by CNBC’s Maria Bartiromo, grabbed the microphone, and boldly called for what private equity loves: More leverage!

More leverage? Someone please tell Mr. Schwarzman that the good years are over and that it's R.I.P. Good Times.

There is no more leverage - the oxygen that fueled alternative investments - and it's going to be a very tough slug ahead for private equity. Nonetheless, public and corporate pension fund executives are unfazed as they expect private equity to be the best performer among asset classes over the next five years. Holy smokes! And I thought Blago was delusional!

That leaves commercial real estate. This is going to be the Mother of all alternative bloodbaths as the slaughter in commercial real estate continues in 2009. And now we have Pimco's Bill Gross telling us that the government needs to prop up other sectors of the credit markets such as commercial mortgage-backed securities and municipal debt. Thanks but no thanks Bill. At least we know where you placed your bets in 2009.

Back to the revolution. While some are openly asking whether it's the end of capitalism, I am telling you it is the end of capitalism as we know it. And if you think you always have your pension to fall back on, think again:

As bad as the economy gets, people can at least say they’ve got their pensions to fall back on. Well, not so fast.

Some employers are able to opt out of their pension promises, and there’s nothing stopping them, according to the final report of the province’s Pension Review Panel.

“We have an odd framework where some employers don’t have to fully fund their promises. To us, that doesn’t make any sense whatsoever,” said report co-author Bill Black.

“If you get down to the regulatory nitty-gritty, I could show you all kinds of things that are just dumb.”

He said employers can cancel employee benefits if plans go into debt, and they don’t have to tie pension benefits to inflation, even if they said they would.

The report calls for a new, consistent regulatory system to be put in place as quickly as possible.

“If we go through to the end of the year 2009 and nothing has been done, then there will be some very great difficulties for pension plans,” said Black, former president of Maritime Life.

“It’s going to be just impossible for employers to maintain their required funding.”

Whether that happens, though, is still up in the air. Labour and Workforce Development Minister Mark Parent said fall is the soonest government could prepare legislation.

Employers funding their pension promises should be mandatory, according to the report. To get to that point, there would be some “transitional relief.” The plan also offers employers more flexibility. Currently, plans that are in debt need to be fixed within five years. The report suggests extending that to 10, to help cope with the recession.

The government will take some time to study the plan before a deciding on a course of action.

Finally, President Obama issued a withering critique Thursday of Wall Street corporate behavior, calling it "the height of irresponsibility" for employees to be paid more than $18 billion in bonuses last year while their crumbling financial sector received a bailout from taxpayers.

The President is right and his tough stance will assuage the masses, for now. But as unemployment rises and pension deficits soar to unprecedented levels, I can't help wondering that in the not too distant future unions will be calling upon their brothers and sisters to protest the financial and pension fiasco on this side of the Atlantic.

Vive la Révolution!

Wednesday, January 28, 2009

Nowhere to Hide?


The U.S. House passed President Barack Obama’s $819 billion stimulus package, aimed at lifting the economy out of recession through tax cuts and more than a half-trillion dollars in new spending.

For its part, the Federal Reserve left the benchmark interest rate as low as zero, said it’s prepared to purchase Treasury securities to resuscitate lending and warned inflation may recede too quickly.

Let me quote the following from the Fed's monetary policy statement:

The Federal Open Market Committee decided today to keep its target range for the federal funds rate at 0 to 1/4 percent. The Committee continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.

Information received since the Committee met in December suggests that the economy has weakened further. Industrial production, housing starts, and employment have continued to decline steeply, as consumers and businesses have cut back spending. Furthermore, global demand appears to be slowing significantly.

Conditions in some financial markets have improved, in part reflecting government efforts to provide liquidity and strengthen financial institutions; nevertheless, credit conditions for households and firms remain extremely tight. The Committee anticipates that a gradual recovery in economic activity will begin later this year, but the downside risks to that outlook are significant.

In light of the declines in the prices of energy and other commodities in recent months and the prospects for considerable economic slack, the Committee expects that inflation pressures will remain subdued in coming quarters. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

The Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability. The focus of the Committee's policy is to support the functioning of financial markets and stimulate the economy through open market operations and other measures that are likely to keep the size of the Federal Reserve's balance sheet at a high level.

The Federal Reserve continues to purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand the quantity of such purchases and the duration of the purchase program as conditions warrant.

The Committee also is prepared to purchase longer-term Treasury securities if evolving circumstances indicate that such transactions would be particularly effective in improving conditions in private credit markets.

The Federal Reserve will be implementing the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Committee will continue to monitor carefully the size and composition of the Federal Reserve's balance sheet in light of evolving financial market developments and to assess whether expansions of or modifications to lending facilities would serve to further support credit markets and economic activity and help to preserve price stability.

For those of you who still feel bonds are in a bubble and inflation will roar back, I invite you to listen to Charles Collyns, Deputy Director, Research Department at the IMF.

After listening to his presentation, take the time to read the IMF's World Economic Outlook that came out today, Global Economic Slump Challenges Policies. I quote the following:

A pernicious feedback loop between the real and financial sectors is taking its toll.

Global output and trade plummeted in the final months of 2008 (Figure 2, view: Data Figure 2). The continuation of the financial crisis, as policies failed to dispel uncertainty, has caused asset values to fall sharply across advanced and emerging economies, decreasing household wealth and thereby putting downward pressure on consumer demand. In addition, the associated high level of uncertainty has prompted households and businesses to postpone expenditures, reducing demand for consumer and capital goods. At the same time, widespread disruptions in credit are constraining household spending and curtailing production and trade.

At the bottom of the page, there are two documents that you must print and read, Gauging Risks for Deflation and Fiscal Policy for the Crisis.

I quote the following from the first paper, which is more important for pension funds:

  • An index of deflation vulnerability developed by Kumar and others (2003) covering countries accounting for roughly 80 percent of world output suggests that deflationary tendencies in the global economy are now somewhat higher than during the 2002–03 deflation scare. A key difference between then and now is the weakness in many housing markets, and the financial crisis. Neither are fully captured by the vulnerability indicator. Considering this, risks for sustained deflation are appreciably greater than in 2002–03, particularly in several G-7 economies. Nonetheless, the most likely outcome is that sustained deflation will be avoided, as was the case in2002–03.
  • A model-based analysis for the G-3 economies (United States, euro area, and Japan) also suggests that, on the assumption that the financial distress is gradually resolved, the most likely outcome is that the global economy will stay clear of sustained deflation. However, if financial sector problems are not remedied or further shocks add to current stresses, there is a significant probability of more negative deflationary outcomes, with a deeper and more prolonged recession.
  • Policymakers should err on the side of acting too soon rather than too late in countering deflationary shocks. Very low inflation and inflation expectations can create a problem for monetary policy even before a sustained deflation sets in. Key considerations are that the lower inflation and inflation expectations are, the smaller the scope for central banks to stimulate activity with interest rate cuts; notwithstanding the recent experience of relatively high global inflation, slumping aggregate demand can quickly lead to expectations of falling prices in large parts of the world because in these parts inflation expectations are not very persistent; and monetary policy takes one to two years to exert its full effect on activity.

In plain English, the deflation psychology can wreak havoc before actual deflation sets in. And once deflation sets in, good luck trying to get out. This is why you are seeing unprecedented fiscal and monetary policy as well as quantitative easing. Anything to avoid deflation.

Against this backdrop, it's not surprising to see gloom is deepening among business leaders and economists, casting a pall over this year’s World Economic Forum in Davos, Switzerland:

“The crisis is getting worse,” Rupert Murdoch, chief executive officer of News Corp., said at a press conference to kick off the five-day event today. “It’s going to take very drastic action to turn that around, if it can be turned around, quickly. I believe it will take quite a long time.”

Concerns over the economic outlook are virulent as executives from JPMorgan Chase & Co.’s Jamie Dimon to Stephen Green of HSBC Holdings Plc join more than 2,500 counterparts, academics and policy makers in the ski resort for five days of soul-searching and deal-making.

“You have to realize the size of the problem confronting us today is significantly larger than in the ‘30s,” George Soros, the billionaire hedge-fund owner and philanthropist, said today. “The situation will continue to deteriorate.”

Just one in five of 1,124 chief executives in 50 nations said they were very confident about prospects for revenue growth in 2009, down from half last year, and more than a quarter said they were pessimistic, a survey by PricewaterhouseCoopers LLP showed. The sentiment was the worst since the accounting and consulting firm began tracking the CEO outlook in 2003.

The global economy will slow close to a halt this year as more than $2 trillion of bad assets in the U.S. help sink economies from Russia to the U.K., the International Monetary Fund said today.

‘Pretty Grim’

“The outlook is pretty grim,” said Howard Davies, director of the London School of Economics and a former Bank of England policy maker who is in Davos. “Things are not good and business surveys are coming out showing they’re getting even worse.”

What began as a financial meltdown 17 months ago has morphed into an economic calamity unseen since the Great Depression.

In the past year, Lehman Brothers Holdings Inc. and Bear Stearns Cos. have collapsed and officials around the world have committed trillions to prevent more from toppling. The Standard & Poor’s 500 Index is still falling after its worst year since 1937 as the U.S., Japan and Europe sink into their first simultaneous recession since World War II.

World Bank Chief Economist Justin Lin said today the world was in a “protracted recession” and that injecting capital into banks won’t revive it. “We need to have coordinated fiscal stimulus that’s large enough,” he said.

‘Delusional’

It’s “delusional” to expect the U.S. fiscal stimulus plan crafted by President Barack Obama to “jump start” the economy, Stephen Roach, Morgan Stanley Asia’s chairman, told a panel in Davos today.

The executives polled by PricewaterhouseCoopers survey don’t see a turnaround soon.

Only about a third were very confident about growth in the next three years, down from 42 percent last year. Almost seven in 10 said their companies will be affected by the credit crisis, and 70 percent of those said they will delay planned investments as a result.

Just 13 percent of U.S. executives said they were “very confident” about revenue growth in the next 12 months, compared with 36 percent last year, while 15 percent in Western Europe expressed the same sentiment, down from 44 percent. Among developed economies, French executives were the most skittish, with just 5 percent calling themselves very optimistic.

Emerging Markets

Business leaders in emerging markets were more confident. Seven in 10 Indian executives expressed optimism about their company’s growth, as did about three in 10 of those in Brazil, Russia and China.

One further bright spot: Only about a quarter of the business chiefs said they plan to cut payrolls in the coming year, while 35 percent said they intended to maintain staffing levels. That would be welcome news to workers as unemployment accelerates around the world with Home Depot Inc., Caterpillar Inc. and ING Groep NV among those axing positions this week.

So why are these people so gloomy? I think a significant problem was identified by the FT's Martin Wolf in his article, Why dealing with the huge debt overhang is so hard:

How much debt is too much? Nobody knows. But the governments of highly indebted high-income economies – such as the US and UK – think they know the answer: more than today. They want even more credit to flow to their struggling private sectors. Is that an attainable ambition and, if so, how might it be achieved?

Let us start with some facts. The ratio of US public and private debt to gross domestic product reached 358 per cent in the third quarter of 2008. This was much the highest in US history (see charts). The previous peak of 300 per cent was reached in 1933, during the Great Depression.

Nearly all of this debt is private. That reached an all-time high of 294 per cent of GDP in 2007, a rise of 105 percentage points over the previous decade. The same thing happened to the UK, on a yet more impressive scale. This has been a gigantic debt and credit expansion.

Particularly remarkable is the composition of the increased debt. In the early 1930s, most US private debt was owed by non-financial companies: so balance-sheet deflation occurred in companies, as was also the case in Japan in the 1990s. This time, however, the big increase in debt was in the financial and household sectors.

Over the past three decades the debt of the US financial sector grew six times faster than nominal GDP. The consequent increases in its scale and leverage explain why, at the peak, the financial sector allegedly generated 40 per cent of US corporate profits. Something decidedly unhealthy was going on: instead of being a servant, finance had become the economy’s master. In a superb brief account of today’s calamity, Lord Turner, chairman of the UK’s Financial Services Authority, refers explicitly to “illusory profits”*.

Moreover, household debt – much of it associated with housing – also rose rapidly: from 66 per cent of US GDP in 1997 to 100 per cent in 2007. A slightly bigger jump in household indebtedness can be seen in the UK.

What do such rises in indebtedness portend? The answer might be: nothing. After all, over the world, debt nets to zero. In principle, the ability to transfer purchasing power from lenders to borrowers is highly desirable: as a British advertising campaign once claimed, credit “takes the waiting out of wanting”. Yet people can also make big mistakes, particularly if they confuse bubbles with permanently high prices. The financial sector is particularly prone to such blunders. As Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard comment: “Systemic banking crises are typically preceded by asset price bubbles, large capital inflows and credit booms, in rich and poor countries alike”**.

Once such asset bubbles burst, it becomes hard to find borrowers and lenders who are either willing or creditworthy. The over-indebted start paying down their debts, instead, as now. Desired savings also soar. Realised savings may not rise, however: incomes may collapse, instead. This is what John Maynard Keynes called “the paradox of thrift”. The result will be a slump caused by balance sheet collapse rather than attempts to control high inflation.

What then might be done?

Some recommend a “liquidation”. A chain of bankruptcy would indeed eliminate a debt overhang, as happened in the 1930s. But, with much of the economy enmeshed in bankruptcy and the financial sector imploding, a depression would result. To choose that option must be insane.

Less unappealing is organised mass bankruptcy. Proposals for an organised debt-for-equity swap in failed or enfeebled financial institutions fall into this category. So, too, does allowing courts to modify mortgage contracts. Executed efficiently and expeditiously, such ideas are attractive. Costs would fall on shareholders and creditors, not taxpayers, and so sustain the principle of private responsibility.

An opposite approach is to sustain existing levels of debt, by slashing its cost to borrowers and trying to grow out of it over many years. This is what current monetary policies seek to achieve. It is a good idea, however unpleasant to creditors. But this would not generate much additional borrowing or fresh spending; it would not stop the indebted from trying to lower their debt; and it would not restore the financial sector to health.

Yet another approach is to replace private debt with public debt. That is what recapitalisation of banks now means. Over time, private-sector debt should fall, while public-sector debt, explicit and implicit, rises. Socialising debt increases the chances of growing out of it. That has happened before, notably in the case of UK public debt over the course of the 19th century.

Finally, there is inflation. If central banks and governments are aggressive enough, they can generate inflation, which will lower the debt burden. But they will imperil – if not terminate – the experiment with unbacked fiat (or man-made) money that started in 1971.

So which is the best approach?

At the overall level, it must largely be to grow out of the debt overhang, with socialisation of a part of it an essential element. Relapse into inflation would be a huge policy failure. A plan is also needed to deal with the plight of many households and with the overextended and undercapitalised financial sector.

The financial sector, as a whole, cannot deleverage by selling assets. It would be helpful if claims of global financial institutions could be netted out, instead, though that would require international co-operation. The Obama administration must also soon launch a recapitalisation of US banking, but not by buying the “toxic assets” at above-market prices. A debt-equity swap would be preferable. If that is politically impossible or too destabilising, publicly financed recapitalisation is inevitable. Just do not dare to call it nationalisation.

Whatever is done, one compelling truth cannot be evaded. It is going to be very hard to generate substantial net borrowing by households and non-financial corporations in the high-income countries with high internal debt. It is unimaginable that they will return to levels of private-sector borrowing, spending and increases in debt that characterised these countries for so long. Countries with large current account surpluses have long demanded an end to the profligate borrowing and spending of the customers upon whom they depended. They should have been careful what they wished for: they have now got it. Enjoy!

What does all this mean for pensions? It means that it will take a very long time before they recoup the losses of 2008 - possible a decade or longer.

Pension fund managers should listen to Nouriel Roubini who sees 'nowhere to hide' from the global slowdown:

“There is nowhere to hide,” Roubini, an economics professor at NYU’s Stern School of Business who predicted the financial crisis, said from Zurich in an interview with Bloomberg Television. “We have for the first time in decades a global synchronized recession. Markets have become perfectly correlated and economies are also becoming perfectly correlated. This is not your kind of traditional minor recession.”

Roubini said the U.S. government should nationalize the biggest banks because losses will exceed assets, threatening to push them into bankruptcy. The banks could be privatized again in two or three years, Roubini said. The professor reiterated his prediction that U.S. financial losses will more than triple to $3.6 trillion and that global equities will fall 20 percent this year from current levels.

‘Zombie Banks’

“Nobody’s in favor of long-term ownership of the U.S. banking system by the government, but if you don’t do it this way, you end up like Japan where you kept alive for a decade zombie banks that were never restructured,” he said. “That’s going to be much worse. It’s better to clean it up, nationalize it and sell it to the private sector.”

Japanese policy makers hesitated in addressing a banking crisis in the 1990s and then struggled to revive growth and fight deflation in what is known as the “Lost Decade.”

Roubini recommended holding cash or short-term government debt and said high-yield bonds are cheap relative to U.S. stocks.

[Note: Stick to high quality corproate bonds (AAA). According to S&P, default rate for issuers of U.S. corporate junk bonds — bonds that Standard & Poor’s rates BB+ and below — is expected to “catapult” to an all-time high of 13.9% by December.]

But pensions followed Harvard (and Yale) into alternative investments and now they are going to suffer the same fate as the world's biggest endowment who may have lost more than it previously stated:

Harvard Management Co., which runs the world's largest endowment fund, has had until recently an incredible record. Over the past six years, it succeeded in more than doubling the notional value of Harvard's endowment to $36.9 billion in fiscal 2008 (which ended on June 30) even after paying for about one-third of Harvard's operating expenses.

So its recent loss of $8.1 billion from July 1 to Oct. 31, 2008, came as a stunning blow. Yet this huge loss, as staggering as it sounds, might be only the tip of the iceberg of illiquid investments. According to a source close to the Harvard Management Co., the damage, if the fund's illiquid investments are realistically appraised, may be closer to $18 billion—or more than twice the amount previously reported. (This is in line with a report, released today, showing an average 22.5 percent drop in endowments in North America.)

The lack of clarity says a lot about how exotic Harvard's finances have become. Its team of highly incentivized money managers—who themselves earned $26.8 million in 2008—adopted a strategy aimed at taking maximum advantage of an inflationary global boom in the early 2000s by shifting the lion's share of Harvard's money from conventional endowment assets—such as bonds, preferred stocks, Treasury bills, and cash—into more esoteric investments that would presumably rise as more money chased after scarcer goods. They bought, for example, oil in storage tanks, timber forests, and farmlands. As the proliferation of trillions of dollars worth of subprime mortgages further expanded the bubble, driving up the price of oil, lumber, and land, the notional value of Harvard's portfolio soared.

The price of oil, for example, which Harvard and other speculators were storing, more than quadrupled to $153 a barrel on commodity exchanges, allowing Harvard to hugely appreciate the notional value of its portfolio. So between fiscal 2003 and 2008, Harvard's "real assets" showed a gain of nearly 25 percent annually. But even after the subprime mortgage crisis began to unfold and a number of financial institutions had collapsed, Harvard's money managers persisted in pursuing this risky course.

Consequently, as late as June 2008, the fund kept almost no reserve of cash or Treasury bills and allocated a mere 6 percent of its money to fixed-interest bonds. It also borrowed more than $1 billion to amplify the returns on its less conventional investments. So by the time the bubble burst in the fall of 2008, only a small fraction of the endowment fund investment was even under the jurisdiction of the SEC. According to the November 7th 13F holding report it filed with the SEC for the quarter ending September 30th, 2008, Harvard had only $2.88 billion of its funds in exchange-listed stocks, options, or other derivatives. What of the more than $35 billion it had allocated to investments at the start of fiscal 2009 (i.e., July 2008)?

Most of the balance had been allocated to investments, which if not totally illiquid could not be valued by market activity. The breakdown that follows illuminates how far HMC had strayed from the path of traditional endowment investing in the last decade.

More than one-quarter of Harvard's funds were still sunk in "real assets": about 8 percent in stockpiled oil, about 9 percent in timber and other agricultural land, and 9 percent in real estate participation. Then came the financial crises, and prices plunged. Oil fell to less than $40 a barrel. Lumber suffered almost as badly. And, with the drying up of bank lending, the value of Harvard's real estate holdings—which remain opaque—became at best problematic.

One indication of how steep the loss may be is that CalPERS, the giant pension fund of the California Public Employees' Retirement System, which owned even more real estate acreage than Harvard, reported in this period a 103 percent loss on real estate deals in which, like Harvard, it had borrowed to amplify its profits.

Another huge portion of Harvard's endowment had been farmed out to hedge funds (18 percent) and private equity funds (13 percent). While these funds provided some diversification, many of them also impose restrictions on withdrawals, including ones, like Citadel, that suffered substantial losses.

To get back its money under such circumstance, it was often necessary to sell at a steep discount to a "secondary" hedge fund. One major player in the private equity business tells me that Harvard had tried this fall to sell its private equity stakes at 30 percent to 35 percent discounts but could find no buyers even at those prices. It's also possible that Harvard will have to meet "capital calls" on its private equity investments that would sap even more capital.

Harvard also allocated nearly $4 billion, or 11 percent of its fund, to volatile emerging markets, such as Brazil, Mexico, and Russia. Here its money managers bet both that the stocks would go up and that the local currencies would at least hold steady against the dollar, but they lost on both counts.

First, the thin local stock markets, which had little liquidity, collapsed in the financial crises. For example, Russian stocks lost almost 80 percent of their value in a matter of days last fall. Then, as banks and hedge funds got out of their currency trades, the local currencies in many of these countries also lost heavily against the dollar. The Brazilian real, for example, fell about 40 percent last year. So presumably the endowment fund took a double hit. Aside from emerging markets, Harvard had invested another 11 percent if its portfolio in more established foreign economies, as those of Britain, Germany, France, Italy, Australia, and Japan. But here the stock markets declined and, with the exception of the Japanese yen, so did their currencies.

Given the true cost of getting its money out of the hedge funds and other illiquid investments, my knowledgeable source finds the claim by Harvard's money managers that the fund lost only 22 percent at best "purely Pollyannaish." (A Harvard University press representative declined to comment for this story.)

But while Harvard's money managers may chose to look through rose-colored glasses at the value of their portfolio, Harvard University, which relies on the interest from distribution from its endowment to fund one-third of its operating budget, needs to be more realistic. As its president, Drew Faust, noted in an e-mail to the Harvard community, "We need to be prepared to absorb unprecedented endowment losses and plan for a period of greater financial constraint."

Harvard is hardly alone in moving from traditional investments to more exotic instruments. Yale's endowment fund, which with $22.5 billion in assets in 2008 was second only to Harvard's, followed a similar strategy of finding alternate investments including hedge funds, private equity funds, physical commodities, and emerging markets.

Its longtime manager, David Swensen, indeed makes the argument in his book Pioneering Portfolio Management that diversifications of this kind are safer than just investing in traditional stocks and bonds. And during the decade preceding the present financial crises, his fund actually outperformed Harvard's. But despite his efforts at diversification, Yale lost at least 25 percent of its fund in the fall of 2008 if one takes into account the plunging value of its illiquid assets. Columbia University, too, is seeing losses.

So institutions of higher education, like other speculators seeking enormous profits in what is essentially a zero-sum game, learned the sad lesson that playing for high stakes in the casino economy inexorably entailed the risk of catastrophic losses.

After reading tonight's comment, I hope you get a deeper understanding of the seriousness of the problem at hand.

This isn't just another market downturn - it's a catastrophe and taxpayers are going to be called upon once again to bail out the incompetent and reckless decisions that pension fund managers and their boards of directors undertook over the last decade.

As pension fund consultants get busy firing and hiring money managers in coming months, I wonder how many more billions of losses before senior pension fund managers get axed?

Then again, unlike the hard working members they invest for, senior pension fund managers have golden parachutes to cover themselves in case they get fired. All upside, no downside. No wonder they take excessive risks with other people's money.

Tuesday, January 27, 2009

Canada's Budget Fails to Address Pension Crisis


After months of speculation, Canada's Finance Minister Jim Flaherty tabled a federal budget that includes $40 billion in economic stimulus over the next two years in the form of infrastructure spending and income tax cuts.

Late tonight, there are signs that the budget will not receive support from the opposition parties. Canada's largest union, the Canadian Union of Public Employees (CUPE), strongly condemns the federal budget:
Faced with losing power, the Harper government is showcasing dozens of new measures to address the economic crisis. But today’s federal budget still falls short of what is needed to revive the economy, create jobs and protect struggling Canadians.

“The budget smacks of short-term political opportunism instead of long-term solutions,” said CUPE National President Paul Moist. “Many of these measures have a shelf-life of only two years. What happens to people after that? The budget must be substantially amended if the government is really concerned about providing relief to the people who need it most.”

CUPE is calling on opposition leaders to reject the budget unless amendments are made. The current budget fails to include any serious measures to provide relief for the hundreds of thousands who are expected to become jobless over the next few years. The budget also needs to address essential social needs such as health care, pensions, child care, and a comprehensive anti-poverty plan.

Ignoring the advice of the country’s top economists, the government is forging ahead with broad-based personal income tax cuts equal to $2 billion per year. “This kind of irresponsible investment of public revenues drives home Mr. Harper’s incompetence as an economic manager,” said Moist. “It doesn’t make sense to give the middle class another tax break, while 60% of Canada’s unemployed can’t collect employment insurance.”

Hidden, but still included in this budget are the cuts to transfers, controls on program spending, weakening pay equity for federal employees and the privatization plans announced in Harper’s disastrous November economic and fiscal update. This includes limiting growth of transfers under the equalization program and selling off over $10 billion in federal public assets over the next five years.

While the government has increased training opportunities for laid-off workers, the majority ofCanada’s unemployed remain shut out of the budget. “The training and support funding listed in the budget is only one part of the drastic EI reform this country needs,” said Moist. “What kind of unemployment relief overlooks more than half of Canada’s unemployed?” The budget does nothing to expand the country’s low eligibility rate, even though working Canadians have paid into an EI program that now sits at a $54 billion dollar surplus.

Relief for those depending on pensions is almost non-existent in the budget. “If we don’t expand public pensions and reduce reliance on financial markets for retirement security, the end result is fairly straightforward: thousands of Canadians will face poverty in retirement. The government needs to take action. We need an immediate increase in Old Age Security, and a commitment to increasing benefit levels under CPP/QPP.” “The budget fails at what should be the number one priority: protecting vulnerable Canadians,” said Moist.
I am not going to get into the specifics of each budget proposal. I happen to agree with CUPE on many points - especially expanding the eligibility rate for Employment Insurance (EI) for Canada's unemployed. I also add that extending EI benefit entitlements by five extra weeks - increasing the maximum benefit duration to 50 weeks from 45 weeks- is simply not enough.

Where I disagree with CUPE is on tax cuts. I think now is the time to cut taxes even though it will hurt government revenues and it might not make a difference on overall consumption because people will save tax cuts or pay down debts.

I also happen to like the idea of infrastructure spending but there are quite a few conditions attached to this proposal, including the condition that cash-strapped municipalities have to invest in these projects. Where are they going to find the money?

But this blog is about pensions and I agree with CUPE that the budget does not address the needs of those who have lost a substantial portion of their nest egg in 2008's stock market rout.

Importantly, CUPE is right, if we do not increase Old Age Security and expand benefit levels under CPP/QPP, then thousands will face poverty in retirement.

One problem. We need to fix our public pension funds at the same time that we expand coverage or increase benefit levels under CPP/QPP. If we maintain the status quo, the $85 billion in deficit over the next five years will mushroom as the federal and provincial governments are called upon to shore up public pension funds.

If you read the 2009 federal budget carefully, you'll see that on page 90, the following is mentioned on federally regulated pension plans:
In the November 2008 Economic and Fiscal Statement, the Government announced temporary solvency funding relief for federally regulated pension plans for solvency funding payments in respect of 2008 solvency deficiencies.

In addition to that funding relief, federally regulated pension plans are able, subject to rules established by the Office of the Superintendent of Financial Institutions (OSFI), to take advantage of the smoothing of asset value changes over a period of not more than five years to stabilize short-term fluctuations. One of these rules, as currently applicable, prevents the use of asset values in excess of 110 per cent of market value.

In order to assist OSFI to provide further pension funding flexibility by increasing the 110 per cent limit on asset value smoothing, the Government will take action to improve pension plan member protection by making the amount of any deferral of funding that results from the use of an asset value in excess of 110 per cent subject to a deemed trust.

OSFI will be issuing detailed guidance on this subject in the near future.

On January 9, 2009, the Government released a consultation document seeking views from Canadians on the legislative and regulatory framework for federally regulated pension plans. As part of this process, the Parliamentary Secretary to the Minister of Finance will be engaging with Canadians through public meetings across Canada to examine issues pertaining to defined benefit, defined contribution and other private pension plans to ensure that the framework pertaining to these pension plans is appropriate. Given the importance of some of the issues involved, the Government will accelerate its timeline so that consultations will be completed within 90 days.
These measures are there to buy time because a lot of pension plans got clobbered as stocks crashed last year. Moreover, many private pension plans hold illiquid assets in their portfolios like real estate and private equity whose values are falling.

But what about the problems in large public pension plans? What is being done to address these problems?

Unfortunately, not much. It's a topic that makes politicians very nervous, but this problem isn't going away and if we ignore it, it will just keep getting worse.