Public Pensions Falsifying Investment Returns?

Stocks tumbled on Thursday as President Obama took on the banks:

Mohamed El-Erian, chief executive of Pimco, told the Financial Times: “Today’s announcement is part of the broader phenomenon of de-risking banks, and moving the sector more towards the ‘utilities’ end of the operating spectrum.

“This reflects post-crisis governments reaction to both systemic risk and political realities. It comes at a time of increasing structural inconsistencies in advanced economies, including the conflict between the de-risking banks and expecting them to lend more to the struggling real economy.

“After a liquidity and stimulus driven rally, stocks are starting to reflect the realities of structural imbalances in both the economy and the policy responses.”

The Dow Jones was down 213 points, its fourth consecutive day of triple-digit moves. The volatility saw the Vix index, known as Wall Street’s fear gauge, jump 19.2 per cent to move back above 22.

Investors rushed into the perceived haven of government bonds. The yield on 10-year US benchmark Treasuries reversed an early rise to drop 5 basis points to 3.59 per cent, with a worse than expected US weekly initial claims number and a disappointingly soft Philly Fed business survey providing further support.

The dollar initially lurched higher to fresh 15-month peaks as the President’s plans were revealed. However, it swiftly fell back into losses as traders baulked at the belligerent tone of Mr Obama’s remarks and the impact his proposals may have on US financial sector competitiveness. The buck was 0.1 stronger at $1.4091 versus the euro but fell 0.9 per cent to Y90.41 against the yen.

With all due respect to Mohamed El-Erian, if he thinks today's action reflects the "de-risking" of banks, then he's sorely mistaken. President Obama can huff & puff all he wants publicly, but privately he knows he's going to have a hard time passing a fraction of those proposals.

This is just political smoke because as was mentioned by someone on the Zero Hedge blog, Big Banks Have Already Figured Out The Loophole In Obama’s New Rules. But the bears are growling now, led by guys like Bob Prechter, who is convinced the bear market is back.

I remain optimistic that equities will grind higher and will accumulate more shares (in specific sectors like tech and solar) from now until the next US employment report.The best line I heard on Thursday came from Warren Buffett who stated on Fox news that bank failures should destroy CEOs:

“There ought to be a huge downside,” said Buffett, whose Berkshire Hathaway Inc. is the largest shareholder in Wells Fargo & Co. “Make it so that the CEO of an institution that fails, or goes to the government and needs help, really gets destroyed himself financially. Why should he come out any better than somebody that gets laid off as an auto worker at General Motors?”

Buffett, who collects a $100,000 salary as Omaha, Nebraska- based Berkshire’s leader, said CEOs must act as the “chief risk officer” of their companies. He has repeatedly criticized bankers for failing to realize that housing prices could fall and said they exacerbated their mistakes by borrowing to increase the size of their failed bets.

“I think you have to change the incentives,” Buffett said on the cable news channel. “It’s nice to have carrots but you need sticks. The idea that some guy is worth $500 million and leaves and only has $50 million, that’s not much of a stick. There ought to be a huge downside.”

You certainly need more sticks. Soros talked about alignment of interests and that's exactly what Buffett is hinting at. These banking "prima donnas" have no skin in the game. All upside, hardly any downside. No wonder they take reckless risks to maximize profits.

And if you think bankers' incentives are bad, let me introduce you to Canadian public pension fund managers. They too have no skin in the game and if the shit hits the fan, like it did in 2008, they just fall back on their four-year rolling returns to collect multi-million bonuses.

One senior vice-president in private equity once told me "it's a great gig". It sure is, especially if you have incompetent board of directors who do not know how to properly compensate pension fund managers using benchmarks that accurately reflect the risk being taken.

As if that's not bad enough, I was skimming through some articles on Jack Dean's Pension Tsunami, and noticed an article in Forbes from Edward Siedle, Public Pensions, Managers Falsify Investment Returns:

The Ohio Bureau of Workers' Compensation fund provides coverage for workplace injuries to two-thirds of its state's workforce and has $22 billion in funds to back it up. In April 2005 this then little-known organization reported investment returns that seemingly made it a star of the financial world--16.5% per year in a decade when the S&P 500 had earned only 10.6% annually.

Later that year, however, those returns came under suspicion when the BWC burst into the headlines as the focus of a massive investment fraud. It involved unconventional investments that had been managed by people closely connected to financial backers of the Ohio Republican Party. Have you ever heard of a state investment fund investing in gold coins or Beanie Babies? This one did.

Upon further review, it turned out that the BWC's reported investment returns were fictitious. "We are unable to establish any basis whatsoever for the 16.5% figure," an outside performance review concluded. The fund had actually earned 7.3% annually--less than half of what it had previously claimed.

In other words, the largest state-operated workers comp fund in the country had massively misrepresented its performance. Subsequent revelations showed that sloppy mathematical calculations weren't the problem. There had been a deliberate, concerted effort involving BWC's investment staff and vendors to inflate the performance.

If a Securities and Exchange Commission-registered money manager had committed similar fraud, it would have been shut down. But governmental investment funds, including hundreds of public pension plans, are generally not subject to SEC regulation.

This brings into question not only their overall performance claims but also those of the outside managers they hire. Given that such outsiders are often paid based on the returns they report, and thus have a huge incentive to cook the books, I suspect that many of the numbers issued by public pension funds are wrong. What's more, in my experience, many public funds fail to submit their reported rates of return to the sorts of audits and verification money managers in the private sector regard as mandatory. It's just too politically fraught. I call this politicization of the investment process.

For a look at just how averse outsiders can be to reporting bad numbers, see the Alaska Retirement Management Board. In 2007 the state agency filed suit against Mercer, a unit of Marsh & McLennan ( MMC). Mercer, the agency contends, made multiple errors as the state's actuarial consultant when it estimated the amounts that two of the state's retirement plans needed to set aside for health care and pension benefits. The agency is seeking damages of $2.8 billion. Now it seems the financial health of these systems is far different from what investors were told, perhaps dire. Liabilities were grossly understated. Again, if an SEC-registered money manager had committed these errors, they'd be held accountable.

This article highlights the need for external performance audits conducted by independent industry experts. It's not just about benchmarks; it's also about making sure the investment returns reported by internal and external managers are being reported accurately, verified internally by the finance department, and by external, independent experts to see if they pass the highest industry standards.

And annual financial audits are simply not enough. Accounting firms are notorious for letting things go and they are not trained experts in hedge funds or private equity funds so they will not know what to look for. Moreover, there are potential conflicts of interests since accounting firms want future business from the public pension funds they're auditing and will not dare piss off their senior managers.

The more I think about it, the more I like Buffett's idea. Let's go after the personal assets of Canadian public pension fund managers who invested in ABCP, shady real estate, private equity and hedge fund investments. If they lose billions, they should feel the pain too.