Thursday, April 29, 2010

Beyond the Greek Crisis: Will Capitalism Survive?

Reuters reports, Greece readies austerity measures, markets steady:

Union officials said the International Monetary Fund asked Athens to raise sales taxes, scrap bonuses amounting to two extra months pay in the public sector, and accept a 3-year pay freeze.

"They want Greece to cut the deficit by 10 percentage points in 2010 and 2011 ... so that Greece can go back and borrow on markets in the third year of the program," said a union official who requested anonymity.

Andreas Loverdos, social affairs minister, said pensions would be reformed. "There isn't much room for maneuver -- this is about saving the country from collapse," he told the FT.

IMF, European Union and European Central Bank officials are in Athens to negotiate the bailout and hope to wrap up a deal within days in an effort to prevent the debt crisis from sinking other fragile EU countries.

German politicians have said the aid package could be worth 100-120 billion euros ($133-160 billion) over three years, against an original plan for 45 billion euros of aid in 2010.

"The immediate emergency measures will be a strong bridge to cross over to great changes, secure the life of every citizen and have dynamic growth in a more just society," Greek Prime Minister George Papandreou said.

"We will do whatever it takes to save the country."

Germany has expressed deep reservations about bankrolling a profligate Greece, which misled partners over its catastrophic finances, and demands fierce budget rigor in return.

But German Finance Minister Wolfgang Schaeuble said there was no alternative to aiding Athens to protect the euro.

"We have to go this route," he said. "We are not defending Greece, we are defending the stability of our currency."

Fears have grown of the contagion spreading to other indebted eurozone countries. "We want to limit the crisis to Greece," said German Economy Minister Rainer Bruederle.

Economists said euro zone states could end up footing a bill of half a trillion euros ($650 billion) to save several nations if they failed to engineer a Greek bailout that calmed markets.

Ilias Iliopoulos, general secretary of Greek public sector union ADEDY, met the prime minister to discuss the salvage plan.

"We realized we stand before a done deal," he complained afterwards. "This will acutely burden people and, what is worse, unfairly."

Police fired tear gas to disperse hundreds of protesters outside the Greek finance ministry.

Sources familiar with the aid talks said officials were expected to announce details of a 3-year package by Monday, ending months of uncertainty. That was enough to spark a relief rally in markets fearful of contagion across the eurozone.

The euro wavered in Asian trade on Friday, after gaining for the second straight day on Thursday. Peripheral euro zone bond yield premiums eased and costs of insuring risky debt fell on hopes an accord was imminent.

European and U.S. shares rose, and in Japan hopes for a bailout were cited as a major factor in an early rise of more than one percent in the benchmark Nikkei.

Germany's opposition Social Democrats said it supported the Greek package, but wanted banks to help out.


The gravity of the Greek crisis became apparent weeks ago. But EU leaders were slow to react, promising vaguely to help but only really acting when markets dived and other heavily indebted nations, like Portugal and Spain, were threatened.

French President Nicolas Sarkozy insisted France and Germany were working in tandem. "We're in perfect agreement," he said in China, adding Greece's economic plan was "perfectly credible."

Unions have called a series of strikes in the days ahead.

"It's a disaster! The government has crossed the line. We can't live this way," said ADEDY board member Despina Spanou. "We will fight these measures with all our might, because this is a battle for survival."

Opinion polls show most Greeks object to the involvement of the EU and IMF and two-thirds believe there will be unrest.

But local markets appeared confident the deal would work. The Athens bourse's banking index jumped more than 13 percent, rebounding from losses in previous days, and the general Athens index gained 7.14 percent.

Some of the aid to Greece will come from the IMF but the bulk would have to come from other euro zone countries, many of which are struggling with their own spiraling deficits, and it was not clear how they would finance such a deal.


Concerns over the Greek crisis prompted global investors to cut back holdings of euro zone government bonds, although such a flight has yet to occur with the region's stocks, Reuters polls showed.

ECB President Jean-Claude Trichet called on Thursday not just for a deal on Greece, but also a revamp of Europe's fiscal rules and more intense surveillance of governments' finances.

"The weak points of past multilateral surveillance will be corrected, and the Stability and Growth Pact will be reinforced and rigorously applied in its letter and in its spirit," he said in a speech at the Munich Economic Summit.

Ratings agency Standard & Poor's cut Spain's credit rating on Wednesday, a day after downgrading Portugal and slashing Greece to junk status. On Thursday Moody's told Reuters it might also give Greece junk status in the next few days.

"The prospect isn't zero that it can go that far, but it's very difficult to see it with certainty," Kristin Lindow, a Moody's senior analyst, told Reuters in a phone interview, when asked whether Greece could be downgraded to a speculative level.

Moody's expects Greece's debt to stabilize in the next few years, but at higher levels, which needs to be reflected in the country's sovereign ratings, Lindow said.

The path to stability will be a tough one, however, as Moody's foresees years of low economic growth, adding to the difficulty of making needed fiscal adjustments.

Fitch Ratings has the country at BBB-minus, the lowest investment-grade level, with a negative outlook.

Spooked by the ratings cuts, Portugal announced it would speed up its austerity strategy and said this might allow it to reduce its deficit more than expected in 2010.

Opinions on the Greek debt crisis vary. Jeffrey Miron writes in Forbes, Let Greece Default. Boyd Erman of the Globe and Mail reports that while a rescue could encourage other nations to seek a handout, forcing Greece into bankruptcy could freeze credit markets:

As much as some investors and politicians would like to make an example of Greece by forcing it to essentially declare national bankruptcy as a deterrent to other spendthrift nations, the odds of a ripple effect are too large to ignore, analysts say.

For example, should Greek debt be downgraded by a second rating agency, it will create huge problems for the nation’s banks. That’s because Greek bonds will no longer be acceptable as collateral for loans from the European Central Bank that banks use for emergency funding.

A full-scale default would also hammer other debt owners, including banks elsewhere in Europe. As of the end of 2009, European banks held $193-billion of Greek government debt, with most of it on the balance sheets of French and German lenders. That could create losses that eat into bank capital, reducing their ability to lend and slowing economic growth across the region, a prospect that could force governments to aid banks yet again.

“I can’t dismiss concerns that a contagion of sovereign debt defaults from Greece to Portugal to Spain might have the same consequences as the collapse of Lehman and AIG,” Ed Yardeni, president and chief investment strategist at Yardeni Research, told clients on Wednesday. “Apocalypse Now might have severe unexpected consequences, as occurred during Apocalypse Then. This time, however, the stress will be much greater on European banks than on American ones.”

There is no doubt that as Greece falters, fears stretch around world:
Debt levels of all developing countries are rising to levels not seen over the past 60 years, the IMF said in an economic survey released last week.

The U.S. government forecasts that its publicly traded debt as a percentage of the total economy will reach 77 percent by 2020. By comparison, Greece's debt burden exceeds 100 percent.

"The Greek problem highlights a broader problem across the globe," said Mark Zandi, chief economist at Moody's "Governments used their resources to end the financial panic and the Great Recession, but now they have to figure out how to pay for it."

He added, however, that the United States has one thing in its favor that other countries such as Greece do not: A competitive economy capable of producing solid growth to increase government revenue.

Japan, the world's second biggest economy, isn't Greece either, economists say.

Even though it shoulders the biggest public debt burden in the industrialized world, the country does not face an imminent crisis.

More than 90 percent of its debt is funded domestically, putting the country at low risk for capital flight. Servicing that debt remains manageable because of low interest rates. Moreover, Japan holds the world's second largest store of foreign reserves and consistently posts a current account surplus.

The turmoil in Greece has in fact led investors to turn to Japanese government bonds as a safe haven.

"Claims that Japan's debt mountain is about to explode have been around for over a decade," said Richard Jerram, head of Asian economics at Macquarie Capital Securities, in a recent report.

But the future is another matter.

Prime Minister Yukio Hatoyama's government will issue a record 44 trillion yen ($473 billion) in bonds to fund this fiscal year's budget. Fitch Ratings warned last week that Japan's credit rating could worsen if Tokyo does not rein in snowballing debt, which reached 201 percent of gross domestic product in 2009. Deflation, slow growth and dwindling household savings could eventually undermine Japan's ability to fund itself.

The rest of Asia is on sounder financial footing, especially considering its rapid growth. The region underwent a "profound deleveraging" in the 1990s following its own financial crisis, mandated by the IMF's strict bailout conditions, said Glen Maguire, chief Asia economist at Societe Generale.

China's government reports its debt at about 20 percent of GDP. But Tom Orlik, an analyst in Beijing for Stone & McCarthy Research Associates, says the figure is far higher than official numbers suggest. Add in local government debt and nonperforming loans in the government-owned banks, and the level tops 50 percent of GDP, he said.

"The number is higher than the government acknowledges, and that is well known, but it is still not a very alarming number," Orlik said.

The European turmoil, however, may compel Beijing to postpone any moves to allow its currency to rise until the international outlook is clearer, said Ken Peng, China economist for Citigroup in Beijing.

China has tied its yuan to the dollar since late 2008 to help its exporters compete amid weak global demand. Washington and others complain that keeps the yuan undervalued, giving China's exporters an unfair price advantage and swelling its trade surplus.

"The government reaction to any major disturbance is to avoid moving," Peng said. "The enthusiasm for de-pegging has probably fallen."

While Asia appears strong enough to avoid the debt problems engulfing Greece and Europe, it hasn't been immune to the anxiety the turmoil has produced. Asian equity markets have been hammered this week, in line with deep share declines in Europe and the U.S.

Signaling what may lie ahead, the chief executive of ANZ Banking Group Ltd., an Australian lender with operations across Asia, warned Thursday that the sovereign debt crisis in Europe could make it harder for banks to access credit.

"I am still quite worried about the global economy," Smith told reporters. "Europe is a mess."

Europe is a mess and politicians there keep showing their ineptitude in handling the Greek crisis. While Germany will pony up most of the aid, Floyd Norris of the NYT is right, they're saving Greece to protect Germany:

Angela Merkel, the German chancellor, made clear this week what she believed to be the primary purpose of the European rescue package. It was not to spare Greeks pain, or even to help that country’s economy regain competitiveness.

“When Greece accepts these tough measures, not for one year but several, then we have a chance for a stable euro,” she said.

All this brings to mind the American politician William Jennings Bryan, who was nominated for president three times more than a century ago. He campaigned against the “cross of gold,” arguing that American prosperity was being sacrificed so the country could stick to a gold standard.

Now the Greeks — and soon, perhaps, the Portuguese or the Spaniards or the Irish — are being told to accept higher unemployment and lower wages for the indefinite future. Not for their own good, necessarily, but to preserve a currency.

At the moment, the euro has weakened because of the Greek crisis. For Germany, that is another bonus. Its already competitive manufacturing industries get an extra boost.

My fear is that when Greeks, Spaniards, Portuguese, Italians and Irish figure out what these austerity measures entail, their population might turn around and say screw the euro and screw Germany. Don't be surprised if Greek revolts spread throughout southern Europe.

Finally, don't think for a second that what's going on in Greece and Europe will never happen in the US and even Canada. On Monday, the WSJ reported that
Ken Griffin, the head of Citadel Investment Group said the U.S. risks becoming "the next Greece" within a decade unless action is taken on fiscal reform.

Ken Griffin, founder and CEO of the financial services group, also blamed the lack of job creation on "policy uncertainty" in the wake of the financial crisis.

"We have a crisis in front of us," said Griffin on a panel at the Milken Institute Global Conference, citing the rising cost of health and social security benefits.

"There's no acknowledgment of that at any [policy level]. That worries me," he added.

Griffin said without action he is concerned about the U.S. becoming "the next Greece" and added the Obama administration missed a chance for "a new social compact" to fund reform.

His concerns over job creation reflected the gains in productivity seen during the recent recovery. He cited the lingering debate over cap-and-trade and broad financial reform for restraining bank lending.

There is no acknowledgment of the global pension crisis either and how we are going to address serious social issues, including the widening wealth gap between workers and financial oligarchs who are sucking this economy dry, leaving crumbs for the rest of us.

So while the IMF and the EU impose austerity measures on Greeks and who knows who else, let's step back and remember who profited the most from the global debt crisis. I don't see the banksters taking cuts in their bonuses or corporate titans accepting higher taxes. They conveniently escape the burden of "austerity measures".

Watch the clip below on the Greek crisis and pay attention to what Max Keiser says. There is much more at stake here than the Greek crisis, but mainstream media seems to be ignoring the restless many, focusing on the concerns of the privileged few.

It is clear to me that pensions and the global economy have succumbed to Casino Capitalism - a form of capitalism which benefits the financial and corporate oligarchs, leaving the rest of the population behind. Greece is the birthplace of democracy, will it also be the birthplace of a new form of capitalism?

Toppling Goliath?

Reuters reports, Pension funds eyed debt, property in 2009:

European pension funds hired more fund managers in 2009 than in the previous year to take advantage of bargains in crisis-hit asset classes, a study by Mercer said on Tuesday.

In the UK, manager searches recovered to pre-crisis levels hitting 245 from 189 in 2008 and 242 in 2007.

Pension schemes in Europe and around the world are moving towards a broader investment strategy, which involves allocations to alternative assets such as property and hedge funds aside from traditional areas such as equity and bonds.

The crisis accelerated this trend, allowing investors the opportunity to buy new assets at lower costs.

The asset class that benefitted most according to the Mercer study was global fixed income, where manager searches rocketed to 45 from two in 2008.

"For both corporate bonds and real estate, an element of pent-up demand was realised in 2009 as many investors had been waiting for more realistic prices before committing new money," said Andy Barber, global head of manager research at Mercer.

Mercer said pension funds in the UK will invest more in the future in higher yielding products as the continued search for returns prompt them to venture away from mainstream markets.

Real estate manager searches grew four-fold to 28 and global equity to 57 from 48 in 2008. Assets invested in global equity nearly doubled to $13.9 billion, while the mandate size awarded in 2009 in the UK was just under $42 billion from $26.1 billion the previous year.

"Looking forward, we expect a growing interest in liability driven investment (LDI) as defined benefit pension clients seek to manage their assets with closer reference to their liabilities," said Barber.

Mercer said that mandate searches in continental Europe increased in 2009 to 126 from 93, although the assets invested fell to $10 billion from $13.4 billion.

"Although there are regional variations (globally), we do sense a greater investor appetite for taking advantage of dislocation and low valuations than in previous market downturns," said Barber.

And Helia Ebrahimi of the Telegraph reports, Canadian pension fund Aimco eyes Candover:

Stock market listed Candover, which has been slashing costs in the face of a cash shortage, is in talks with Aimco about a deal at a price no higher than its last reported net asset value of £10.38 per share.

A deal with Candover would give Aimco exposure to most of the private equity group's portfolio, as well as the management team in its general partnership – who in recent months have been at the centre of speculation about Candover's future.

Shares in Candover, which did not name Aimco when it confirmed the approach after the market closed, closed at 739p, valuing the business at £161m.

A one time darling of the private equity sector, Candover, whose investments include Spanish theme park operator Parques Reunidos and Belgium nappy maker Ontex, was one of the financial crisis's biggest victims. In January its affiliate company Candover Partners pulled its €3bn (£2.6bn) fund after Candover Investments failed to meet its own €1bn commitment.

Aimco has about $70bn of assets and would be the latest Canadian pension fund to make an aggressive move on the UK market.

People familiar with the situation have said the dealmaking team at Candover, which has been cut from more than 100 people to about 40, is still aiming to raise a fresh funds for new deals

The Aimco-Candover deal makes sense, adding the expertise internally, but it's far from being a sure thing. In particular, Candover has been struggling to raise cash, but now that Aimco is backing them up, they might find their footing again. What remains to be seen is whether this deal will add value over the long-term. Unlike the Habs, I'm not convinced that private equity is going to stage a serious comeback.

Tuesday, April 27, 2010

The Goldman Goose?

Louise Story of the NYT reports, Panel’s Blunt Questions Put Goldman on Defensive:
Even before the first question was leveled inside the Senate chamber, Tuesday was going to be uncomfortable for Goldman Sachs.

But then the questions kept coming — and coming and coming.

Through the day and into the evening, Goldman Sachs officials met with confrontation and blunt questioning as senators from both parties challenged them over their aggressive marketing of mortgage investments at a time when the housing market was already starting to falter.

In an atmosphere charged by public animosity toward Wall Street, the senators compared the bankers to bookies and asked why Goldman had sold investments that its own sales team had disparaged with a vulgarity.

“The idea that Wall Street came out of this thing just fine, thank you, is just something that just grates on people,” said Senator Edward E. Kaufman Jr., a Democrat from Delaware, said. “They think you didn’t just come out fine because it was luck. They think you guys just really gamed this thing real well.”

But throughout a more-than-10-hour subcommittee hearing, current and former Goldman officials insisted that they had done nothing to mislead their clients. Time and again, the senators and the Goldman executives, among them the chairman and chief executive, Lloyd C. Blankfein, seemed to be talking past each other.

Among the Goldman retinue was Fabrice P. Tourre, a vice president who helped create and sell a mortgage investment that figures in a fraud suit filed this month by the Securities and Exchange Commission.

Mr. Tourre defended his role in the sale of the investment. In his opening remarks to the Senate Permanent Subcommittee on Investigations, Mr. Tourre declared: “I deny, categorically, the S.E.C.’s allegation. And I will defend myself in court against this false claim.”

Senate investigators are building on the S.E.C. case, which accuses Goldman of defrauding investors in a transaction called Abacus 2007-AC1.

The hearing was held against the backdrop of a debate about overhauling financial regulation. During the questioning, senators highlighted the need for greater openness and questioned the ethics of the financial sector.

At one point, the Goldman witnesses were asked what they would change in the regulatory system.

“Clearly some things need to be changed,” said Daniel L. Sparks, a former partner and head of the mortgage trading department in the Goldman Sachs Group, who was one of the four initial witnesses.

Steering away from financial jargon, the senators tried to put a human face on the questioning. Senator John Ensign, Republican of Nevada, declared that more transparency was needed “so we don’t end up hurting the little guys out there on Main Street.”

A Republican member, Senator Susan M. Collins of Maine, turned from one witness to the next as she asked repeatedly whether they felt a duty to act in the best interest of their clients. Only one of the four witnesses she questioned seemed to affirm such a duty outright.

In what almost added up to a light moment, Senator Mark L. Pryor, Democrat of Arkansas, said the public wanted to know what went wrong and “how we can fix it,” adding that Americans feel that Wall Street contributed to the financial crisis. “People feel like you are betting with other people’s money and other people’s future,” he said. “Instead of Wall Street, it looks like Las Vegas.”

Senator Ensign said he took offense at the comparison, saying that in Las Vegas the casinos do not manipulate the odds while you are playing the game. The better analogy, he said, would be to someone playing a slot machine while the “guys on Wall Street” were “tweaking the odds in their favor.”

The gap between Wall Street and the rest of the country was a recurring theme, with senators occasionally pointing out how much Goldman, and indeed the witnesses, had profited as the overall economy was headed for a plunge.

Senator Claire McCaskill, Democrat of Missouri, mentioned during her questioning that she was trying to “home in on why I have so many unemployed people” and lost money in pensions.

The questioning Tuesday put the Goldman witnesses on the defensive, with the senators expressing exasperation that they were deliberately dodging questions or stalling for time.

It was at 10:01 a.m., one minute late, when the session began with opening remarks from subcommittee chairman, Senator Carl Levin, Democrat of Michigan. The public galleries, accommodating roughly 100 people, were full and included four people dressed in mock stripped prison jumpsuits who jeered at the Goldman officials.

“How do you live with yourself, Fab?” one shouted as Mr. Tourre was ushered out of the chamber after his testimony.

A tone of confrontation was set at the beginning, with Senator Levin’s opening remarks. He said the questioning would focus on the role of investment banks in the financial crisis, and particularly on the activities of Goldman Sachs in 2007, which “contributed to the economic collapse that came full blown the following year.”

While the hearing had ramifications for the entire sector and the activities of lenders to make more money from risky mortgage loans, Senator Levin added, it was focusing on Goldman as an “active player in building this mortgage machinery.”

He said that while the S.E.C. suit and the courts would address the legality of its activities, “the question for us is one of ethics and policy: were Goldman’s actions in 2007 appropriate, and if not, should we act to bar similar actions in the future?”

In addition to Mr. Tourre and Mr. Sparks, Goldman executives testifying included Joshua S. Birnbaum, a former managing director in the structured products group trading, and Michael J. Swenson, another managing director in that group.

A second panel included David A. Viniar, executive vice president and chief financial officer, and Craig W. Broderick, the chief risk officer.

At one point Mr. Viniar prompted a collective gasp when Mr. Levin asked him how he felt when he learned that Goldman employees had used vulgar terms to describe the poor quality of certain Goldman deals. Mr. Viniar replied, “I think that’s very unfortunate to have on e-mail.”

Senator Levin then berated Mr. Viniar for not saying that he was appalled that Goldman employees even thought their deals were of poor quality, much less put it in e-mail. Mr. Viniar later apologized.

As the hearing stretched into the evening, Mr. Blankfein, Goldman’s chief, entered the chamber with an almost angry demeanor. In a brief prepared statement, he held tight to Goldman’s defenses.

Later, asked if he knew the housing market was doomed, Mr. Blankfein replied, “I think we’re not that smart.”

Mr. Blankfein was asked repeatedly whether Goldman sold securities that it also bet against, and whether Goldman treated those clients properly.

“You say betting against,” Mr. Blankfein said in a lengthy exchange. “The people who were coming to us for risk in the housing market wanted to have exposure that gave them exposure to the housing market, and that’s what they got it. The unfortunate thing, and it’s unfortunate, is that the housing market went south very quickly.”

Senator Levin pressed Mr. Blankfein again on whether the his customers should know what Goldman workers think of deals they are selling, and Mr. Blankfein reiterated his position that sophisticated investors should be allowed to buy what they want.

Mr. Blankfein was also pressed on the deal at the center of the S.E.C. case. He said the investment was not meant to fail, as the S.E.C. claims, and in fact, that the deal was a success, in that it conveyed “risk that people wanted to have, and in a market that’s not a failure.”

To which Senator Jon Tester, Democrat of Montana, replied, “It’s like we’re speaking a different language here.”

As I worked today, I listened to the hearings on C-SPAN. At times, they were endless, but there were many excellent points where my antennas went up.

Let me give you my general impressions. I wasn't very impressed with the morning panel which consisted of Mr. Tourre (aka 'Fabulous' Fab), Mr. Sparks, Mr. Birnbaum, and Mr. Swenson. They were evasive and I found them young and arrogant. They didn't impress me much; in fact, at times, they seemed like a bunch of amateurs.

The Goldman executive that impressed me today was the CFO, David Viniar. Leaving aside his dumb comment "that’s very unfortunate to have on e-mail,” Mr. Viniar was solid as a rock, answering tough questions straight on. Let me be blunt, if you have an investment firm, you want a guy like David Viniar as your CFO. In fact, after listening to Lloyd Blankfein, I am left wondering why isn't David Viniar Goldman's CEO?

As I suspected, the hearings were mostly a circus show. There is a lot of pent up anger on Main Street and the senators used this occasion to publicly scold the Goldman Sachs boys. Goldman made a killing shorting subprime mortgage structures while the working class were losing their homes and jobs. The senators used Goldman as their financial piñata, no doubt trying to score political points and set the stage for passing financial reform.

But these hearings aren't just about Goldman; they are about a Wall Street model that is fraught with conflicts of interest. I was surprised to see Citadel Investment Group founder Ken Griffin coming to Goldman's defense when he knows that investment banks are fraught with conflicts of interest.

Go back to read Soros' thoughts on alignment of interests. When investors allocate to funds managed by George Soros, Bruce Kovner, Ken Griffin, Steve Cohen, Ray Dalio, Paul Tudor Jones, John Paulson, Jim Simons, Louis Bacon, David Shaw, or any other elite hedge fund manager, they'll pay hefty performance fees, but at least they know that those managers have skin in the game. Their net worth is tied up in the funds they're managing. There is an alignment of interest.

That alignment of interest does not exist in the current investment banking model. It might exist (loosely) between Goldman and say, Citadel or other big hedge funds, because Citadel and those hedge funds do a lot of business with them, but I'll bet your bottom dollar it doesn't exist between Goldman and their dumb public pension fund clients. The latter are as sophisticated as grandma Jones (and many of them, even less so).

Alignment of interests. That was the key point Senator Levin was trying to make towards the end of the hearings when he grilled Lloyd Blankfein. Soros knows all about this point. He thinks risk-takers should start a hedge fund and take risks with their own capital:
“That would push the risk-takers who are good at taking risks out of Goldman Sachs into hedge funds, where they actually belong, because hedge funds take risks with their own capital, not with deposits and not with government guarantees,” he said.
You see if Goldman (and other investment banks) really cared about their clients, they'd be feeling the pains and gains right alongside them. That is the essence of these hearings, and the most important takeaway from today's circus show. You can't be selling products to clients that you're actively shorting in your proprietary trading books.

I leave you with the opening statement of the one senator that impressed me the most today, Senator Claire McCaskill. She reminds us that Casino Capitalism is threatening our standard of living, and unless we change course, we are doomed.

And one final thought. Goldman reversed course in the summer of 2006, right about the same time a senior investment analyst from PSP Investments was asking them about the best way to short the U.S. residential mortgage structured credit bubble. Now, if I can only find those emails!

Monday, April 26, 2010

Pension Bomb Ticks Louder?

The WSJ reports, Pension Bomb Ticks Louder:

The time-bomb that is public-pension obligations keeps ticking louder and louder. Eventually someone will have to notice.

This month, Stanford's Institute for Economic Policy Research released a study suggesting a more than $500 billion unfunded liability for California's three biggest pension funds—Calpers, Calstrs and the University of California Retirement System. The shortfall is about six times the size of this year's California state budget and seven times more than the outstanding voter-approved general obligations bonds.

The pension funds responsible for the time bombs denounced the report. Calstrs CEO Jack Ehnes declared at a board meeting that "most people would give [this study] a letter grade of 'F' for quality" but "since it bears the brand of Stanford, it clearly ripples out there quite a bit." He called its assumptions "faulty," its research "shoddy" and its conclusions "political." Calpers chief Joseph Dear wrote in the San Francisco Chronicle that the study is "fundamentally flawed" because it "uses a controversial method that is out of step with governmental accounting standards."

Those standards bear some scrutiny.

The Stanford study uses what's called a "risk-free" 4.14% discount rate, which is tied to 10-year Treasury bonds. The Government Accounting Standards Board requires corporate pensions to use a risk-free rate, but it allows public pension funds to discount pension liabilities at their expected rate of return, which the pension funds determine. Calstrs assumes a rate of return of 8%, Calpers 7.75% and the UC fund 7.5%. But the CEO of the global investment management firm BlackRock Inc., Laurence Fink, says Calpers would be lucky to earn 6% on its portfolio. A 5% return is more realistic.

Last year the accounting board proposed that the public pensions play by the same rules as corporate pensions. But unions for the public employees balked because the changed standard would likely require employees and employers to contribute more to the pensions, especially in times when interest rates are low. For now, it appears the public employee unions will prevail with the status quo accounting method.

Using these higher return rates for their pension portfolios, the pension giants calculate a much smaller, but still significant, $55 billion shortfall. Discounting liabilities at these higher rates, however, ignores the probability that actual returns will fall below expected levels and allows pension funds to paper over the magnitude of their problem.

Instead, the Stanford researchers choose to use a risk-free rate to calculate the unfunded liability because financial economics says that the risk of the investment portfolio should match the risk of pension liabilities. But public pensions carry no liability. They're riskless. That's because public employees will receive their defined benefit pensions regardless of the market's performance or the funds' investment returns. Under California law, public pensions are a vested, contractual right. What this means is that taxpayers are on the hook if the economy falters or the pension portfolios don't perform as well as expected.

As David Crane, California Governor Arnold Schwarzenegger's adviser notes, this year's unfunded pension liability is next year's budget cut—or tax hike. This year $5.5 billion was diverted from other programs such as higher education and parks to cover the shortfall in California's retiree pension and health-care benefits. The Governor's office projects that, absent reform, this figure will balloon to over $15 billion in the next 10 years.

What to do? The Stanford study suggests that at the least the state needs to contribute to pensions at a steadier rate and not shortchange the funds when markets are booming. It also recommends shifting investments to more fixed-income assets to reduce risks.

But what the public-pension giants find "political" and "controversial" is the study's recommendation to move away from a defined benefits system to a 401(k)-style system for new hires. Public employee unions oppose this because defined benefits plans are usually more lavish, and someone else is on the hook to make up shortfalls. Calpers and Calstrs are decrying the Stanford study because it has revealed exactly who is on the hook for all of this unfunded obligation—California's taxpayers.

Shifting investments into more fixed-income assets when bond yields are at historic lows? While it sounds counterintuitive, it may be the wisest decision (read my last comment).

Jonathan Jacob of Forethought Risk set me these comments, which I share with you:

A couple comments on recent blog posts:

First off, apparently bonds are by far the most hated asset which makes them a reasonable candidate for outperformance.

More focused on pensions, however, is my disagreement with the massive public plans – I think by creating these megafunds we would be inventing a new financial entity which would be “too big to fail” as large segments of the population would rely on them for future income.

Jonathan is right on both counts, which is why I keep harping on setting the tightest governance standards on large public funds. I also think we should cap them after they reach a certain size.

The problem is that public pensions are already “too big to fail”and if they're understating their true liabilities by using a discount rate based on rosy investment expectations, then some time in the near future those pension bombs will stop ticking, and just explode in our faces.

Sunday, April 25, 2010

When the Facts Change?

In my last post, I went over the IMF's latest World Economic Outlook, as well as some comments made by Bank of Israel Governor Stanley Fischer.

Interestingly, more and more experts are saying that the global recovery will be stronger than anticipated, but that once the stimulus measures wear off, and developed nations deal with their fiscal problems, growth will moderate.

There is also unanimous consensus that extraordinary policy intervention has eliminated the risk of a second Great Depression and that advanced economies don't face a deflationary threat.

I'd like to explore the deflationary threat in more detail. Why is this topic so important? Because the long-term trajectory of the global recovery, and the health of the global financial system, crucially hinge on whether inflationary forces swamp deflationary forces.

Those of you who have followed my blog know that I've been bullish on stocks since last year. Record low interests rates have been a boon for banks and hedge funds trading stocks and other risk assets. The liquidity party continues and money managers are once again succumbing to performance anxiety, bidding risk assets even higher.

From a policy perspective, the Fed couldn't be happier. They are promoting the reflation trade hoping that the rise in asset values will recapitalize banks, allowing them to start lending again to small and medium sized businesses. Moreover, the Fed hopes that a sustainable economic recovery will take hold, and that this will reintroduce 'mild' inflation in the economy, effectively killing the deflationary threat they're so desperately trying to avoid.

But this is a dangerous game because if a sustainable recovery doesn't take hold, then all these "extraordinary policy measures" will have failed, deflation will follow, crippling the global recovery and banking system for decades.

In essence, the whole world is "too big to fail", so policymakers are working hard to ensure that the reflation trade continues. This is why I've been telling people to keep buying the dips on stocks because I know at the end of the day, financial oligarchs have a vested interest to keep rising financial markets going. Everyone wants this outcome and that is why everyone continues to be long risk assets.

But will they be successful or are they just prolonging the agony that's to come? That is the key question that every money manager and regular citizen is wondering about. Are we going to finally get out of this mess or are we in for decades of frustratingly low growth or worse, another Great Depression?

I want to bring to your attention two important commentaries that are absolute must reads. The first is from Niels Jensen of Absolute Return Partners. In his April 2010 commentary, When the Facts Change, Mr. Jensen and his team look at the implications of being in a structural bear market and they make five specific recommendations: (1) Beware of echo bubbles; (2) Do not benchmark; (3) Include uncorrelated asset classes in your portfolio; (4) Do not use leverage; (5): Prepare for bond yields to surprise everyone by falling further.

Mr. Jensen adds: "The last one in particular is controversial. The vast majority of investors appear to have resigned themselves to the fact that interest rates will have to go higher. We believe precisely the opposite could happen, at least in those countries where sovereign default is not a significant risk."

Mr. Jensen goes over many interesting topics in his monthly commentary, but let me focus on a few here. In the short-term, Mr. Jensen is more worried about commodities than emerging market bubbles:
As we all know, investor appetite for commodities has been growing rapidly in recent years - just look at the growth of commodity linked ETFs. However, I suspect that many of those investors do not fully understand the complexity of the products they invest in (see here for a brilliant analysis of this problem), and they don’t realise how small many commodity markets actually are. I fear that many investors are setting themselves up for serious problems as ETFs account for a bigger and bigger share of the total commodity pool.
Having assisted a few of these commodity conferences, I couldn't agree more. Investors should be very careful as to how they approach their investments in commodities because many investors underestimate the risks of these commodity linked ETFs. I know the "brains" at Barclays, Goldman and other firms will peddle these products hard, but do your due diligence, and be weary of these products.

As far as recommendations, Mr. Jensen talks up his business and warns on the misuse of leverage:
Ideally, in the current environment, I would allocate 30-40% to uncorrelated asset classes. This is a much higher allocation than most investors give to this space at the moment. Many became disillusioned with absolute return investing, following the horrible experience of 2008-09 where many absolute return vehicles did as poorly as, and in some cases worse than, more directional investment vehicles. Ever since, it has been difficult to attract investors to attract investors back to absolute return products.

What is not so well understood is why so many absolute return vehicles failed to deliver what it says on the tin. As a whole, absolute return strategies actually did much better than more directional strategies, but returns were widely dispersed. And those products/strategies which performed poorly mostly did so, because they underestimated the liquidity mismatch between the asset and the liability side of the balance sheet.

Which brings me to the next point. If we are, as I suspect, in echo bubble territory, there will be at least on more down leg before we can finally declare this crisis to be over. One does not want to be leveraged when that happens - not so much because leverage per se is bad. In fact, I am a believer that leverage, applied intelligently, can significantly enhance returns. However, our banking industry has not yet recovered from the near disaster of 2008-09 and, even worse, is not likely to have fully recovered by the time the next downturn kicks in. This will leave the banking industry on either side of the Atlantic extremely vulnerable and, as we can testify to at Absolute Return Partners, a bank which is under severe stress can virtually obliterate your business if you have leveraged your investments.

Having said that, we are starting to see leverage creeping up again across the hedge fund industry.
I take issue with some claims made here. First, good luck allocating 30-40% in uncorrelated assets. In this environment, this is a pipe dream. Second, pension fund allocations to hedge funds “have returned to pre-crisis levels”, according to Mercer, one of world’s largest investment consultants (never underestimate the stupidity of the pension herd).

But on the issue of leverage, I agree that most hedge funds have cranked up the leverage to meet their return expectations. This is one of the primary factors driving risk assets higher. Most hedge funds are betting that rates will remain low for a long time, so why not crank up leverage? In fact, some pension funds are also leveraging up, trying to get extra yield to meet their pension liabilities.

This is the one thing that worries me the most. With so much leverage in the bond market and the financial system, if rates do start spiraling out of control, the second wave of the financial crisis will be brutal, and many hedge funds and pension funds will get decimated. It will make 2008 look like a walk in the park.

On the outlook for interest rates, however, Mr. Jensen sees things differently and isn't afraid to stick his neck out:
Bond yields could very well fall over the next few years. This is unquestionably my most controversial prediction, and it is admittedly a risky forecast. I have been arguing for a while (see here) that for years to come we will face a tug-of-war between deflationary and inflationary forces, and I continue to stick to my projection that deflationary forces will ultimately prevail. Classic monetary thinking would suggest otherwise. The rapid growth in the monetary base over the past 18 months is hugely inflationary, or so the monetarists amongst us argue. In a cash based economy I would agree, but we are dealing with the biggest credit bubble of all times which must now be shrunk. That is extremely deflationary. Just look at the wider measures of monetary growth. There is none.

Another argument frequently put forward by the inflationary camp is that governments will be forced to inflate their way out. They have no alternative because they cannot afford otherwise. I am not convinced it is that simple. Morgan Stanley published a very interesting research report recently in which they made the observation that nearly half of all US budget outlays are now effectively indexed to inflation. The obvious implication of this simple fact is that it is no longer possible for the US government to inflate its way out of its deep deficit hole, however tempting that may be. We should also learn from the Japanese experience.
Mr. Jensen ends his commentary by stating:
The final point I would like to make with respect to the outlook for interest rates has to do with the sheer supply of bonds waiting around the corner. In the past, I have taken the view that interest rates would probably have to go up, even if there is little or no inflationary pressures; however, after having studied the Japanese case in more detail, my conviction level is weakening day by day.

The reason was pencilled out in last month’s letter and has to do with why governments are running these exorbitant deficits. The deficits are to a large degree necessitated by rising savings rates which translates into lower economic activity. In other words, without the large deficits, we would be facing negative GDP growth in many countries at the order of 5-10% per annum for several more years. Not only would that be politically unacceptable, but don’t forget that, contrary to common belief, much of the money to buy those bonds will be available because of the higher savings rates.

On this note, one needs to pay attention to which government debt one buys. In the UK, for example, the average government debt maturity is about 14 years, whereas in the US it is less than 5 years (see chart 8). Whether by design or sheer luck (I suspect the latter), it does provide the UK with a significant advantage over most other countries which have significantly less room for manoeuvring.

The UK pension funds play a significant role here. There has been, and continues to be, an enormous appetite for long-dated gilts from the pension sector. Although this is not well understood outside the pensions industry here in the UK, many pension schemes have automated investment programmes in place which are triggered when real interest rates hit certain pre-defined trigger points. All other things being equal, this puts a very effective lid on real rates and is one of the key reasons why I am gradually coming around to the realisation that long dated bonds could be one of great surprises of the next few years.

However, the inflation v. deflation war of words is likely to rage for several more years. This implies that none of the above will happen in a straight line so be prepared for a bumpy ride. It also means that volatility could be quite dizzying at times, so make sure you have investments in your portfolio which benefit from high volatility. Unfortunately, these types of strategies are typically unregulated which means that I am not permitted to write about them in a freely available letter like this. Call us instead if you want to learn more about being long volatility or would like some help in positioning your portfolio for what lies ahead.
One way for pension funds to position their portfolio in a volatile environment is to increase their allocation to good old government bonds, and use overlay strategies (both internal and external) to play on the volatility.

This brings me to the second must read commentary from Van Hoisington and Lacy Hunt of Hoisington Investment Management. In their latest Quarterly Review and Outlook, they too argue that long term Treasury yields are heading lower:
While conterintuitive, the deceleration in the money supply measures should not be surprising. As we have discussed previously, Fisher outlined the rationale almost 80 years ago. In extremely overleveraged economies, monetary policy doesn’t work. Potential borrowers do not have the balance sheet capacity to take on more debt.

Currently, borrowers are loaded with excess houses, office buildings, retail space, and plant capacity. No need exists to get even deeper in debt. Moreover, due to rising foreclosures and delinquencies, bank capital has been badly eroded and banks are not in a position to put more risk onto their balance sheets by lending to already over committed borrowers.

Also, to the extent that borrowers and lenders manage to increase leverage further, the benefits to the economy are fleeting, only serving to make the economy more vulnerable to economic deterioration and possibly systemic risk in the future.

Another major development in interest rate theory was the cofounding of behavioral economics in the late 1970s by Richard Thaler and Daniel Kahneman. Kahneman won the Nobel Prize in economics in 2002. In the compelling analysis of behavioral economics, markets are determined over the short-run by a host of psychological and transitory conditions, including but not limited to, heuristics, or various rules of thumb, to guide trading practices. However, in behavioral economics, the fundamentals apply over time to market prices. This confirms the analysis of both Fisher and Friedman, at the end of the day. That is, lower inflation leads to lower interest rates.

With excessive levels of debt and contractionary monetary and fiscal policies in place, inflation will continue to moderate, thereby driving long term treasury yields lower. The path to lower rates will not be smooth as volatility will arise from heavy sales of U.S. government debt and occasional transitory improvements in economic activity. However, patient investors will be significantly rewarded.
My only comment here is that banks are making a killing in their capital markets operations, and they are in a position to lend more, but they obviously prefer making money on liquid assets than getting tied up in illiquid loans.

Below, I leave you with a Bloomberg interview with Hoisington's Lacy Hunt which took place last year. He was wrong on corporate bond spreads, but ultimately Hoisington's call on lower Treasury yields may be right on the money.

Saturday, April 24, 2010

A Fragile Global Recovery?

Larry Elliott of the Guardian reports, Western economies too weak for spending cuts, IMF warns:

The International Monetary Fund today provided a boost for Labour's campaign strategy when it warned rich western countries that their economies were too weak for spending cuts, tax increases or higher interest rates.

In its influential World Economic Outlook, the IMF said the recovery in global growth over the past year had relied on "highly accommodative" policies and there was a risk of a relapse.

"In most advanced economies, fiscal and monetary policies should maintain a supportive thrust in 2010 to sustain growth and employment," the WEO said.

"Regarding the near term, given the fragile recovery, fiscal stimulus planned for 2010 should be fully implemented, except in countries that are suffering large increases in risk premiums," the IMF added.

The fund's comments are likely to be seized upon by Gordon Brown, who has been arguing the UK could suffer a double-dip recession if the Conservatives implemented plans for £6bn of spending cuts in an emergency post-election budget in June.

While raising concerns about the possibility of a sovereign debt crisis spreading from Greece, the Washington-based fund said action to tackle budget deficits should wait until 2011 for most countries, the point at which government plans for tax increases and spending restraint kick in: "If macroeconomic developments proceed as expected, most advanced economies should embark on significant fiscal consolidation in 2011. Countries urgently need to design and implement credible fiscal adjustment strategies, emphasising measures that support potential growth."

The fund added that central banks could keep interests low provided inflation remained low.

After experiencing the first contraction since 1945, global output is expected by the IMF to grow by 4.2% this year and by a further 4.3% in 2011. But it stressed that the multi-speed nature of the recovery would continue, with the advanced economies growing by 2.3% this year but China and India posting expansion of 10% and 8.8% respectively.

Europe will be the slowest-growing part of the global economy, with all five of the leading economies struggling to boost output by more than 1.5% this year. The fund has pencilled in growth of 1.3% for the UK this year, in line with Alistair Darling's budget forecast, and 2.5% in 2011, lower than the Treasury is expecting. The IMF's prediction for UK growth this year is unchanged on its last forecast in January, but it has shaved 0.2 points off its estimate for 2011.

"In the United Kingdom, the recovery is projected to continue at a moderate pace, with previous sterling depreciation bolstering net exports even as domestic demand likely remains subdued," the fund said.

It added that Spain should be braced for a second year of economic contraction in 2010, with Italy likely to grow by 0.8%, Germany by 1.2% and France by 1.5%. "Among the hardest hit during the global crisis, Europe is coming out of recession at a slower pace than other regions," the fund said.

It believes the pace of growth in the US will ease next year from 3.1% to 2.6% as the impact of big cuts in interest rates and an expansionary fiscal policy wear off.

"Extraordinary policy intervention since the crisis has all but eliminated the risk of a second Great Depression, laying the foundation for recovery," the fund said. "The interventions were essential to prevent a downward debt-deflation spiral, in which increasingly severe difficulties would have fed back and forth between the financial system and the rest of the economy."

Bank of Israel Governor Stanley Fischer, a former top official at the International Monetary Fund, also said advanced economies don’t face a deflationary threat and the U.S. economy is rebounding faster than anticipated:

Rising commodity costs and gains in global demand will prevent a downward spiral in consumer prices without sparking a surge in inflation, Fischer said in an interview in Washington yesterday. The U.S., U.K. and Canadian economies are growing quicker than was forecast when the global recession took hold, he said.

“I don’t think we’re going to see a serious deflationary threat in the countries that are recovering reasonably,” said Fischer, who was Federal Reserve Chairman Ben S. Bernanke’s thesis adviser. “I don’t want to say it’s an inflationary threat, inflation is going to be within comfortable ranges.”

Fischer said now isn’t the time for his central bank to stop buying foreign currency. He urged countries with mounting debt burdens to pare them and suggested the allegation of fraud at Goldman Sachs Group Inc. improves the chances of a regulatory overhaul of Wall Street.

While not enjoying a so-called v-shaped recovery, the U.S. is doing a “bit better than people expected,” he said. The IMF this week raised its forecast for the world’s largest economy to show growth of 3.1 percent this year, up from its January estimate of 2.7 percent and last year’s 2.4 percent contraction.

Ahead of Consensus

“If we think of all the scenarios we were listening to 1 1/2 years ago we’re well ahead of the consensus,” Fischer said.

Fischer, 66, last month accepted a second term as Israel’s central bank chief. From 2002 to 2005 he was a vice chairman at Citigroup Inc. having previously worked as the IMF’s first deputy managing director, where he helped resolve financial crises in Mexico, Russia and Southeast Asia.

With interest rates still near zero in the U.S. and other major economies and Israeli inflation above the government’s target of 1 percent to 3 percent, Fischer said his central bank is not ready to stop buying foreign currency. It began doing so in March 2008 and has more than doubled reserves since then in a bid to weaken the shekel to help exporters weather the global economic crisis.

“We’re not at that point yet,” Fischer said when asked if he can stop the two-year effort. “It’s a very uncomfortable situation and until we see interest rates around the world beginning to move in a direction which will return them to something more normal, markets are going to be very volatile.”

Surge in Yields

With a surge in Greece’s bond yields yesterday to the highest since 1998 putting pressure on its government to accept an international bailout, Fischer said aid would only work best if accompanied by efforts to cut the country’s budget deficit.

“The best sort of strategy is to undertake the measures that will solve the underlying problem,” Fischer said. “If you’re not going to adjust, but Greece is going to adjust, then you’re just making a bigger debt problem for the future.”

Asked whether Greece’s woes will prompt investors to start targeting other European economies with large budget gaps, Fischer said “it depends how well the other countries decide to deal with their problems.”

Fischer said last week’s announcement by the U.S. Securities and Exchange Commission that it is suing Goldman Sachs for alleged fraud linked to derivatives improves the “atmospherics” around a push to tighten regulation of the financial industry.

While the international campaign to regulate banks better is “being fragmented,” he said he would rather countries were advancing at their own speeds than not do anything.

“We’re seeing individual countries, individual groups of countries move,” he said. “It’s a good thing countries are moving ahead.”

On whether China should allow its yuan to appreciate, Fischer said doing so would help narrow international trade imbalances and temper the “threat of domestic overheating.”

Reading these articles, you sense experts are cautiously optimistic, but remember what was posted a few days ago, the second wave of the financial crisis will be brutal, especially if rates start spiraling out of control.

Thursday, April 22, 2010

A Group Pension Fix?

Jack Mintz's writes in the National Post, A group pension fix:
Governments are searching for new measures to help Canadians save for their retirement. One proposal among current federal consultations: Amend regulations to allow insurance companies or other providers, including government-sponsored pension plans, an opportunity to effectively provide multi-employer pensions.

Here is an alternative proposal that could have a big impact in helping business provide multi-employer plans at a relatively low cost: Eliminate the current discrimination against group RRSP plans by enabling companies to deduct their employer contributions from the tax base used to determine CPP, EI and other payroll taxes. At present, employer contributions to pension funds are deductible but not in the case of group RRSPs.

Why would this be important? Many companies are abandoning defined benefit plans — pensions with benefits based on years of service and salary levels — in favour of defined contribution plans or group RRSPs, both of whose retirement benefits ultimately depend on the investment experience of the funds held on behalf of the employee. From an employee’s perspective, the defined contribution plan and group RRSPs are similar in that the employee bears investment risk that determines how much wealth is accumulated at retirement.

However, from an employer’s perspective, group RRSPs and defined contribution pension plans are not the same. Since contributions to group RRSPs are not deducted from the payroll tax base, they are less favourable to provide than defined contribution plans. Larger companies will choose to set up defined contribution plans even though they are more costly to administer than group RRSPs. Small businesses have little choice since defined contribution plans are harder to set up for their employees.

Group RRSPs have grown very quickly in the past decade and are now as important as defined contribution pension plans. As an inducement to save for retirement, employers can contribute to a plan, often on a matching basis, thereby strongly encouraging participation. Employees can choose the type of investment on advice given by the provider. If the employee quits the firm, the amounts are transferred to individual-managed RRSPs.

Groups RRSPs can be reasonably inexpensive, especially if the funds are invested in indexed funds, although employees have often chosen to invest in actively managed funds that can be more costly. Current administrative, distribution and advisory costs are about 90 basis points on average, about 30 basis points more than defined contribution plans largely because group RRSPs are typically smaller accounts.

For employees who move from job to job, group RRSPs are much more flexible saving plans compared to defined contribution pension plans. If leaving an employer, defined contribution pension assets are kept in the plan or transferred to other pension assets or locked-in retirement accounts. Locked-in accounts require individuals to hold assets in plans until a certain age when they can be withdrawn but only up to a regulated amount (e.g. 8% of assets). While lock-in arrangements encourage plan holders to use assets only for retirement purposes, the arrangements make estate planning more difficult (for example when someone has a terminal disease) or for contingencies that come up before the age of retirement.

If contributions to group RRSPs became deductible from payroll tax bases, larger firms would likely be more willing to provide them, enabling them to be offered at a low cost. Employees might prefer them since group RRSPs are far more flexible than defined contribution plans in saving money and meeting future needs and contingencies.

Governments would see some decline in payroll tax revenues to the extent that new group RRSP plans are created, as opposed to substituting for current defined contribution pension plans whose contributions are already deducted from the payroll tax base. It could require a slight revision in CPP, EI and worker compensation payroll taxes or benefits to ensure full funding of these plans.

While eliminating the existing discrimination against group RRSPs would help many businesses to provide retirement income benefits for their employees, other policy changes would still be useful to consider.

Several experts have recommended changes to pension regulations to enable insurance companies or pension administrators to set up multi-employer plans that would enable the comingling of assets and allow a sponsor who is not the employer or employee. This would be another change giving employers and employees greater choices while achieving cost efficiencies and more risk pooling in handling their retirement accounts. Even with this form of regulatory change, it would still be quite appropriate to amend tax law to create a level-playing field among different plans.

Also, many employees worry that they could see their accumulated wealth decline when the market turns south, thereby reducing their retirement income. Defined benefit arrangements whereby employees contribute to a fund that provides a more secure retirement income, essentially by deferring their salary to retirement years, may be a preferable arrangement since employees avoid risk as much as possible.

The shift away from defined benefit pension arrangements addressed the risk faced by employers with funding shortfalls when credit becomes scarce, as witnessed with the 2008 downturn. However, as the labour force ages and employees become in short supply, many employees may wish to return to defined benefit plans to retain workers. Policies are needed to ensure that defined benefit arrangements are as viable as alternatives.

Group RRSPs may not be the best vehicle to provide defined benefit arrangements, although it is possible to develop more annuitized income arrangements for employees under these plans. As a supplement to help especially low-income workers, increases in CPP limits on a fully funded basis for existing workers might be needed if markets are unable to achieve alternative defined benefit arrangements.

Whatever reforms are being considered, it is a no-brainer to eliminate the tax discrimination against group RRSPs. It would help many businesses provide reasonable efficient retirement saving plans to their workers, especially small businesses.
Other proposals are coming in to fix the Canadian pension system. Jonathan Chevreau of the National Post reports, Pension Reform for Dummies: 5 simple "no-brainer" proposals:
This morning BMO Financial Group's BMO Retirement Institute released a paper by director of retirement strategies Tina Di Vito [pictured above] outlining five such simple changes. Those who read Tina's paper in the March issue of Policy Options may already be familiar with them. While I've borrowed the ideas from the paper, the exact wording here below is mine. You can find Di Vito's original here.

1.) Remove age restrictions for RRSPs

Currently, RRSPs have to be converted to annuities or RRIFs at age 71, or cashed out with a big tax penalty. This makes little sense in a world where mandatory retirement is a thing of the past. If Ottawa wants us to live longer and save more, it's sending us the wrong message in legislating unnecessary and unwanted RRIF payments that are fully taxable and may trigger OAS clawbacks. I agree with BMO that Canadians should decide when they need to withdraw the money from their RRIFs to live on -- it's inevitable that they will one day need to do so and when they do, the government will get its coveted tax bonanza.

2.) Reduce taxes on RRIF withdrawals

RRIF withdrawals are taxed as if they were interest/salary income even if the growth was derived from some combination of dividends and capital gains. We looked at this topic and Andrew Dunn's suggestion for fixing it in this blog last week. Di Vito is singing from the same song sheet and notes that had such growth been achieved outside registered plans, the income would have received preferred tax treatment and resulted in a lower tax rate. The current tax treatment "skews" investment behaviour in favor of sheltering the highest-taxed but lowest-yielding fixed income investments. At today's low interest rates, such retirees may not even keep up with inflation. The fix is to consider only the original RRSP contributions as "deferred employment income" while the growth in the plan should be taxed at a rate that mimics non-registered investments.

3.) Broaden opportunities for tax-free RRSP/RRIF rollover on death

Ottawa gets a big tax bonanza when a RRIF holder who is the second spouse to die passes away: the plan balance is included as taxable income in the year of the death. BMO suggests a tax-free rollover to the next generation's RRSP or RRIF. This would have huge implications for the much ballyhooed "trillion-dollar " intergenerational transfer of wealth. Of the five proposals this is the one Ottawa may balk at most and I'd think the industry would be content if 1,2, 4 and 5 were adopted at the expense of conceding number 3.

4.) Lower the rate of mandatory RRIF withdrawals

Seniors get understandably upset by the requirement to withdraw -- and be taxed on -- at least 7.38% of a RRIF's balance every year, a percentage that rises to 20% in one's 90s. These requirements were designed during an era of high interest rates but at current rates means retirees are in danger of outliving their money in old age. As medical science advances and longevity rises further, current policy puts those in their 90s at peril. As BMO says, "it is highly unlikely in today's investment world that investment returns will keep pace with the withdrawals" -- especially if invested in fixed income. To point number 2, seniors would have a better shot at it if invested in stocks but current policy motivates them to stay in low-yielding interest-bearing vehicles. BMO suggests Ottawa can extend the lives of RRIFs by lowering the withdrawal rate but doesn't specify what the new lower rate might be. I'd suggest it should be no higher than what 3- or 5-year GICs currently pay.

5.) Increase maximum contribution amounts for RRSPs

This recommendation parallels a similar one by the CD Howe Institute, as mentioned in this blog entry. BMO thinks RRSP contribution limits need to be hiked from the current 18% of earned income and $22,000 maximum to higher (but unspecified) levels. It suggests there be parity with current Defined Benefit pensions, which are able to make plan members whole in the event of investment losses. BMO notes an interesting fact I'd not seen before: that current RRSP rules favor households: a couple each earning $75,000 get combined RRSP room of $27,000 while a single taxpayer earning $150,000 can only contribute $22,000.

This particular paper focuses on just RRSPs and RRIFs but of course further tweaking is possible with the new TFSAs, of which Di Vito is a fervent advocate. We've looked before at Malcolm Hamilton's proposal to make TFSA contribution room retroactive to age 18, or to introduce a lifetime TFSA contribution room that might be some hundreds of thousands of dollars. There are also suggestions that it be made easier to make lump-sum contributions to RRSPs or TFSAs from special lifetime events like inheritance, severance and the sale of certain assets.

In short, the tools to fix a pretty-good system and make it into a world-beating system are all there now: all we need to do is get Ottawa to bring them into the 21st century. BMO's suggestions are a good place to start.
This morning, I appeared before the Senate Standing Committee on Banking, Trade and Commerce. James Pierlot, pension lawyer and consultant also presented his views. After us, the Committee heard from Kevin Milligan and Richard Shillington. The minutes of the proceedings will soon be available here.

James and I agreed on many fronts, except he was touting more the benefits of large multi-employer pension plans, whereas I was arguing more for a universal pension plan (UPP) managed by several large public defined-benefit plans (not just CPP Investment Board) spread throughout the country, and incorporating world leading governance standards.

I enjoyed this meeting but it was too short. The senators asked great questions but I feel like we only scratched the surface here. Hopefully they will invite us back so we can discuss pensions, the financial system and the economy. I thank them for giving me the opportunity to discuss my thoughts on this important issue.

Wednesday, April 21, 2010

Second Wave of Financial Crisis?

Jim Bianco warns, "Punishingly High" Interest Rates Coming in Second Wave of Financial Crisis:

As this week's earnings show, banks are once again printing money, lots of it; and most economists believe the recession is a thing of the past, even if jobs are still hard to come by.

Unfortunately, Jim Bianco President of Bianco Research in Chicago thinks this might be the eye of the storm rather than the dawn of a new day. "My fear is, history shows, we might have a second leg to the financial crisis in [the form of] a sovereign debt crisis."

The crisis is of course already visible in Greece where yields on their 10-year government bonds just hit a record high as Europe works out a bailout package for the heavily indebted nation. Meanwhile, in Portugal - another one of Europe's so-called PIIGS - bond yields are also spiking, fueling suspicion the debt crisis may spread.

With huge federal deficits, this something the U.S. also needs to worry about. "I'm not suggesting the U.S. is on the verge of defaulting," Bianco says, but the market is already signaling it's hesitation to lend to the government. Two-year notes sold by Berkshire Hathaway Inc. in February yielded less than U.S. Treasuries of similar maturity; the same is true of paper issued by Procter & Gamble, Johnson & Johnson and Lowe's, Blooomberg reports.

As growing budget crises in states and municipalities from California to New York come to a head, Bianco fears it will be too much for the Treasury to bear. "If one of these municipalities has to borrow from [the federal government] they're all going to have to borrow from them, pretty much on the same day," he speculates.

If that happens, Bianco is confident you can bet on "very high, punishingly high interest rates for the economy." And that storm may cause even more damage than the first.

The big fear is that there is so much leverage in the bond market right now, that when rates do start to rise, watch out, it could get real ugly, real fast.

Why should we be concerned about rising rates? Go back to read Paul Krugman's comment on Greece, where he ends with this ominous warning:

Equally important, however, we need to steer clear of deflation, or even excessively low inflation. Unlike Greece, we’re not stuck with someone else’s currency. But as Japan has demonstrated, even countries with their own currencies can get stuck in a deflationary trap.

What worries me most about the U.S. situation right now is the rising clamor from inflation hawks, who want the Fed to raise rates (and the federal government to pull back from stimulus) even though employment has barely started to recover. If they get their way, they’ll perpetuate mass unemployment. But that’s not all. America’s public debt will be manageable if we eventually return to vigorous growth and moderate inflation. But if the tight-money people prevail, that won’t happen — and all bets will be off.

Let's hope the liquidity party continues. If rates rise too high, too soon, we're in deep trouble. Watch out, the second half of 2010 is getting more interesting. Are pensions prepared for a second wave of financial crisis? If not, it will be another bloodbath.

Tuesday, April 20, 2010

Will SEC "Witch Hunts" Hurt the Economy?

Jim Bianco was on Yahoo Tech Ticker on Tuesday saying that SEC "Witch Hunts" Could "Hurt the Economy in the Long Run":

The party may have just ended on Wall Street. Stellar earnings from Bank of America, JP Morgan, Citigroup and Goldman Sachs are all being overshadowed by the SEC's fraud charges against Goldman.

Did the SEC just take away Wall Street’s punch bowl with this suit?

"They might have," says Jim Bianco, President of Bianco Research in Chicago.

"The structured CDO business is basically dead" but there were $40 to $50 billion of deals like this per quarter in 2007 and 2008, Bianco says, noting Goldman was just one of many banks active in the market.

If the SEC wins the Goldman case, "this would have far-reaching effects," he says. "I think they're setting a precedent for many other CDO cases and many, many other fines. Not just at Goldman but basically at all investment houses."

If the SEC makes CDOs the scapegoat for the collapse of the housing market, Bianco estimates the damages could cost Wall Street $50 to $75 billion in damages.

The bigger concern, Bianco says, is the case could freeze the securitization market, which he fears would further prevent banks from lending. "By going through these kind of witch hunts we’re just telling investors 'don’t have anything to do with this market' and it could hurt the economy in the long run."

You can watch the interview below:

Jim Bianco is one of the smartest guys I ever met during my pension fund days. I loved reading his research and I still remember when I first brought him to the Caisse back in 2000 for one of our strategic off-sites. Jim delivered a phenomenal presentation which really impressed all the senior managers.

Nevertheless, while I admire Jim's insight, I think he's wrong. He's placing way too much emphasis on the "need for securitization". Banks aren't going to dampen lending because of the absence of securitization. Banks have no incentive to lend because they're making a killing trading in their capital market operations.

And there is no "end to risk appetite". Jim should plot the chart of total hedge fund assets and the S&P 500. Importantly, there is plenty of liquidity in the financial system to drive risk assets even higher. Everyone - banks, hedge funds, pension funds, insurance funds, endowment funds, private equity funds - has vested interests to see risk assets go even higher.

The other reason why I disagree with Jim is that fraud is fraud. The SEC's so-called "witch hunts" won't affect straightforward securitization, but it will affect fraudulent or sketchy securitization. I say good riddance to super complicated structures, especially ones based on dishonest disclosure.

And it's not just the SEC who is concerned. The California Public Employees' Retirement System, which owns 1.8 million Goldman shares, said it was "disturbed" about a federal lawsuit and it also said it intended to question company executives at an upcoming meeting to discuss the way they operate.

CalPERS should ask the executives of other investment banks the same tough questions because while it's popular to scold Goldman, the truth is all the Wall Street sleazebags were engaging in equally fraudulent activities.

But what will happen to the financial sector if these "witch hunts" continue? Who cares? I hope the financial sector goes through a long-term secular bear market. We need less financial engineers, and more electrical, mechanical, chemical and software engineers. We need less complicated structured products, more transparency and new sectors should take the lead in the economy. In other words, enough of the tyranny of high finance.

Let the witch hunts continue. Besides, it's just another circus show and ultimately nothing will change on Wall Street. The sleazebags will concoct new ways to satisfy their insatiable greed.

Monday, April 19, 2010

Staving Off the Pension Crisis?

John Crocker, President & CEO of Healthcare of Ontario Pension Plan (HOOPP), writes in the Toronto Star, Staving off the pension crisis:

Canada is headed for a retirement income crisis. The last 20 years have seen a steady shift of retirement income risk from employers to workers, and studies show Canadians are not saving enough for retirement on their own.

According to experts, you need about $20 of savings for every dollar of retirement income you want to receive. So if you seek an income of $50,000 a year, you need to save $1 million. If you want $25,000 a year, you need $500,000. Yet the average Canadian has only about $60,000 in his or her RRSP at the time of retirement. RRSPs simply aren’t working for most Canadians.

As a result, I worry that as a country we are undoing decades of success at raising the standard of living for retired people and shrinking the scourge of elderly poverty.

Canadians share my concern. According to research conducted for HOOPP this month, 84 per cent of Ontarians are concerned about not having enough money for retirement. And 58 per cent believe it is principally the role of government — not individuals — to ensure Canadians have adequate incomes in retirement.

The pension puzzle: The issue is adequacy, not coverage

The magnitude of the problem is clear. However, the best, and perhaps most obvious solution — the defined benefit pension (DB) plan — is being overlooked or prematurely dismissed.

My experience at HOOPP has convinced me that defined benefit plans are viable, affordable and must be an integral part of providing retirement income security for Canadians in both the public and private sectors. Our members are not the rich of society. They are the nurses and other working people who provide us with health care. Yet they have peace of mind while working — and a decent standard of living while retired — because they have an annual retirement income that is both adequate and reliable.

Recent years have seen a shift to defined contribution (DC) plans, where employees are responsible for choosing their own investments, with no promise of exactly how much will be there for them upon retirement. Despite the significant downside for employees, DC plans have become popular among employers due to the perception they are more affordable.

It’s time to debunk the affordability myth. A 2008 study by the U.S.-based National Institute on Retirement Security found that DB plans are more affordable than DC plans, assuming the same pension payout. In both types of plans, the inputs from employer and employee are the same, but DB plans yield pension results that are three times or more those of a typical DC plan because DB plans have professional investing, pooled longevity risk, and are ageless — designed to run over the long term.

With a DC plan, the employee pays just as much in contributions — as does the employer — as they would in a DB plan. The core issue is the adequacy of the pension that is offered.

A typical DB plan’s goal is to provide replacement income equal to 67 per cent of working earnings. There’s no such target for a DC plan. They typically generate a pension of about 20 per cent of working earnings.

More DC plans, or their variants, may solve a narrowly defined “pension coverage” problem in Canada. But if one is looking to solve the retirement income crisis that looms ahead, DC plans will not cut it. Well-run defined benefit pension plans will.

The solution: Enable multi-employer private plans

That is why I am calling on governments to enable the formation of large, multi-employer defined benefit pension plans to provide pensions for workers in the private sector.

These funds could be set up either by sector, industry or region. Employees would contribute up to 10 per cent of their salaries to the plan, and employers would match their contributions.

The multi-employer model provides a number of significant advantages. The liability would not be carried on any one company’s balance sheet, making participation more attractive for private corporations. No longer would the full weight of funding be on one set of corporate shoulders. The most important would be meaningful replacement income for every employee upon retirement — not a process where the employee is left on his or her own.

There are two public policy barriers that must be overcome. First, government must change pension funding rules that allow employers to stop contributing when times are good, thus creating problems when the economy worsens. Second, we must abandon the use of “point-in-time” accounting for valuations of pension plans. While plans are designed for the long term, the use of this “snapshot” approach can lead a plan to be found insolvent even when it can pay everyone their entitled benefits. Yet the plan must still “fix” the solvency — spending time and effort on an artificial, technical problem.

Providing every citizen with a livable retirement income will be critical to both Canada’s prosperity and our social cohesion in the 21st century.

The good news is that the solution is in our grasp. Governments must act now to get the rules right, and to show leadership in encouraging the development of new multi-employer DB plans to serve more Canadians.

Together, we need to fix our pension system so that it looks after the retirement income needs of our citizens. If we focus on the right issue — adequacy — we can build a sustainable retirement system that makes sound business sense, while meeting allowing Canadians to retire with dignity and independence.

Mr. Crocker is absolutely right on the benefits of DB plans. Of course, HOOPP is a private DB pension plan, which is why he is calling on governments to enable the formation of large, multi-employer defined benefit pension plans to provide pensions for workers in the private sector.

But what if we were able to offer every Canadian an affordable public defined benefit pension plan? Why not allow private companies to focus on their businesses and leave pensions in the public domain? Companies can still contribute part of the money but they would be offloading the risk of a pension deficit - or worse in the case of a bankruptcy - to the federal or provincial government.

I am tossing ideas out here. Sure, some companies like CN might refuse because they're happy with the way their pensions are being managed, but most other large companies would probably jump on the idea of offloading their pension risk to a universal public pension plan.

If this idea is too radical, then I am all for large, multi-employer defined benefit pension plans to provide pensions for workers in the private sector. Again, we need to make sure these plans are well governed, but this idea also has merits.

It's just that I prefer pushing the envelope even further than Mr. Crocker and saying that pensions need to be a public good, much like we treat healthcare in Canada. There will always be a private system but the dominant system providing pensions for Canadians should be public.

This is my ultimate vision for improving our pension system and I believe we have the collective resources and brain power to achieve this social goal. So let's get on with it. The longer we wait, the harder it will be to create a sustainable retirement system allowing Canadians to retire with dignity and independence.