Monday, May 31, 2010

Will Canada Lead G7 Rate Hikes?

Reuters reports, World trade growth slows in 1st qtr:

Global trade volumes in the first three months of this year were 5.3 percent higher than in the previous quarter, representing slightly slower growth than in recent months but still a healthy rebound from the crisis, data from the Dutch CPB institute showed on Monday.

The CPB, whose data are used by the European Commission and World Bank, said world trade in the three months ended February had grown by 5.8 percent over the previous three months and grown 6.0 percent in the last quarter of 2009.

Trade growth remained strongest in Asia and Latin America, but was relatively low in the euro area, it said in its latest monthly world trade monitor.

On the more volatile monthly figures, world trade volumes were 3.5 percent higher in March than in February, when they grew 1.7 percent.

Trade volumes grew worldwide except for Japanese imports, and both imports and exports in the euro area were strong.

World trade in March was 4 percent below the peak reached in April 2008 and 21 percent above the trough seen in May 2009.

The CPB report also showed a pickup in world industrial production:

On the basis of preliminary data, world industrial production grew by 0.2% in March 2010, following an unrevised 1.0% increase in February. Production continues to grow in all regions, emerging Asia excepted. In March, industrial production was 1.9% below the peak level reached in March 2008. It has risen by an accumulated 12% from the March 2009 trough. In the first quarter of 2010 production was up by 10.9% on year ago, the highest such value in our series (which start in 1991).
Robust global trade helped Canada register a record 6.1% gain in Canadian GDP during Q1. Phred Dvorak of the WSJ reports, Canada's Growth Sets Stage for Rate Increase:

Canada's economy grew at the fastest pace in more than a decade during the first quarter of this year, a stronger-than-expected performance that cemented expectations of an interest-rate increase on Tuesday.

Gross domestic product rose an annualized 6.1% during the three months ended March 31, fueled by continued growth in consumer spending and manufacturing, Statistics Canada said. That growth was more than double what the U.S. economy reported during the same period, and stronger than both the Bank of Canada and analysts' consensus forecasts of 5.8%. It contrasts sharply with an annualized contraction of 7% a year earlier, in the first quarter of 2009.

The strong performance highlights how Canada's healthy financial system and relatively unscathed consumers have underpinned a fast rebound from the downturn of the past two years. Consumer price levels, job creation and housing sales are all rising in Canada, pointing to a solid recovery, even as peers like the U.S. see falling inflation and uncertain consumer demand.

The robust economic growth also sets the stage for what is expected to be the first interest-rate increase among the Group of Seven wealthy nations following the financial crisis. The Bank of Canada is widely expected to say at its Tuesday policy announcement that it is raising its target overnight interest rate by 25 basis points, or hundredths of a percentage point, to 0.5%. Many expect that tightening to continue, raising the overnight rate to 1.5% by the end of the year, according to a survey of economists by Dow Jones.

Some central bank watchers warn there are risks to tightening interest rates in Canada now. The situation in Europe remains volatile after fears of a Greek debt default prompted a bailout from the European Union, followed by credit downgrades of countries such as Spain and Portugal. Banks report that credit is tightening again and global equity markets have weakened.

"Even though the lagging economic data have improved measurably, there has already been enough of a tightening of economic conditions to allow the bank to sit back and assess how the debt crisis unfolds," says David Rosenberg, chief economist at wealth manager Gluskin Sheff & Associates Inc. in Toronto.

Mr. Rosenberg warns that if the Bank of Canada raises rates and global credit markets weaken further, it may have to reverse course, as it did in 2002—the last time it raised rates ahead of the U.S. Federal Reserve.

Most economists also expect Canada's growth to cool down on its own. Some measures that the government implemented to boost consumption—including a popular tax break on home renovations—have expired. Roaring housing sales are slowing as mortgage rates and prices rise. Canada is unlikely to sustain the rapid inventory buildups and high levels of consumer demand that characterized the first quarter, says Douglas Porter, an economist at BMO Capital Markets in Toronto, who is forecasting GDP growth of 3.4% for all of 2010.

Mr. Porter, though, still expects the Bank of Canada to start raising rates on Tuesday—even if it pauses later in the year.

"I have a lot of empathy for how hard the decision is," he says. "But I think the domestic case is so strong that they should be raising interest rates."

I think Mr. Porter is right, the Bank of Canada will likely raise rates on Tuesday. I met up with one of the best economists in Canada during lunch on Monday and he told me that he sees the Bank raising rates as well.

As far as the US is concerned, he told me that strong productivity growth is allowing the Fed to remain on the sidelines "till September", but after that they too will start raising rates.

In fact, he told me that policy rates around the world "are way too accommodative" and that too many bears are focused on events in Europe without understanding the improving fundamentals in the US. He's waiting for a payroll figure of over 500,000 on Friday, and I think it might even be higher.

Anyway you slice it, fundamentals are improving, and rate hikes need to take place to remove some of the excess stimulus that was put in place to fight off the recession. It looks like Canada will be the first among the G7 to start hiking rates. It will be gradual, but expect more rate hikes ahead in Canada and elsewhere.

Sunday, May 30, 2010

Beyond Market Turbulence

As a follow-up to my last comment, David Parkinson of the Globe & Mail reports, Despite the turbulence, strategists stay bullish:

The sight of slumping stock prices hasn’t shaken most market strategists’ confidence that the bull market still has further to fly. But they warn investors to buckle up – we could be in for plenty of turbulence.

In the wake of a selloff that has knocked the U.S. benchmark S&P 500 stock index into official “correction” territory (a drop of more than 10 per cent) in the space of a month while lopping 7 per cent off Canada’s S&P/TSX composite, strategists on Wall and Bay streets are reminding clients that the size of this correction is nothing out of the ordinary in a post-recession bull market. What’s more, they insist that the selling is being driven by fear rather than fundamentals – meaning that markets with solid growth prospects are merely getting cheaper and creating buying opportunities.

“It is difficult to be very bearish of corporate assets when growth is reasonably strong, inflation is low, margins are expanding, monetary policies are easy, and valuations are undemanding,” said economist Larry Hatheway of UBS Ltd. in London.

“In the first four months of this year, investors had become increasingly complacent to risk,” he said. “This was a market vulnerable to correction – all that was missing was a catalyst.”

However, that catalyst – a major sovereign-debt scare out of Europe – has re-awakened investors’ hyper-sensitivity to risk, a lingering effect of the credit crisis of 2008-09. The depth and speed of this risk adjustment does suggest that even if stocks can track generally higher in the coming months, they may do so in a very moody, volatile way.

“People are now a lot faster on the trigger in reducing risk. This increased volatility could be a byproduct of a new way of managing portfolios,” said Stéfane Marion, chief strategist at National Bank Financial in Montreal.

“But we have to keep things in perspective. We haven’t yet seen the collateral damage [from the European debt woes] that would upset global growth.

“In a world where credit markets remain functional, I don’t think the amount of selling we’ve seen can be justified,” he said. “The valuations we have right now are very reasonable.”

George Vasic, chief strategist for UBS Securities Canada Inc., noted in a research report that over the past 50 years, post-bear-market rallies on the Toronto Stock Exchange have all been met with corrections on the scale of what we’ve seen recently; the average pullback has been 13 per cent. Similarly, Pierre Lapointe, global macro strategist at Brockhouse & Cooper Inc. in Montreal, said the S&P 500 has routinely rallied in the year after the end of a recession, yet those rallies have all included a considerable correction within them, averaging 17 per cent.

“The next few months will remain volatile, but history tells us that the year that follows a recession is usually very profitable for equities,” said Mr. Lapointe, who reiterated his overweight recommendation on global equities.

David Bianco, chief U.S. equity strategist at Bank of America-Merrill Lynch in New York, is among several strategists who issued research notes in the past few days reiterating their earnings and stock-index targets over the next 12 to 18 months. His 12-month target for the S&P 500 remains at 1,350, a whopping 25 per cent above Tuesday’s closing levels.

He said the current S&P 500 levels imply a price-to-earnings multiple of about 12 times, far below the historical norm of 15 times. At normal P/Es, current levels are pricing in S&P 500 earnings of just $72 (U.S.) a share for 2011 – almost 20 per cent below Mr. Bianco’s “base-case” forecast, and toward the low end of his worst-case projections in the case of another global recession.

“Times like this make it clear that the risk equity premium is no free lunch, and volatility is gut-wrenching, even for the most long-term investors,” he said. “[But] we believe the best way to feel better during a correction is to buy some shares.”

I think volatility is here to stay. Itchy traders selling at the first sign of weakness, memories of 2008, and way too much risk management stifling the large portfolios, forcing managers to cut positions when the VIX rises, are all wreaking havoc on markets. Add to this market disinformation usually spread by large investment houses or their large hedge fund clients looking to capitalize on volatility, and you come away thinking that maybe the month of May is a harbinger of things to come.

But the reality is that US fundamentals have turned the corner. Allan Robinson of the Globe & Mail reports, U.S. consumers could give global stocks a lift:

The bull market needs some fuel and that will come once the U.S. jobs picture improves, incomes start to rise and consumer spending revives, strategists say.

“History tells us that a peak in the U.S. unemployment rate has the potential to sustain the equity rally – globally,” said Pierre Lapointe, a global macro strategist with Brockhouse Cooper. “We have calculated that every time the unemployment rate peaks after a business cycle, the post-recession global rally gets a second wind.”

Basically, investors bet on a recovery. “Investors realize if the jobs market gets better that means consumers will start spending again and that means profits down the road,” Mr. Lapointe said.

What is the market looking for now?

After three solid months of increased spending, economists are looking for consumers to take a breather and investors may need to be patient. Personal spending data scheduled for release Friday is forecast to have increased 0.3 per cent during April, compared with a lofty 0.6 per cent rise in March, according to a survey of economists by Bloomberg.

On the plus side, personal income is expected to have crept higher rising 0.4 per cent in April, compared with 0.3 per cent in March.

Another positive for U.S. consumers is that they have had no reason to be worried about rising prices. The personal consumption expenditures inflation data, known as the PCE deflator, measure price changes for a broad range of goods and services, excluding food and energy. The deflator also due out Friday is forecast to have declined to a 47-year low of 1.1 per cent in April, well below the U.S. Federal Reserve Board’s long-run forecast of 1.7 per cent to 2 per cent, according to BMO Nesbitt Burns Inc.

“The sharp turnaround in the labour market in recent months suggests that incomes will soon start to rise more significantly,” said Paul Dales, the U.S. economist for Capital Economics Ltd. “This will allow households to raise their savings rate without too much of a slowdown in consumption growth,” he said.

How will the market react?

So far stock markets have not reflected that bullish scenario. Investors have been preoccupied with sovereign risks concerns, which has driven stock markets lower. Last week the VIX, a measure of equity volatility, soared to 45.79 but this week it plunged to about 30.

“Only on five occasions in the past 25 years has the VIX reached such heights,” said Carmine Grigoli, chief investment strategist with Mizuho Securities USA Inc. Such elevated readings suggest emotional selling and on average the stock market has jumped 26 per cent in the following year.

And Brockhouse Cooper’s Mr. Lapointe said that on average six months after U.S. unemployment levels peak (in October, 2009) global markets increased 9.4 per cent, compared with the recent 1.1-per-cent decline. “One year after the unemployment rate peak, global equities were up 17 per cent on average,” he said.

It's easy to get all flustered in these markets. With volatility on the rise, more uncertainty over Europe's future, stocks coming off one of the worst months, it's no wonder everyone is pessimistic and bearish.

But if you look beyond the turbulence, and focus on the improving fundamentals, then a different picture emerges. To be sure, the big beta moves of 2009 are over, but going forward, there will be money to be made if you pick your stocks and sectors right. That much I'm sure of.

Below, William Greiner, chief investment officer at Scout Investment Advisors, talks with Bloomberg's Matt Miller and Carol Massar about the outlook for U.S. inflation. Greiner also discusses the outlook for U.S. stocks, corporate earnings and Europe's financial crisis.

Saturday, May 29, 2010

Relax! It's Not as Bad as You Think!

Stocks closed out their worst month in more than a year by sliding again on more unsettling news about Europe, including a downgrade of Spain. The old adage "sell in May and go away" seems to be absolutely right on the money again.

But not everyone is buying all the gloom & doom. James Altucher, president of Formula Capital, was on Tech Ticker on Friday stating that the U.S. recovery is better than a V and look for new highs in 2012:

The debt crisis in Europe likely spells slower growth across the Atlantic. China is taking steps to put the brakes on its runaway economy and the U.S. housing market still looks weak. There's seemingly plenty of reasons to be a stock market bear, especially after the run we've had over the last year.

Nonsense, says James Altucher, president of Formula Capital. The economy and market will continue to surprise, he tells Aaron in this clip. In fact, he's calling for a 'checkmark'-shaped recovery, stronger than the ‘V’ we hear so much about. "The debate is over, it’s already been a V, now the question is, does it continue? I think it does," he says.

Why is he so confident?

  • -- The job market is improving. “We've seen temp workers go up for seven months in a row," the fastest pace since 2004. Average pay and hours worked are up and the U.S. added 290,000 jobs last month, the biggest jump in four years. Plus, he notes, “jobs in self-employed positions and start-up businesses have jumped by 1.9 million in the past four months."
  • -- Car sales are up by 25% in April compared to a year ago. “How did Toyota have 27% year over year car sales increase?"
  • -- Pending home sale are up 21% year over year.

Altucher is confident all this will translate into record profits and an all-time high on the S&P 500 by the end of next year. "I know people are going to laugh," but the proof is in the pudding, he says.

How do you make money on this?

"Play the triple play companies. The ones that beat earnings, beat on revenues and guided up," he says. At the top of his list are Intel, Starwood Hotels, Humana, Intel, EMC and IBM.

Watch the interview below:

Mr. Althucher might be a little too optimistic, but he is right that the fundamentals have drastically improved in the last 12 months. On my blog, I provide a link to the Dallas Fed's US economic data. I would urge you to keep an eye on the charts when trying to gauge fundamentals.

But what about Europe's sovereign debt woes? Mr. Altucher says "relax", we've been through much worse than this:

Europe’s sovereign debt crisis has wrecked havoc on the markets in the last few months. We’ve had a spike in the VIX, aka the fear index, the flash crash and many global markets are now back in bear market territory. In the U.S. were on track for the worst May in half a century.

The wild market action has many investors wondering: How will we get out of this mess?

"Everybody needs to just relax a little bit," says James Altucher, president of Formula Capital. "This is not Argentina, this is not Zimbabwe."

The market has been through much worse than this in the past 30 years and Altucher believes the economy and stocks will remain resilient.

When has it been worse?

  • --In 1982-83 Brazil, Mexico, Venezuela and most of Latin America all defaulted or, came close to defaulting. "The whole world was going bankrupt and we were coming out of the Volcker led recession from the early '80s where he was fighting inflation," he notes. Guess what? After a bailout – U.S. markets were up 49% those two years.
  • -- 1987’s Black Monday. Think the 'flash crash' was frightening? On October 19th, 1987, the Dow fell 22%. In a single day! Hong Kong markets fell 45% on that day, alone.
  • --1997’s Asian financial crisis lead to Russia debt default in the following year and the collapse of hedge fund Long Term Capital Management. Talk about contagion.
  • -- September 11th, 2001. "It seemed like the world was ending, it was the scariest thing that happened to me, at least, in my lifetime, and it was horrible for the country," Altucher recalls. "And, we were in the middle of a recession."

Bailouts and quantitative easing followed most of these previous crises. But our current predicament comes after we've already had the biggest bailout in history and rates can't go lower. Altucher has a retort to that concern too, noting half the stimulus package hasn't been spent yet. In fact, he's more concerned that using the rest of the funds will create another bubble and lead to higher inflation.

That's a problem the Fed might look forward to.

Watch the interview below:

I also think that longer-term, the structural changes taking place in Europe will benefit the global economy. As for the next bubble, I agree that it's only a matter of time before the liquidity tsunami pushes risk assets much, much higher.

My bet is that the next bubble will be in alternative energy, especially Chinese solar stocks. In fact, I love all solar stocks at these levels and I see a secular bull market in this sector. The overall market might be range bound, but again, Mr. Altucher is right, some large caps are making solid earnings and their cash positions are indicative of solid fundamentals.

Finally, Bill Ackman of Pershing Square Capital Management, a well known bear, was also on Tech Ticker saying that he's bullish on America and Citigroup:
In April 2009, Bill Ackman of Pershing Square Capital Management said America had suffered "the equivalent of a heart attack, but now we are in recovery, hopefully. It takes time to heal."

Fast forward 13 months and, "yes," America has healed, Ackman says.

Furthermore, "I think the market's not particularly expensive," the famed activist hedge fund manager declares. "Look at large-cap, very high quality businesses today [and] they seem pretty cheap to me. "

Much to everyone's surprise - including Ackman's - those "very high quality businesses" include Citigroup. On Wednesday, the day after Treasury announced the sale of 1.5 billion shares of Citi stock, Ackman stunned Wall Street by revealing his firm has taken a big stake in the big bank.

With theatrical flair, Ackman made the announcement as a throwaway line at the end of his presentation at the 15th annual Ira Sohn investment research conference in New York: "And by the way, we bought about 150 million shares of Citigroup, but I don't have time to talk about it," he said, according to multiple reports.

And by the way, when Ackman and Bloomberg reporter Christine Richard joined us this morning to talk about Confidence Game, a new book about Ackman's public battle with MBIA (and regulators), I just had to ask him about the Citigroup position.

The Bull Case for Citigroup

"If you had asked me a year ago ‘could I conceive of owning Citi 12 months later?', I couldn't conceive of owning the company," he says. "It was hard for me to even look at it in light of a year ago."

Upon further review - and while admitting "there are still question marks" -- Ackman determined Citi was attractive based (in part) on the following:

  • -- Money Talks: Thanks in large part to the government's conversion of its preferred stake in Citi to common stock in 2009, Citigroup is "probably one of the best capitalized banks today, ironically," Ackman says.
  • -- Free Money Is Even Better: Because Ben Bernanke has kept the fed funds rate effectively at zero, banks like Citigroup "effectively they've got free money," Ackman says. Furthermore, "it's a great time to make loans - they can earn attractive spreads" because collateral values are down and lending standards are up.
  • -- Franchise Value: Despite hits to its reputation in recent years, Citigroup still has a "great deposit franchise" and a "very well capitalized balance sheet," the fund manager says. In addition, he notes off camera Citi has less exposure to home equity loans than most of its big competitors.

In sum, "it's really a great time to be in the banking business," Ackman says.

Watch the accompanying video below for more about Ackman's take on Citigroup, General Growth Properties and other investments -- and stay tuned for additional segments where Ackman and Richards discuss Confidence Game and the ongoing war against the shorts.

Mr. Ackman is not the only hedge fund manager bullish on Citigroup. If you peruse through the holdings of other top funds, you'll see many others are also long Citiroup. I will update that list of funds over the weekend, but there is enough info there to give you an indication that the top funds are still bullish and long risk assets.

So relax, the world is not coming to an end. It's going to be volatile, there will be more fear mongering and manipulation by the big hedge funds (they thrive on vol), but at the end of the day, the fundamentals are improving and stocks will grind higher. Some sectors will soar higher.

I too am bullish on America and the rest of the world. Put away your crash helmets and enjoy the long weekend.

Thursday, May 27, 2010

Easy Money, Hard Truths?

I want to share with you comments on my last entry on a pension chief's exit. A senior pension fund manager emailed me with some important observations which I will share with you (some comments are edited out):

Here are some things you may want to consider in shaping your argument:

I believe that economies of scale are important in asset management so having public sector related funds operate at arm's length on competitive terms is a good thing.

Moving from a fund to a supplier is a bit much, but what drove the guy out is problematic as well.

The public seems more worked up about paying internal managers for performance than paying external managers double or triple regardless of performance

This year, my internal team added 600 million over public market benchmarks and may get 10 million (in addition to about 10 in wages and benefits); external managers lost 500 million relative to market and their fees are related to assets and amount to 120 million. Want to guess what the headlines will be?

On benchmarks my landing spot is that the simplest way to implement a policy is with index funds. Return will be index - implementation costs.

If you run an active program, incremental return on incremental risk has to be attractive.

Most of the time incremental risk is actually insignificant or negative. A good active manager tries to improve on market return/risk and cap weighted markets are not quite risk efficient. Consequently, active risk tends to be negatively correlated with the market.

Benchmarks for unlisted assets are tough. Has nothing to do with fraud in most cases.

In any case the principle has to be that it will do better that the listed assets it displaces. Private equity should improve on listed equity adjusted for leverage.

For infrastructure and timber we know that the unlevered return is typically between stocks and bonds once the market becomes reasonably efficient. I think it should do better than some combination of stocks and RRBs.

Hedge funds are a hodge podge. Few can deliver uncorrelated return on risk. The HFRX usually tracks global equities except for 2000-2003

Annual value added does not tell you much. Good active programs can easily be negative 1 year out of 4. My experience is that longer periods are better.

The 4 year rule was chosen by most funds because that is all CRA allowed. I proposed a perpetual inventory method over ten years ago. It now appears that this may fly as long as the balance is at risk.

I feel that something like 5 cents per dollar of net value added over net index return is fair to clients and managers if incremental risk is insignificant.

Typically, if you can do something for x internally, you pay 3x or 5x externally.

If the public really prefers to pay more for what it cannot see, vs less for what it can see, more power too them.

My goal is to squeeze margin out of total asset management and increase net return to my clients.

No one care who gets paid what as a percent of a reasonable price of toothpaste. All we consider is whether the toothpaste does the job. Why should we care in pension management.

If I can deliver an extra 1 or 2 % over market with an all in total pension asset management cost of 30 bps my clients should be well served, and that is the only criterion that should matter.

But it seems that doing so will get you vilified by all sides: you make more than the Prime Minister (so the public thinks you are overpaid), and you cut into the external manager industry income.

And he added :

We have been arguing over comp since Plato.

As I recall he thought philosopher kings were the most deserving. I am not sure what the right answer is.

However, there is a market for talent out there, and it works reasonably well. I have to compete with what external managers pay as well as what the public plans pay.

Like it or not, comp systems have to hold on to people in bad times and good. There will always be some optionality involved.

The comparisons at any point in time are not always very easy.

Benchmarks are one issue.

Maturity of portfolios (J-curve effects) can be important.

Legacy portfolios when you have a new manager coming in.

All these things average out over longer periods.

The smell test is net investment cost in bps. For a 60-100 billion fund that should be in the 30-40 bps range. Bonuses usually are a very small part of that.

I have financed all the corporate remedial investment in operations and investment out of a 40 million cut in fees so far.

Yet the argument has not been over fees or net costs but over whether I should be paid more or less than a mediocre hockey player. If I sound cynical it is because I have become so.

We need more focus on the forest, less on individual trees.

The comments above come from one of the wisest people in the pension industry. He is absolutely right to say that too much focus goes on internal compensation and not on external fees.

At the end of the day, what counts is returns net of all fees. If you can bring assets internally, deliver alpha and cut a huge chunk of external manager fees, then all power to you. Moreover, if you're adding value over a long period using appropriate benchmarks in all asset classes, then you deserve to be paid for this added value.

What gets under my skin is when I see pension fund managers getting paid big bonuses for what is essentially leveraged beta. The leverage can come internally through alpha strategies using derivatives or externally through hedge fund or private equity funds taking huge leveraged bets on markets. It doesn't matter where it comes from - at the end of the day leveraged beta is beta, not alpha, and we shouldn't pay big bonuses for it. Quite simply, benchmarks must reflect the risks taken in each investment activity.

As far as costs are concerned, the senior pension fund manager is right, the smell test is investment cost in basis points. All public funds should report these costs clearly in their annual reports.

Finally, take the time to read David Einhorn's op-ed article in the NYT, Easy Money, Hard Truths. Some have criticized Mr. Einhorn for "blatant gold book talking", but he makes several important observations and asks a very simple question:
At what level of government debt and future commitments does government default go from being unthinkable to inevitable, and how does our government think about that risk?
As Congress weighs a pension bailout, I fear that they're past the point of thinking about that risk. In my mind, it's crystal clear. Financial oligarchs and their political puppets are doing everything in their power to reflate risk assets hoping that it will translate into moderate (or severe) inflation for the economic system. Their biggest fear is debt deflation, and if their gambles don't work, they're going to get get it sooner than they think.

Wednesday, May 26, 2010

Ties Surface in Pension Chief's Exit

Michael Syre of the Boston Globe reports, Pension chief says he’ll quit over pay:
Michael Travaglini, who as head of the state’s pension fund is among the highest-paid government employees in Massachusetts, plans to quit next month, citing as a reason efforts by legislators to limit what he and his staff can earn.

In his six-year tenure as executive director, Massachusetts Pension Reserves Investment Management ran one of the top-rated public pension funds in the nation — until last year, when losses from the financial crisis made it one of the worst.

Prior to that downturn, the pension fund’s high performance earned Travaglini a $64,000 bonus in 2008, on top of his $322,000 salary. But now he cites the legislative backlash to that bonus system as a factor in his decision to leave June 11 and go to work for a Chicago investment firm.

“The issue of incentive compensation here is back on the front burner,’’ said Travaglini, who will formally announce his resignation June 1. “If you need the context for my decision, it’s an entirely personal one. I have a wife and three children, and I’m going to provide for them.’’

Under the bonus system, which Travaglini helped to create three years ago, he can make as much as 40 percent more if the pension fund exceeds certain investment benchmarks on a three-year basis. Bonuses for other pension fund employees range from 30 percent to 40 percent.

Travaglini said two legislative proposals would limit such bonuses, and thus make it harder to attract and retain talent to run the state’s $44 billion pension fund. One would limit the ability of state workers to earn more than the governor, whose annual salary is $143,000. Another would block bonuses for the years in which the fund lost money, regardless of how it performed against its benchmarks.

“Someone else can hang around for that, but it’s not going to be Mike Travaglini,’’ said Travaglini.

“Most people will say, ‘Good riddance. If you want to make more money, go do it in the private sector,’ and that’s what I’m going to do. But there’s a real threat to not being able to recruit and retain competent people here.’’

He added: “People can vote with their feet, and that’s what I’m doing.’’

Travaglini also bristled at the campaign ads aimed at Timothy Cahill, the state treasurer and gubernatorial candidate who also serves as chairman of the Pension Reserves Investment Management board. The ads, financed by the Republican Governors Association, say the state paid out performance bonuses when the pension fund lost billions in 2008.

The ads, he said, are “false’’ and “irresponsible.’’

The bonuses were paid in September 2008 and were based on the fund’s performance for the three-year period that ended June 30, 2008. The Massachusetts fund ranked among the top 5 percent of comparable funds for that three-year period, according to Wilshire Associates, which rates pension fund returns.

But the one-year return for fiscal 2008 was not so great. Massachusetts lost 1.81 percent that year, but still placed among the top 20 percent for comparable funds for the one-year period.

Cahill did not respond to requests for comment.

The Massachusetts pension fund has performed relatively well under Travaglini’s leadership, which started in 2004. He earned double-digit investment returns in each of his first three years.

But the fund lost 23.9 percent in the fiscal year that ended in June 2009, its worst performance ever. The fund had more invested in equities than other pension funds during a period when global stock markets plummeted because of the credit crisis and banking failures.

For that one-year performance alone, the Massachusetts fund ranked in the 99th percentile of Wilshire’s ratings.

Travaglini — a veteran state operative whose brother Robert is a former state Senate president — will join Grosvenor Capital Management as a managing director for business development, pitching Grosvenor’s hedge fund investments to public pension funds.

Travaglini’s bonus plan for pension fund employees has been controversial from the start, when he initially advocated for an even richer arrangement. But it has had relatively little impact so far, with none being paid last year and none expected this year, Travaglini said.

The plan rewards his employees if the fund’s performance exceeds the returns of investment indexes that reflect the mix of the state’s pension assets. Employees could earn bonuses if the pension fund loses money in a given year, so long as its decline is less than the indexes. On the other hand, if the fund makes money, but not enough to match the indexes, employees do not get bonuses.

Travaglini said a bonus system based on relative performance, not on whether the fund earns an investment profit, is important to reward employees who add value rather than pursue excessively conservative strategies.

“If there’s no added value, there’s no bonuses,’’ Travaglini said. “My naive view is that relative performance was always going to be looked at. Now, in this environment, it’s not about relative performance.’’

Mr. Travaglini is wasting his time with US public pension funds. If he wants the big bonuses based on bogus benchmarks, he should try landing a job with a Canadian public pension fund. There's a reason why CPPIB's managers were smiling last year.

And this year is no different. I perused through the CPPIB's 2010 Annual Report, and right on page 73, we see total compensation doled out to CPPIB's senior management:

(click on image to enlarge)

As you can see, we pay our public pension fund managers big bucks in Canada. I can assure you David Denison, Mark Wiseman, Grame Eadie and Don Raymond make a lot more than the Prime Minister of Canada or any other public service or Crown Corporation employee (except, of course, for their cousins in Montreal, PSP Investments which are anxious to make as much).

Even better, their bonuses are based on four-year rolling returns, not three year rolling returns, ensuring a handsome payday even when the Fund gets whacked hard as it did in FY2009.

It gets even better. Neither CPPIB nor PSPIB clearly present their benchmarks for private markets. When pressed for an explanation as to why this is, PSP's president , Gordon Fyfe, gave a convoluted answer to NDP finance critic, Thomas Mulcair.

Back to Travaglini. While we grossly overpay our public pension fund managers here in Canada, in the US, they grossly underpay them, leaving public funds exposed to fraud and abuse. Travaglini's bonus system was reasonable (except for bonuses when the Fund loses money), but in the US, politics trumps reason. So they end up getting what they pay for - mediocre public pension fund managers delivering mediocre results.

But there is something else that concerns me in this whole Travaglini affair. Michael Norton of the Boston Herald reports, Ties surface in pension chief’s exit:
The Chicago-based hedge fund hiring Michael Travaglini away from the state pension management team survived the pension fund’s downsizing of its hedge-fund portfolio last fall and landed a major asset management contract under his watch, the State House News Service has learned.

Grosvenor Capital Management was one of five firms slated to manage the Pension Reserve Investment Trust board’s $3.2 billion in hedge-fund assets last fall.

The board, chaired by state Treasurer Tim Cahill, last October axed four hedge fund managers - The Blackstone Group, E.I.M, Strategic Investment Group and Crestline Investors Inc. - as it reduced its investments in hedge funds to 8 percent of all assets, down from 11 percent. It placed the remaining $3.2 billion with Grosvenor and four other firms: Arden Asset Management, K2 Funds, Pacific Alternative Asset Management Company and The Rock Creek Group.

Grosvenor emerged from the asset allocation shake-up with $616 million in PRIT funds under management, according to state pension fund documents.

In an April 6, 2010 letter to the treasurer and State Ethics Commission, Travaglini stated he would be discussing employment with Grosvenor and recused himself from further dealings with the firm. Travaglini, the fund’s director since 2004, earns $322,000 a year and is leaving June 11. The board will meet June 1 to discuss a succession plan, Cahill said in a statement yesterday.

This sort of stuff should never be allowed. There should be clauses barring senior pension fund managers from joining any fund they allocate money to for a minimum three year period. This is all part of pension governance 101, and it makes me sick to my stomach seeing this sort of nonsense going on time and time again.

Unfortunately, it also takes place here in Canada. In fact, I'd like to see the Auditor General of Canada stop fussing over over the expenses of members of Parliament, and start fussing over expenses at Canadian public pension funds, and closely examine ties between senior public pension fund managers and the private funds they allocate to.

The truth is that way too many shenanigans are routinely taking place and taxpayers deserve to know what the hell is going on at these large funds. As I've said repeatedly, financial audits are simply not enough. These public funds should be subjected to comprehensive performance, fraud and operational audits every year and the results of these independent audits should be publicly available. Amazingly, MPs' expense reports seem to be a more pressing concern!!!

Bailing Out Union Pension Funds?

Megan McArdle of the Atlantic asks, Should the Government Bail Out Union Pension Funds?:
Fox Business has made something of a splash claiming that Senator Casey has introduced a bill to bail out union pensions that will cost $165 billion. Media Matters lashes back, arguing that the bill will only cost $8-10 billion and isn't a bailout. Who's right?

As so often with these things, the truth is somewhere in between.

The bill in question will essentially let multi-employer union pension plans, like the Teamster's plan that is currently causing UPS so much trouble, segregate out the workers of defunct companies and get the Pension Benefit Guarantee Corp to pony up for their benefits. Media Matters says that the bailout won't cost $165 billion, and they're right; that's the total liabilities of the plan. Theoretically, it could cost $165 billion if every single employer went bankrupt, but that's not a very likely scenario.

However, Media Matters also says it's not a bailout, which is silly. When you give someone money because they've gotten their finances into an untenable state, that's a bailout. $8-10 billion is double the current level of underfunding in the PBGC, and that's just the undoubtedly rosy number cited by Senator Casey. If the funding levels of the MEPs get worse (as is possible, even likely) it will cost more.

More to the point, the multi-employer plans have not paid any premiums for the benefits Senator Casey now wants to give them. The PBGC provides insurance (for which it does not charge adequate premiums, but that is another rant.) It is not a charitable institution.

The whole point of a multi-employer plan is to pool the risk, and ensure that workers do not lose benefits merely because they have transferred around. It is true that there are now big shortfalls in these plans, and the bankrupt employers are (definitionally) not around to help the going concerns make up their losses. That makes it difficult to convince firms that they should, say, employ teamsters.

But while there's a certain amount of unfairness to this, I don't see why it's more fair to get the taxpayers to suck up the bill. The employers knew what they were getting into. So did the unions. The PBGC exists to shelter workers from total destitution in the event that their pension fund does not have resources to meet its obligations, and there is no going concern behind the fund able to make up the shortfall. It does not exist to make UPS more profitable, or more competitive with UPS.
F. Vincent Vernuccio and Jeremy Lott examined this further in the Washington Post, Look for the union fable:

Flanked by representatives from the International Brotherhood of Teamsters, YRC Transportation and ABF Freight Systems, Sen. Bob Casey, Pennsylvania Democrat, proposed a massive bailout for the Teamsters' and other union pension funds on March 22. The deceptively named Create Jobs and Save Benefits Act of 2010 (the Save Adorable Fluffy Bunnies Act was taken, apparently) should really be called the Bail Out Irresponsible Unions Act. That is exactly what the bill would do.

After denying for years that their pension funds were in trouble, labor unions of late have been forced to admit that union-managed multi-employer pension funds are in wretched shape. Moody's Investor Services estimated multi-employer pensions were underfunded by $165 billion in 2009. Because of labor mismanagement, millions of current and former workers' retirements are in real danger. Labor is doing everything it can to buy time and shift the blame elsewhere.

The Teamsters' Central States Fund has been woefully underfunded for years. It had only 47 cents on every dollar owed in 2007 and likely is much worse today in light of the recent economic downturn. United Parcel Service understood the severity of this problem and paid an astounding $6.1 billion in withdrawal fees in 2007 just for permission to back away from that actuarial ticking time bomb.

When Reps. Earl Pomeroy, North Dakota Democrat, and Pat Tiberi, Ohio Republican, introduced a similar bill last fall, Teamster President James Hoffa Jr. blamed the Pension Protection Act (PPA) of 2006 for "greatly and unnecessarily accelerated funding requirements for many plans," which "hastened the [pension] crisis." What it did really was finally force the unions to come clean about the crisis. The PPA required the Teamsters to send letters to thousands of workers telling them their pensions were in critical status - less than 65 percent funded - meaning that future retirees might not get as much as promised and even current retirees could be in trouble. Many union leaders were against the PPA because it meant they could no longer tell members that their pensions were in good shape.

Mr. Hoffa asserted, incredibly, that multi-employer plans are "not controlled by unions" because they are "operated by management-labor boards" and legally "independent of unions and companies." Multi-employer pension boards, in fact, consist of several companies that contribute half of the trustees and generally a single union that contributes the other half. The deck is heavily stacked for labor control.

When pension funds prove unable to pay their obligations, the Pension Benefits Guarantee Corp. (PBGC) steps in to provide relief for workers. PBGC is financed by insurance premiums on private pension plans. Union pension plans pay a much lower premium, and their workers are insured at a much lower rate than retirees in single-employer plans. Retirees in union pension plans are insured only up to $12,870 per year. The House and Senate bills would increase this coverage to $21,000 and put taxpayers on the hook for the pensions of union workers.

The bills would create a special "fifth" fund to help pre-emptively bail out struggling multi-employer pension funds. The fund would apply to so-called "orphans" - workers of companies that had to leave the plan because of bankruptcy - in union pension funds that have twice as many retirees as workers and owe two times the amount of benefits that they receive in contributions. PBGC would take retirees in the plans that worked for bankrupt companies and put them in special segregated plans.

According to Mr. Casey's summary, the legislation would be targeted to the Teamsters' "Central States Pension Fund, a few other Teamster-based pension funds and one other union-based large multi-employer plan (subject to the approval of the PBGC.)" But that's far from the whole of what the bill might allow.

To start, it would reward unions for past bad behavior by leaving them in charge. When a PBGC has to fund an insolvent plan, it controls the benefits and payments. The segregated plans in the fifth fund - known as a partition - would be controlled by the same trustees who failed to adequately fund the original plan. According to Mr. Casey's own office, "PBGC [would] not provide notices, calculate benefits or in any other form administer the plan."

Retirees in partitioned plans would receive their full benefits courtesy of the U.S. taxpayer. The bill states that obligations of this "fifth" fund would be "obligations of the United States" - and no longer just by PBGC insurance premiums. Taxpayers could be on the hook for even more, too. A provision in both bills would allow the fifth fund to transfer money to other parts of PBGC. That means that the fifth fund could be the camel's nose under the tent, using taxpayer dollars to shore up the deficit-ridden PBGC. According to the corporation's own report released earlier this month, it had a deficit of almost $22 billion in September 2009. By 2019, the shortfall is expected to balloon to $34 billion.

The Senate Committee on Health, Education, Labor and Pensions will debate the bill on May 27.

As things stand now, either businesses or taxpayers are going to pay billions for union mismanagement of these funds. Mr. Hoffa sermonizes that this is "about living up to the responsibility to provide the retirement security promised to employees."

Taxpayers, however, didn't make those promises to workers. Many unions did. In fact, they used the promise of reliable union pensions to lure skeptical new workers to become dues-paying members. They told prospective members not to trust 401(k) plans and instead to rely on solid union-bargained plans. Those plans, they claimed, are more secure and guaranteed by the government. Of course, they left out the inconvenient and potentially devastating truth that the guarantee is less than $13,000 and applies to current retirees. Isn't it about time the unions told the truth and lived up to their responsibility?

I agree with the authors. It's about time unions told the truth and lived up to their responsibility. They can't abdicate their fiduciary duties and then ask taxpayers to make up the shortfall. If anything, these multi-employer plans have proven to be a miserable failure, and I wonder if union corruption had anything to do with the mismanagement of the plans.

And now Senator Casey wants to bail out this mess? Tread carefully dear senator, tread very carefully. You don't know what you're getting involved with; this bill is going to come back and bite you in the ass.

Monday, May 24, 2010

The End of Welfare States?

Following up on my previous comment, Steve Doughty of the London Mail reports, Euro crisis 'spells the end of welfare states': Post-war system in ashes, warns U.S. think tank:

The welfare states of Europe that rose out of the ashes of the Second World War are now facing destruction because of the sovereign debt crisis, analysts say.

The troubles that began with the collapse of Greece and which now threaten the euro spell the end for excessive and occasionally corrupt welfare systems, they say.

The pronouncement from a highly regarded U.S. think tank reflected popular opinion across northern European countries.

Uri Dadush, of the Carnegie Endowment's International Economic Programme, said: 'The current welfare state is unaffordable.

'The crisis has made the day of reckoning closer by several years in all the industrial countries.'

The verdict follows the surprise in the U.S. caused by the discovery that the average age of retirement in Greece is 53, thanks to a generous benefit system and pensions for state employees.

It symbolised the unaffordability of the welfare states set up across Europe from the 1940s onwards with the aim of suppressing popular unrest and paying off tensions that could lead to another continental war.

A Death Blow to Europe's Welfare State?

Steven Erlanger of the NYT reports, Europeans Fear Crisis Threatens Liberal Benefits (HT: Tyler):
Across Western Europe, the “lifestyle superpower,” the assumptions and gains of a lifetime are suddenly in doubt. The deficit crisis that threatens the euro has also undermined the sustainability of the European standard of social welfare, built by left-leaning governments since the end of World War II.

Europeans have boasted about their social model, with its generous vacations and early retirements, its national health care systems and extensive welfare benefits, contrasting it with the comparative harshness of American capitalism.

Europeans have benefited from low military spending, protected by NATO and the American nuclear umbrella. They have also translated higher taxes into a cradle-to-grave safety net. “The Europe that protects” is a slogan of the European Union.

But all over Europe governments with big budgets, falling tax revenues and aging populations are experiencing rising deficits, with more bad news ahead.

With low growth, low birthrates and longer life expectancies, Europe can no longer afford its comfortable lifestyle, at least not without a period of austerity and significant changes. The countries are trying to reassure investors by cutting salaries, raising legal retirement ages, increasing work hours and reducing health benefits and pensions.

“We’re now in rescue mode,” said Carl Bildt, Sweden’s foreign minister. “But we need to transition to the reform mode very soon. The ‘reform deficit’ is the real problem,” he said, pointing to the need for structural change.

The reaction so far to government efforts to cut spending has been pessimism and anger, with an understanding that the current system is unsustainable.

In Athens, Aris Iordanidis, 25, an economics graduate working in a bookstore, resents paying high taxes to finance Greece’s bloated state sector and its employees. “They sit there for years drinking coffee and chatting on the telephone and then retire at 50 with nice fat pensions,” he said. “As for us, the way things are going we’ll have to work until we’re 70.”

In Rome, Aldo Cimaglia is 52 and teaches photography, and he is deeply pessimistic about his pension. “It’s going to go belly-up because no one will be around to fill the pension coffers,” he said. “It’s not just me; this country has no future.”

Changes have now become urgent. Europe’s population is aging quickly as birthrates decline. Unemployment has risen as traditional industries have shifted to Asia. And the region lacks competitiveness in world markets.

According to the European Commission, by 2050 the percentage of Europeans older than 65 will nearly double. In the 1950s there were seven workers for every retiree in advanced economies. By 2050, the ratio in the European Union will drop to 1.3 to 1.

“The easy days are over for countries like Greece, Portugal and Spain, but for us, too,” said Laurent Cohen-Tanugi, a French lawyer who did a study of Europe in the global economy for the French government. “A lot of Europeans would not like the issue cast in these terms, but that is the storm we’re facing. We can no longer afford the old social model, and there is a real need for structural reform.”

In Paris, Malka Braniste, 88, lives on the pension of her deceased husband. “I’m worried for the next generations,” she said at lunch with her daughter-in-law, Dominique Alcan, 49. “People who don’t put money aside won’t get anything.”

Ms. Alcan expects to have to work longer as a traveling saleswoman. “But I’m afraid I’ll never reach the same level of comfort,” she said. “I won’t be able to do my job at 63; being a saleswoman requires a lot of energy.”

Gustave Brun d’Arre, 18, is still in high school. “The only thing we’re told is that we will have to pay for the others,” he said, sipping a beer at a cafe. The waiter interrupted, discussing plans to alter the French pension system. “It will be a mess,” the waiter said. “We’ll have to work harder and longer in our jobs.”

Figures show the severity of the problem. Gross public social expenditures in the European Union increased from 16 percent of gross domestic product in 1980 to 21 percent in 2005, compared with 15.9 percent in the United States. In France, the figure now is 31 percent, the highest in Europe, with state pensions making up more than 44 percent of the total and health care, 30 percent.

The challenge is particularly daunting in France, which has done less to reduce the state’s obligations than some of its neighbors. In Sweden and Switzerland, 7 of 10 people work past 50. In France, only half do. The legal retirement age in France is 60, while Germany recently raised it to 67 for those born after 1963.

With the retirement of the baby boomers, the number of pensioners will rise 47 percent in France between now and 2050, while the number under 60 will remain stagnant. The French call it “du baby boom au papy boom,” and the costs, if unchanged, are unsustainable. The French state pension system today is running a deficit of 11 billion euros, or about $13.8 billion; by 2050, it will be 103 billion euros, or $129.5 billion, about 2.6 percent of projected economic output.

President Nicolas Sarkozy has vowed to pass major pension reform this year. There have been two contentious overhauls, in 2003 and 2008; the government, afraid to lower pensions, wants to increase taxes on high salaries and increase the years of work.

But the unions are unhappy, and the Socialist Party opposes raising the retirement age. Polls show that while most French see a pension overhaul as necessary, up to 60 percent say working past 60 is not the answer.

Jean-François Copé, the parliamentary leader for Mr. Sarkozy’s center-right party, says that change is painful, but necessary. “The point is to preserve our model and keep it,” he said. “We need to get rid of bad habits. The Germans did it, and we can do the same.”

More broadly, many across Europe say the Continent will have to adapt to fiscal and demographic change, because social peace depends on it. “Europe won’t work without that,” said Joschka Fischer, the former German foreign minister, referring to the state’s protective role. “In Europe we have nationalism and racism in a politicized manner, and those parties would have exploited grievances if not for our welfare state,” he said. “It’s a matter of national security, of our democracy.”

France will ultimately have to follow Sweden and Germany in raising the pension age, he argues. “This will have to be harmonized, Europeanized, or it won’t work — you can’t have a pension at 67 here and 55 in Greece,” Mr. Fischer said.

The problems are even more acute in the “new democracies” of the euro zone — Greece, Portugal and Spain — that embraced European democratic ideals and that Europe embraced for political reasons in the postwar era, perhaps before their economies were ready. They have built lavish state systems on the back of the euro, but now must change.

Under threat of default, Greece has frozen pensions for three years and drafted a bill to raise the legal retirement age to 65. Greece froze public-sector pay and trimmed benefits for state employees, including a bonus two months of salary. Portugal has cut 5 percent from the salaries of senior public employees and politicians and increased taxes, while canceling big projects; Spain is cutting civil service salaries by 5 percent and freezing pay in 2011 while also chopping public projects.

But all three need to do more to bolster their competitiveness and growth, mostly by changing deeply inflexible employment rules, which can make it prohibitively expensive to hire or fire staff members, keeping unemployment high.

Jean-Claude Meunier is 68, a retired French Navy official and headhunter, who plays bridge to “train my memory and avoid Alzheimer’s.” His main worry is pension. “For years, our political leaders acted with very little courage,” he said. “Pensions represent the failure of the leaders and the failure of the system.”

In Athens, Mr. Iordanidis, the graduate who makes 800 euros a month in a bookstore, said he saw one possible upside. “It could be a chance to overhaul the whole rancid system,” he said, “and create a state that actually works.”

I have mixed feelings over the profound changes taking place in Europe right now. On the one hand, I knew that benefits were way too generous and it was only a matter of time before they'd be cut. On the other hand, I prefer European capitalism over American capitalism. Europeans work to live, not the other way around.

The way we're heading, we're all going to be asked to work till we die. Defined-benefit plans will become extinct for new members and older members risk seeing deep cuts in benefits. At the root of the problem, it's not just that promises were never able to be kept, it's also that wealth is increasingly being concentrated in the hands of few and the restless many are asked to shoulder the bulk of the fiscal holes despite being tapped out themselves.

Finally, Diane Urquhart sent me this message:

I am sending this email to you on behalf of Greg McAvoy, a Nortel LTD Employee from Calgary, Alberta.

CBC will be airing a series of news stories on Tuesday, May 25th about the dire consequences faced by employees whose companies self insure their disability and medical benefits, and then go bankrupt. There is breach of trust going on by employers and trustees failing in their fiduciary duties to protect their disabled employees as prescribed in the trustee agreements for Health and Welfare Trusts. The toxic self insured plans are completely unregulated and disabled employees are being forced into poverty because their long term disability benefits have not been funded. Several disabled Nortel employees from across the country in this situation are interviewed along with legal experts, the Council of Canadian Disabled and key political leaders.

It is estimated that more than 1.1 million Canadians have toxic long term disability benefit plans and they are being put at risk by the government’s failure to regulate them. One in ten Canadians in the workplace are exposed to toxic insurance, and it is not possible to detect if you are one of the unlucky ones.

The shows start in the morning on CBC Radio National News running every second hour. It will be on the local CBC Ottawa radio station on the half hour with a longer item at 7:15 AM. It will play across the country on CBC Radio The Current after the 9:00 AM News.

A CBC TV Story will air on the supper hour news across the country at 6:00 PM. These stories will also be available on the CBC websites.

This should serve as a stark reminder that Europe's woes are not just a European problem. They're a global problem, and the absence of leadership on the pensions issue will end up costing us all, especially the most vulnerable in our society.

Saturday, May 22, 2010

The Paradox of Market Chaos?

Zachary Goldfarb of the Washington Post reports, SEC launches inquiry into market's 'flash crash':

The Securities and Exchange Commission is looking at whether key financial firms broke securities laws when they stopped buying and selling stocks during the "flash crash" on May 6, helping fuel the historic plunge in prices.

SEC Chairman Mary Schapiro said at a congressional hearing Thursday that these companies, known as market makers, might have violated a legal duty to continue to buy and sell during the rapid decline.

"We don't have evidence yet of market makers who had affirmative obligations from withdrawing from the market," Schapiro told the Senate banking committee. "It is absolutely something that we're looking at and we've incorporated our enforcement division into our ongoing investigation."

Schapiro's comments are the first signal that the regulator might seek to sanction firms if they contributed to the decline of nearly 1,000 points in the Dow Jones Industrial Average. The agency previously had not suggested that wrongdoing could have been behind the market chaos.

At the hearing, the chairman of the Commodity Futures Trading Commission said the regulator would look into reining in some of the high-speed, mathematics-driven trading that aggravated the volatility.

"A lot of the algorithms are very . . . dumb," said CFTC Chairman Gary Gensler. "We can't stop technology, but I think that we have to update our regulations to stay abreast of this."

Regulators suspect that automated trading in a speculative financial instrument linked to the performance of the Standard & Poor's 500 stock index contributed to the market plunge.

But even if trading in that instrument helped fuel the start of the decline May 6, regulators say the failure of market makers to remain active buyers and sellers of shares sent prices down even more.

Many long-time market makers -- often a major bank or brokerage whose role is to facilitate trades by others -- required to remain active in the market even during times of market stress. But many other upstart firms, often using high-speed electronic trading, face no such legal obligation to keep buying and selling shares.

"I do believe one of the things we absolutely have to look at is the fact that many affirmative obligations of market makers have been eliminated by the markets over the years," Schapiro said. "So one of the things we will be looking at very carefully is the creation of affirmative obligations again."

The SEC has discounted the possibility that an error at a financial firm caused the crisis, or that outright criminal behavior such as hacking or terrorist activity was behind the market chaos.

The agency has largely blamed outdated and inconsistent rules governing trading across a wide array of market venues, as well as speculation in electronic futures markets for fueling the plunge.

One thing I try to explain to people is that erratic market moves have much less to do with fundamentals and more to do with banks' prop desks and hedge funds flows. Big banks made a killing in the first quarter of 2010. In fact, the FDIC reported that nationwide, U.S. banks reported an aggregate profit of $18 billion during the first quarter, up considerably from the $5.6 billion profit recorded in the first three months of 2009.

Where are these profits coming from? Certainly not from lending to small & medium sized enterprises. The bulk of the profits at the big banks are coming from trading revenues and most of these are driven by huge algorithmic trading activities performed by an army of PhDs running ultra fast supercomputers, looking for the slightest discrepancy in asset prices.

And what about hedge fund flows? Earlier this week, Boyd Erman of the Globe & Mail reported, Hedge funds rebound, head for $2-trillion in assets:

Hedge funds are hitting some old high-water marks, with assets in North American funds topping the $1-trillion (U.S.) level for the first time since November of 2008, according to tracking firm Eurekahedge.

Globally, hedge fund assets have passed the $1.5-trillion level and are likely to surpass $1.75-trillion by year-end at the current pace.

It's a big turnaround for a group that had some of the biggest winners and losers of the crisis. On the winning side, funds like Paulson & Co. took home huge returns from bets against housing. Losers found themselves long equities or mortgage-backed securities in 2008, then had their pain compounded by margin calls on their leveraged portfolios.

For the moment, some of the hottest returns are at distressed debt funds as default rates have proved nowhere near what was priced in at the nadir of the crisis.

Eurekahedge said distressed debt funds have posted 13 months straight of positive returns, giving them a 50 per cent gain since March of last year.

Two trillion in hedge fund assets may not sound like a lot, but when you add leverage, it's huge. Many of the larger hedge funds also engage in algorithmic trading and OTC derivative trading, adding more volatility in market moves.

I bring this up because it baffles me when "experts" compare today's markets to those of the 1990s, 1980s or 1930s! The structural changes in the markets are huge, bringing more volatility in periods of uncertainty, and less in periods of stability.

And what really concerns me is what effects this will have on defined-benefit plans and individual retirement plans. Moreover, the Prime Minister of Greece, George Papandreou, raised an important point last week in his interview with CNN's Fareed Zakaria. Mr. Papandreou addressed the "paradox" of bailing out banks that turned around and funded hedge funds that speculated on sovereign debt:

MR. F. ZAKARIA: You know, you are in some ways the bellwether for the Western world. You are the first Western country that is going to try in a comprehensive way to pare back some of the excessive guarantees, commitments and expenditures of the welfare state.

Do you think you can do this and survive politically? I know that you made a reference to taking a voyage like Odysseus, and a Greek columnist said yeah, but it took Odysseus ten years. All his comrades died, and he ended up naked and washed ashore in Ithaca. Do you think you’ll have a few more people than Odysseus did, when this journey is over?

MR. G. PAPANDREOU: Well, we know that these journeys are not easy and there are casualties. But we also know we can reach this goal.

What we lived through in the last few months was also somewhat of a paradox, because – and again I am not trying in any way to get away from our responsibilities; we are fully aware of our responsibilities and what we must do – but there are also the financial markets.

In 2008 we had actually the governments coming in to bail out the financial markets and the banks. They had to accrue a huge debt very often, for stimulating the economies, so that we don’t go into not only a recession but a deep depression.

Now you have banks funding hedge funds. They are actually then betting against governments that had actually helped the banks.

So this is a paradox, and I think this is where we need to also regulate markets.

MR. F. ZAKARIA: Do you think that Greece was a victim of the American investment banks?

: We right now have a parliamentary investigation in Greece, which will look into the past and see how things went the wrong direction and what kinds of practices were negative practices. There are similar investigations going on in other countries, and in the United States.

This is why I think yes, the financial sector – I hear the words ‘fraud’ and ‘lack of transparency.’ So yes, there is great responsibility here.

: Could you imagine going after any of these banks legally? Do you see that you have some legal recourse?

: I wouldn’t rule out that this may be a recourse also, to go into this legally. But we need to let the due process proceed, and then make our judgements once we get the results from the investigations.

: And do you think you will make it, like Odysseus, in the end, personally, politically?

: I am doing what is best for my country, and I think that’s the best way to make sure that this country does get to its destination, which is Ithaca.

What happens to me is of less importance, as long as I feel that I am doing what is best for my country and I can sleep well at night, with my conscience clear, that maybe taking very tough decisions and decisions that very often hurt, not only me but also many of the Greek people, but in the end knowing that this is the best.

On Friday, I had lunch with a buddy of mine that came in from Greece. He told me that he was surprised with the speed that Papandreou's government is moving to implement reforms. He also told me that many of these reforms are hurting individuals like his aunt who was a school teacher for many years and is now seeing her pension decline from 1,200 euros a month to 900 euros a month.

As far as speculators are concerned, my friend told me: "I told you a long time ago that major financial regulations are coming". Indeed, politicians are not going to let hedge funds and banks run amok, threatening the integrity of the capital markets and the global economy.

Let me be clear on something: I'm not against hedge funds or banks with huge prop desks. They provide liquidity to markets and hedge funds that deliver true alpha (not levered beta) are worth paying fees for.

But the paradox remains. Banks that got bailed out are funding hedge funds and so are public pension funds looking to increase their leverage to meet their required actuarial rate of return. What worries me is that by doing this, they're increasing systemic risk. Without taking into account their collective actions, they're sowing seeds of more market chaos.

This is something which needs to be addressed on a global level. Individual countries are powerless to deal with these structural changes and their implications for global systemic risk.

Finally, as you listen to Mike Ryan, head of wealth management research for the Americas at UBS Financial Services Inc., talking with Bloomberg's Matt Miller and Carol Massar about the outlook for U.S. equity markets and prospects for a continued U.S. economic recovery, keep in mind the structural changes I discussed above. Nothing shocks me anymore. Erratic moves have become the norm, not the exception.