Saturday, February 27, 2010

An Extraordinary Coup?


Bill Totten sent me a very interesting article from David DeGraw published on Alternet, The Economic Elite Have Engineered an Extraordinary Coup, Threatening the Very Existence of the Middle Class:

"The American oligarchy spares no pains in promoting the belief that it does not exist, but the success of its disappearing act depends on equally strenuous efforts on the part of an American public anxious to believe in egalitarian fictions and unwilling to see what is hidden in plain sight." -- Michael Lind, To Have and to Have Not

We all have very strong differences of opinion on many issues. However, like our founding fathers before us, we must put aside our differences and unite to fight a common enemy.

It has now become evident to a critical mass that the Republican and Democratic parties, along with all three branches of our government, have been bought off by a well-organized Economic Elite who are tactically destroying our way of life. The harsh truth is that 99 percent of the U.S. population no longer has political representation. The U.S. economy, government and tax system is now blatantly rigged against us.

Current statistical societal indicators clearly demonstrate that a strategic attack has been launched and an analysis of current governmental policies prove that conditions for 99 percent of Americans will continue to deteriorate. The Economic Elite have engineered a financial coup and have brought war to our doorstep...and make no mistake, they have launched a war to eliminate the U.S. middle class.

To those who feel I am using extreme rhetoric, I ask you to please take a few minutes of your time to hear me out and research the evidence put forth. The facts are there for the unprejudiced, rational and reasoned mind to absorb. It is the unfortunate reality of our current crisis.

Unless we all unite and organize on common ground, our very way of life and the ideals that our country was founded upon will continue to unravel.

Before exposing exactly who the Economic Elite are, and discussing common sense ways in which we can defeat them, let's take a look at how much damage they have already caused.

Casualties of Economic Terrorism, Surveying the Damage

The devastating numbers across-the-board on the economic front are staggering. I'll go through some of them here, many we have already become all too familiar with. We hear some of these numbers all the time, so much so that it appears as if we have already begun "to normalize the unthinkable." You may be sick of hearing them, but behind each number is an enormous amount of individual suffering, American lives and families who are struggling worse than they ever have.

America is the richest nation in history, yet we now have the highest poverty rate in the industrialized world with an unprecedented amount of Americans living in dire straights and over 50 million citizens already living in poverty.

The government has come up with clever ways to downplay all of these numbers, but we have over 50 million people who need to use food stamps to eat, and a stunning 50 percent of U.S. children will use food stamps to eat at some point in their childhoods. Approximately 20,000 people are added to this total every day. In 2009, one out of five U.S. households didn't have enough money to buy food. In households with children, this number rose to 24 percent, as the hunger rate among U.S. citizens has now reached an all-time high.

We also currently have over 50 million U.S. citizens without health care. 1.4 million Americans filed for bankruptcy in 2009, a 32 percent increase from 2008. As bankruptcies continue to skyrocket, medical bankruptcies are responsible for over 60 percent of them, and over 75 percent of the medical bankruptcies filed are from people who have health care insurance. We have the most expensive health care system in the world, we are forced to pay twice as much as other countries and the overall care we get in return ranks 37th in the world.

In total, Americans have lost $5 trillion from their pensions and savings since the economic crisis began and $13 trillion in the value of their homes. During the first full year of the crisis, workers between the age of 55 - 60, who have worked for 20 - 29 years, have lost an average of 25 percent off their 401k. "Personal debt has risen from 65 percent of income in 1980 to 125 percent today." Over five million U.S. families have already lost their homes, in total 13 million U.S. families are expected to lose their home by 2014, with 25 percent of current mortgages underwater. Deutsche Bank has an even grimmer prediction: "The percentage of 'underwater' loans may rise to 48 percent, or 25 million homes." Every day 10,000 U.S. homes enter foreclosure. Statistics show that an increasing number of these people are not finding shelter elsewhere, there are now over 3 million homeless Americans, the fastest-growing segment of the homeless population is single parents with children.

One place more and more Americans are finding a home is in prison. With a prison population of 2.3 million people, we now have more people incarcerated than any other nation in the world -- the per capita statistics are 700 per 100,000 citizens. In comparison, China has 110 per 100,000, France has 80 per 100,000, Saudi Arabia has 45 per 100,000. The prison industry is thriving and expecting major growth over the next few years. A recent report from the Hartford Advocate titled "Incarceration Nation" revealed that "a new prison opens every week somewhere in America."

Mass Unemployment

The government unemployment rate is deceptive on several levels. It doesn't count people who are "involuntary part-time workers," meaning workers who are working part-time but want to find full-time work. It also doesn't count "discouraged workers," meaning long-term unemployed people who have lost hope and don't consistently look for work. As time goes by, more and more people stop consistently looking for work and are discounted from the unemployment figure. For instance, in January, 1.1 million workers were eliminated from the unemployment total because they were "officially" labeled discouraged workers. So instead of the number rising, we will hear deceptive reports about unemployment leveling off.

On top of this, the Bureau of Labor Statistics recently discovered that 824,000 job losses were never accounted for due to a "modeling error" in their data. Even in their initial January data there appears to be a huge understating, with the newest report saying the economy lost 20,000 jobs. TrimTabs employment analysis, which has consistently provided more accurate data, "estimated that the U.S. economy shed 104,000 jobs in January."

When you factor in all these uncounted workers -- "involuntary part-time" and "discouraged workers" -- the unemployment rate rises from 9.7 percent to over 20 percent. In total, we now have over 30 million U.S. citizens who are unemployed or underemployed. The rarely cited "employment-participation" rate, which reveals the percentage of the population that is currently in the workforce, has now fallen to 64 percent.

Even based on the "official" unemployment rate, just to get back to the unemployment level of 4.6 percent that we had in 2007, we need to create over 10 million new jobs, and most every serious economist will tell you that these jobs are not coming back. In fact, we are still consistently shedding jobs, on just one day, January 27, several companies announced new cuts of more than 60,000 jobs.

Due to the length of this crisis already, millions of Americans are reaching a point where the unemployment benefits they have been living on are coming to an end. More workers have already been out of work longer than at any point since statistics have been recorded, with over six million now unemployed for over six months. A record 20 million Americans qualified for unemployment insurance benefits last year, causing 27 states to run out of funds, with seven more also expected to go into the red within the next few months. In total, 40 state programs are expected to go broke.

Most economists believe the unemployment rate will remain high for the foreseeable future. What will happen when we have millions of laid-off workers without any unemployment benefits to save them?

Working More for Less

The millions struggling to find work are just part of the story. Due to the fact that we now have a record high six people for every one job opening, companies have been able to further increase the workload on their remaining employees. They have been able to increase the amount of hours Americans are working, reduce wages and drastically cut back on benefits. Even though Americans were already the most productive workers in the world before the economic crisis, in the third quarter of 2009, average worker productivity increased by an annualized rate of 9.5 percent, at the same time unit labor cost decreased by 5.2 percent. This has led to record profits for many companies. Of the 220 companies in the S&P 500 who have reported fourth-quarter results thus far, 78 percent of them had "better-than-expected profits" with earnings 17 percent above expectations, "the highest for any quarter since Thomson Reuters began tracking data."

According to the Bureau of Labor Statistics, the national median wage was only $32,390 per year in 2008, and median household income fell by 3.6 percent while the unemployment rate was 5.8 percent. With the unemployment rate now at 10 percent, median income has been falling at a 5 percent rate and is expected to continue its decline. Not surprisingly, Americans' job satisfaction level is now at an all-time low.

There are also a growing number of employed people who, despite having a job, are still living in poverty. There are at least 15 million workers who now fall into this rapidly growing category. $32,390 a year is not going to get you far in today's economy, and half of the country is making less than that. This is why many Americans are now forced to work two jobs to provide for their family to hopefully make ends meet.

A Crime Against Humanity

The mainstream news media will numb us to this horrifying reality by endlessly talking about the latest numbers, but they never piece them together to show you the whole devastating picture, and they rarely show you all the immense individual suffering behind them. This is how they "normalize the unthinkable" and make us become passive in the face of such a high causality count.

Behind each of these numbers, is a tremendous amount of misery; the physical toll is only outdone by the severe psychological toll. Anyone who has had to put off medical care, or who couldn't get medical care for one of their family members due to financial circumstances, can tell you about the psychological toll that is on top of the physical suffering. Anyone who has felt the stress of wondering how they were going to get their child's next meal or their own, or the stress of not knowing how they are going to pay the mortgage, rent, electricity or heat bill, let alone the car payment, gas, phone, cable or Internet bill.

There are now well over 150 million Americans who feel stress over these things on a consistent basis. Over 60 percent of Americans now live paycheck to paycheck.

These are all basic things every person should be able to easily afford in a technologically advanced society such as ours. The reason we struggle with these things is because the Economic Elite have robbed us all. This amount of suffering in the United States of America is literally a crime against humanity.

David DeGraw followed up with another article, The Richest 1% Have Captured America's Wealth -- What's It Going to Take to Get It Back?:

"The war against working people should be understood to be a real war.... Specifically in the U.S., which happens to have a highly class-conscious business class.... And they have long seen themselves as fighting a bitter class war, except they don't want anybody else to know about it." -- Noam Chomsky

As a record amount of U.S. citizens are struggling to get by, many of the largest corporations are experiencing record-breaking profits, and CEOs are receiving record-breaking bonuses. How could this be happening, how did we get to this point?

The Economic Elite have escalated their attack on U.S. workers over the past few years; however, this attack began to build intensity in the 1970s. In 1970, CEOs made $25 for every $1 the average worker made. Due to technological advancements, production and profit levels exploded from 1970 - 2000. With the lion's share of increased profits going to the CEO's, this pay ratio dramatically rose to $90 for CEOs to $1 for the average worker.

As ridiculous as that seems, an in-depth study in 2004 on the explosion of CEO pay revealed that, including stock options and other benefits, CEO pay is more accurately $500 to $1.

Paul Buchheit, from DePaul University, revealed, "From 1980 to 2006 the richest 1% of America tripled their after-tax percentage of our nation's total income, while the bottom 90% have seen their share drop over 20%." Robert Freeman added, "Between 2002 and 2006, it was even worse: an astounding three-quarters of all the economy's growth was captured by the top 1%."

Due to this, the United States already had the highest inequality of wealth in the industrialized world prior to the financial crisis. Since the crisis, which has hit the average worker much harder than CEOs, the gap between the top one percent and the remaining 99% of the US population has grown to a record high. The economic top one percent of the population now owns over 70% of all financial assets, an all time record.

As mentioned before, just look at the first full year of the crisis when workers lost an average of 25 percent off their 401k. During the same time period, the wealth of the 400 richest Americans increased by $30 billion, bringing their total combined wealth to $1.57 trillion, which is more than the combined net worth of 50% of the US population. Just to make this point clear, 400 people have more wealth than 155 million people combined.

Meanwhile, 2009 was a record-breaking year for Wall Street bonuses, as firms issued $150 billion to their executives. 100% of these bonuses are a direct result of our tax dollars, so if we used this money to create jobs, instead of giving them to a handful of top executives, we could have paid an annual salary of $30,000 to 5 million people.

So while US workers are now working more hours and have become dramatically more productive and profitable, our pay is actually declining and all the dramatic increases in wealth are going straight into the pockets of the Economic Elite.

If our income had kept pace with compensation distribution rates established in the early 1970s, we would all be making at least three times as much as we are currently making. How different would your life be if you were making $120,000 a year, instead of $40,000?

So it should come as no surprise to see that we now have the highest inequality of wealth in the industrialized world and the highest inequality of wealth in our nation's history. The backbone of America, a hard working middle class that has made our country a world leader, has been devastated.

Now that we have a better understanding of how our income has been suppressed over the past forty years, let's take a look at how the economy has been designed to take the limited money we receive and put it into the hands of the Economic Elite as well.

Costs of Living

Other than in the workplace, in almost all our costs of living the system is now blatantly rigged against us. Let's take a look at it, starting out with our tax system.

In total, the average US citizen is forced to give up approximately 30% of our income in taxes. This tax system is now strategically designed to flow straight into the hands of the Economic Elite. A huge percentage of our tax dollars ultimately end up in their pockets. The past decade proves that -- whether it's the Republicans or the Democrats running the government -- our tax money is not going into our community, it is going into the pockets of the billionaires who have bought off both parties - it is obscene.

For an example of how this system flows to the Economic Elite, just look at the Wall Street "bailout." The real size of the bailout is estimated to be $14 trillion - and could end up costing trillions more than that. By now you are probably also sick of hearing about the bailout, but stop and think about this for a momentÖ Do you comprehend how much $14 trillion is?

What could be accomplished with this money is almost beyond common comprehension.

And this is just the tip of the iceberg that has hit us. On top of the trillions given to the Wall Street elite, we already have a record $12.3 trillion in national debt - and we now have to pay $500 billion in interest to the Economic Elite on this debt every year, yet another way they are milking us dry. When you add in unfunded liabilities owed, like social security payments, we actually owe a stunning $74 trillion. That adds up to a debt of $242,000 for every man, woman and child in America.

Trillions more, 25% of taxpayer dollars allocated to military spending goes unaccounted for every year, not to mention the billions spent on overcharging and outright fraud. During the War on Terror, the Economic Elite have used our tax money to build a private army that has more soldiers deployed than the US military - a congressional study revealed that 69% of the "US" fighting forces deployed throughout the world in our name are in fact private mercenaries, 80% of them are foreign nationals. Private contractors regularly get paid three to five times more than our soldiers, and have been repeatedly caught overcharging and committing fraud on a massive scale. A congressional investigation revealed this and strongly recommended that we seize wasting tax dollars on these private military contractors. However, under Obama, there has actually been a drastic increase in total tax dollars spent on them.

In 2009, just over $1 trillion tax dollars were spent on the military, it's safe to say that at least $350 billion of that was needlessly wasted.

When you research our tax system you see an unprecedented level of waste and fraud rampant throughout most expenditures. Our tax system is a national disaster of epic proportions. It is literally an organized criminal operation that continues to rob us in broad daylight, with zero accountability.

Politicians and mainstream "news" outlets will not tell you this, but most every serious economist knows that due to so much theft and debt created in the tax system, the only way to fix things, other than stopping the theft and seizing the trillions that have been stolen, will be for the government to cut important social funding and drastically raise our taxes. Other than the record national debt, many states are running record deficits and ìbarreling toward economic disaster, raising the likelihood of higher taxes, more government layoffs and deep cuts in services.î Our nation's biggest state economies, like California and New York, are the ones in most trouble.

To merely say that things will not be improving economically is to be a delusional optimist. The truth that you will not hear: we have been hit by an economic deathblow and the United States lay in ruins.

It's not just this criminal tax system; the theft is now built into all our costs of living.

Trillions more in our spending on food and fuel has been stolen due to fraudulent stock transactions and overcharging. Just ten years ago, in 2000, American families paid 7% of our income on food and fuel. We now pay 20%. This drastic increase is primarily driven by fraudulent market manipulation that drives up stock prices. Congress uncovered this in 2006, as part of the Enron investigation they found that companies manipulated the oil market to create major spikes in stock values, and then they didn't do anything about it - nothing to see here, just move on.

As mentioned before, we have the most expensive health care system in the world and we are forced to pay twice as much as other countries, and the overall care we get in return ranks 37th in the world. On average, US citizens are now paying a record high 8% of their income on medical care.

Part of the reason why foreclosure rates are so high is because the percentage of income Americans pay on their housing has risen to 34%.

So for these basic necessities - taxes, food, fuel, shelter and medical bills - we have already lost 92% of our limited income. Then factor in ever-increasing interest rates on credit cards, student loans, rising prices for cable, internet, phone, bank fees, etc., etc., etcÖ. We are being robbed and gouged in all costs of living, in every aspect of our life. No wonder bankruptcies are skyrocketing and the amount of people suffering from psychological depression has reached an epidemic level.

The American worker is screwed over every step of the way, and it all starts with the explosion in the cost of a college education. This is one of the Economic Elite's most devastating weapons. To have any chance of succeeding in this economy, it is commonly believed that you must attend the best college possible. With the rising costs involved, today's students are graduating with record levels of debt from student loans. At the same time, the unemployment rate among recent college graduates has risen higher than the national average, and those that do find work are making significantly less than they expected to make. This combination of extreme debt and reduced pay has crippled an entire generation right from the start and has put them in a vicious cycle of spiraling debt that they will struggle with for the rest of their lives. The most recent college graduates are now known as a "lost generation."

The American dream has turned into a nightmare. The economic system is a sophisticated prison cell; the indentured servant is now an indebted wage slave; whips and chains have evolved into debts.

"There are two ways to conquer and enslave a nation. One is by sword. The other is by debt." --
John Adams

Concealing National Wealth

"Liberty in the concrete signifies release from the impact of particular oppressive forces; emancipation from something once taken as a normal part of human life but now experienced as bondage... Today, it signifies liberation from material insecurity and from the coercions and repressions that prevent multitudes from participation in the vast cultural resources that are at hand."-- John Dewey

When you take the time to research and analyze the wealth that has gone to the economic top one percent, you begin to realize just how much we have been robbed. Trillions upon trillions of dollars that could make the lives of all hard working Americans much easier have been strategically funneled into the coffers of the Economic Elite. The denial of wealth is the key to the Economic Elite's power. An entire generation of massive wealth creation has been strategically withheld from 99% of the US population.

The US public doesn't have any understanding of how much wealth has been generated and concentrated into the hands of the Economic Elite over the past 40 years; there is no historical frame of reference. This withholding of wealth is truly the greatest crime against humanity in the history of civilization.

What could be done with all the money that has been hoarded by the Economic Elite is extraordinary!

Let's consider what we could do with the money that has been stolen from us? On top of what should be our average six-figure yearly income, we could have:

* Free health care for every American,
* A free 4 bedroom home for every American family,
* 5% tax rate for 99% of Americans,
* Drastically improved public education and free college for all,
* Significantly improved public transportation and infrastructure,

The list goes on...

This is not some far-fetched fantasy. These are all things that Franklin D. Roosevelt talked about doing in the 1940's, long before the explosion of wealth creation in our technologically advanced global economy. The money for all this is already there, stashed into the claws of the Economic Elite. The denial of wealth to the masses is the key to the Economic Elite's power. Outside of outdated and obsolete economic models and theories -- and incredibly short-sighted greed -- there is no reason why all this money should be kept in the hands of a few, at the immense suffering and expense of the many.

If Americans could just understand how much wealth is being withheld from us, we would have a massive uprising and the Economic Elite would be swept away, into the history books alongside the evil despots of the past.
I realize many of you will dismiss Mr. DeGraw's writings as socialist banter, but I will add that as far as I am concerned, the real master coup revolves around pensions and mutual funds. Many people have no clue where their pensions are being invested, who is profiting off the misfortune of others and what a racket mutual funds are charging exorbitant fees for mediocre results.

There is a financial coup going on right now across the world and while it may have started in the United States, the debt disease is spreading across the globe at the speed of light. Where and how will this all end? Can capitalism survive if wealth is increasingly being concentrated in the hands of an economic elite that shows no sense of civic and moral duty to the societies they inhabit?

Karl Marx may be dead and his theories debunked, but I have a sick feeling in my gut that down the road, his dire prediction that capitalism is destined to self-destruct will ultimately be proven right.

Another US Slowdown Will Jolt Private Markets


Reuters reports that according to ECRI, U.S. economic growth to ease by mid-year:

A forward-looking measure of U.S. economic growth was unchanged in the latest week, while its yearly growth gauge continued to slide, bolstering expectations that economic growth will ease by mid-year, a research group said on Friday.

The Economic Cycle Research Institute, a New York-based independent forecasting group, said its Weekly Leading Index stood at 128.4 for the week ended Feb. 19, unchanged from the previous week.

It was the lowest reading since November 13, 2009, when it stood at 127.5.

The index's annualized growth rate declined for the 11th straight week to 14.9 percent from 17.0 percent the previous week, revised from an original 17.1 percent. It was the yearly growth gauge's lowest level since Aug. 7, 2009 when it read 14.6 percent.

"The decline in WLI growth to a 28-week low reinforces our earlier expectation that economic growth would begin to ease by mid-year," said ECRI Managing Director Lakshman Achuthan.

The chart above was taken from the Pragmatist Capitalist who also covered this story. Given ECRI's strong track record, it's worth paying close attention to their warnings. What is worrisome from a pensions' perspective is that commercial real estate is still in the doldrums and private equity is struggling to regain its footing. If the US economy slows down again, then private markets will experience a long, tough slug ahead, leaving many pensions funds exposed to more downside risk.

This is why I agree with Peter Boockvar who thinks more money printing will go on until inflationary expectations pick up. Listen to the interview below and keep in mind that even if the Fed eventually succeeds to reignite inflation, private markets will still struggle over the next few years. And if deflation does materialize, then it's game over for private markets and global pensions stand to lose trillions.

Thursday, February 25, 2010

Caisse Reports 10% Return for 2009


Paul Delean of the Montreal Gazette reports that the Caisse de Dépôt reports $11.5 billion gain for 2009:
It didn’t do as well as its peers or as badly as some expected.

Quebec pension-fund manager La Caisse de Dépôt et Placement du Québec generated a return from its investments of 10.04 per cent in 2009, a sub-par number when compared to other Canadian pension funds but a dramatic turnaround from its catastrophic loss of $40 billion in 2008.

“We had a lot of issues to deal with at the start of the year. They’re dealt with. We put the train back on the track. Now we’ve got to get it up to cruising speed,” said president and CEO Michael Sabia, the former BCE chief who’ll mark his first full year at the helm next month.

The Caisse ended the year with assets under management of $131.6 billion, up $11.5 billion from a year earlier.

Its returns lagged its benchmark index by four points, but Sabia said it actually beat the benchmark in the second half of the year, an indication the many changes at the institution are having an impact. All 2009 gains came in the last six months.

“We believe that the worst consequences of the (economic) crisis are behind us,” Sabia said. “Ultimately, we are building solid foundations for the future, but this is just the beginning.”.

According to RBC Dexia Investor Services, the median return for Canadian pension funds with assets of more than $1 billion was 15.4 per cent in 2009, though comparative figures were nowhere to be found in the Caisse documents released at its news conference Thursday. In the past it used to highlight its performance relative to others, but it now says short-term comparisons aren’t crucial.

“We’re long-term investors,” Sabia said. “What matters for us and our clients is long-term results.”

Michel Nadeau, a former top executive of the Caisse who now serves as general manager of the Institute for Governance of Private and Public Organizations, said the 2009 results were “a bit disappointing,” but he doesn’t fault Sabia and his team for the underperformance.

“He (Sabia) had to complete the cleanup of the stables. He worked hard to get rid of the derivatives and financial-engineering products. Risk management has improved with Mr. (Roland) Lescure (the Caisse’s newly-appointed chief investment officer). Next year will really be his first full year and the Caisse appears to be on the right track for 2010,” Nadeau said.

Sabia effectively lowered expectations for 2009 in a round of media interviews a month ago, noting the Caisse was still “in transition” last year and had been underweight in equities when stocks began their spectacular recovery last March.

It added to its equity position as the year went on and ended 2009 with about 34 per cent of its assets in stocks, up from 22 per cent in the spring.

Stocks generated the best return in its portfolio last year, gaining 31 per cent, paced by emerging markets (up 50 per cent) and Canadian equities (36 per cent).

The fixed-income portfolio made 5.8 per cent and private-equity group 17.5 per cent.

Real estate was the weak link, plunging 15.8 per cent, with the European and U.S. markets particularly depressed.

Sabia called 2009 a year of challenges, progress and evolution. He said the Caisse has withdrawn completely from one of its main trouble spots, non-Canadian real estate debt, which erased $2.3 billion from its assets in 2009.

It has also reduced its derivatives exposure by $15 billion, exited commodities and trimmed operating expenses and external management fees by 14 per cent or $43 million.

The goal, Sabia said, is to simplify the investment portfolio and refocus the Caisse on its proven areas of expertise, which include Canadian stocks, fixed income, private equity and real estate operations.

“Are we done? No. Are we in much better shape (than a year ago)? Yes, tremendously better shape,” Sabia said. “It (2008) will never be a happy memory, but we’ll at least try to make it a distant one.”

You can read the full press release and following comments on the Caisse's 2009 performance (*Update: As of April 15thl, the annual report is available here):

Fact sheet – Returns (PDF)
Fact sheet – Fixed Income (PDF)
Fact sheet – Equity Markets (PDF)
Fact sheet – Private Equity (PDF)
Fact sheet – Real Estate (PDF)
Fact sheet – Valuation of Investments (PDF)

I am actually surprised with the results because while they're subpar, they weren't as bad as I thought. Just like CPPIB, the money in 2009 came came from riding the monster beta wave. And just like CPPIB and the rest of the pension herd, the Caisse was late to change gears and go long stocks in 2009.

The Caisse was upfront about this and even provided this chart in their press release (click on it to enlarge):


In private markets , the Caisse was clear that real estate was very weak:
In 2009, the real estate market saw weakening fundamentals, such as rising vacancy rates and shrinking investments, against a backdrop of global economic recession. This environment led to significant decreases in value, particularly in the U.S. and Europe.

Financing conditions improved throughout the year, but credit spreads remain high by real estate standards. Within this climate, there were less non-performing loans in Canada than the U.S., where credit continued to deteriorate.

Although the impact was not as severe in the second half of the year, the real estate and commercial mortgage loan markets remain fragile.
If you read the Real Estate fact sheet carefully, you'll see that the losses were concentrated in the real estate debt portfolio:
The return on this portfolio was -20.3%, 28.8% below its benchmark index. This underperformance is primarily due to participation in third-party subordinated debt and structured products originated by third parties outside Canada. The Caisse ceased these activities in August 2009. The Canadian portion of the portfolio returned -2.0%, while the international portion yielded -46.5%.
I also noted the following on valuations of private markets:
The Caisse conducts a complete evaluation of its less liquid investments semi-annually, on June 30 and December 31. These investments represent nearly one-third of the Caisse’s net assets. External appraisers and valuation committees composed of independent experts review the Caisse's investment valuations.

PRIVATE EQUITY
  • Investments whose fair value exceeds a pre-established materiality threshold are subject to independent valuation committee or external appraiser review.
  • Nearly 80% of the fair value of the portfolio is reviewed this way.

REAL ESTATE
  • Chartered external appraisers certify the fair value of real estate assets.
  • 95% of properties are valuated this way.
Judging by the underperformance relative to benchmarks, you can tell that the Caisse uses the toughest benchmarks in private markets compared to their peers. The benchmarks will be available when the annual report is released next month. It's too bad the Caisse did not release the benchmarks along with the fact sheets on specialized portfolios.

My only concern with the 2009 performance centers around foreign exchange hedging. Recall what was stated last year, when the Caisse lost 25% in 2008:
The first factor that explains the variance in relation to large Canadian pension funds in 2008 is the cost resulting from foreign exchange risk hedging policy.

Hedging is not a currency speculation activity. It is a means of mitigating risk, which has been in place for at least 15 years with the objective of mitigating or offsetting an increase or a decrease in the value of the Caisse’s foreign investments solely as a result of fluctuations in the Canadian dollar.

Currency hedging is a characteristic of the various investment portfolios offered to the depositors. The private equity, real estate investments and hedge funds are 100% hedged. As for equity markets, the U.S. Equity and Foreign Equity portfolios are partially hedged (an average of 29% as at September 30, 2008).

The cost of hedging was unusually high in 2008. The decline of the Canadian dollar, which occurred mainly in October, increased the value of the Caisse’s foreign investments by $11.3 billion, once converted into Canadian currency. The currency hedging policy, which is designed to smooth out the currency effect, incurred a hedging cost of $8.9 billion. This is a record amount, most of which, 78%, is due to 100% hedging of private equity and real estate outside Canada.

“By adopting a long-term policy of 100% hedging of private equity and real estate, the Caisse enables its managers to concentrate on their investment responsibilities without being concerned about currency risk. This policy is also consistent with the fact that our depositors’ commitments are in Canadian dollars,” Mr. Perreault explained.

The annual effect of currency hedging was therefore highly unfavourable in 2008. The long-term effect of this measure is neutral. Over 10 years, including 2008, it is slightly positive.

“This factor undoubtedly explains a good portion of the 2008 variance vis-à-vis large Canadian pension funds of $1 billion or more, since the Caisse has a much larger proportion of private equity and real estate outside Canada, and does more extensive overall hedging,” Mr. Perreault concluded.
The table below shows the losses from currency hedging in 2008 (click on image to enlarge):


If the Canadian dollar came roaring back in 2009, you'd expect there to be favorable gains from currency hedging activities but nothing was mentioned in Thursday's press release. Why? Did the currency hedging activities not make money in 2009? If not, why not?

Finally, if you read the press release, you'll see the Caisse bolstered its financials by cutting risk:
Over the past year, the Caisse strengthened its financial position, reducing its liabilities by $27.7 billion, including $14.5 billion in derivatives. Liabilities fell from $66.8 billion to $39.1 billion, a 41.5% decrease.

Under a new refinancing program, the Caisse recently replaced certain short-term debt with $7.2 billion in longer-term debt, better matching the duration of its financing sources and uses.

In 2009, the Caisse also reduced its operating expenses and external management fees by $43 million or 13.7% to $271 million in 2009 from $314 million a year ago.
In addition, improving credit conditions led to $479 million in ABCP provision reversals, as at December 31, 2009 (renamed asset-backed term notes – ABTM).

The Caisse's President & CEO, Michael Sabia, ended off by stating:
“In 2009, we simplified and improved the way we work. We now have greater operational and financial flexibility to execute investment strategies. In 2010, we plan to vigorously pursue our five strategic priorities, making our depositors – our clients – our everyday focus. We want to lay the cornerstone for sustainable, long-term returns, that meet the needs of our depositors," added Mr. Sabia.
Mr. Sabia and his team have their work cut out for them. In the coming weeks, their performance will be compared to that of other large Canadian pension funds which likely outperformed the Caisse in 2009.

I will be examining these returns and comparing apples with apples, looking at benchmarks, especially private market benchmarks where most of the shenanigans take place. Before you slam the Caisse for underperforming their peers, I will let you in on a little secret: they got the toughest private market benchmarks in Canada. There is no free lunch at the Caisse.

Wednesday, February 24, 2010

Is Bernanke Worried About Japanese Deflation?


Federal Reserve Chairman Ben Bernanke said on Wednesday that short-term interest rates would be kept near zero "for an extended period," and said the Fed will "evaluate" whether additional monetary stimulus of some sort is needed:

Unemployment, not inflation, is "the biggest problem we have," he said.

In testimony prepared for the House Financial Services Committee, Bernanke left the door open to further purchases of mortgage backed securities and agency debt beyond March, and in response to questions from committee members, he said the Fed would also be evaluating whether it should extend its financing of new commercial mortgage backed securities past June.

Bernanke, presenting his semi-annual Monetary Policy Report to Congress on behalf of the Federal Open Market Committee, called the Fed's current monetary policy, which includes a 0-0.25% federal funds rate target and $1.1 trillion in bank reserves, "highly accommodative" and "very stimulative."

But when asked whether yet more monetary stimulus is needed to increase economic growth and spur job creation, Bernanke replied, "The FOMC is going to have to continue to evaluate whether additional stimulus would be necessary depending how the economy evolves, so we'll continue to look at that."

He did not elaborate on what form such "additional stimulus" might take. The Fed has no room to lower interest rates further, but it could do more quantitative easing through purchases of Treasury, agency and agency-backed MBS.

That is not the present intention. The Fed ended Treasury purchases last fall and has scheduled the end of agency and agency-backed MBS for the end of March. And Bernanke again described tools the Fed has developed for shrinking or at least absorbing the reserves created through past purchases.

But in his prepared testimony, Bernanke said, "The FOMC will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets."

Later, he said the Fed is "interested to see what the effect will be" of ceasing to buy MBS. "So far it looks like it will be modest."

TALF financing of "legacy" or older CMBS is due to expire on March 31. TALF loans backed by newly issued CMBS is set to expire on June 30. But in response to a question, Bernanke said the Fed will also "evaluate" whether the TALF should expire as scheduled.

He said the TALF has been "successful" in reducing spreads in the CMBS market, but he said the commercial real estate market is still fraught with problems that have broader implications for credit availability.

Commercial real estate (CRE) loans are "the biggest credit issue that we still have." He traced the increase in the number of problem banks to CRE exposure. "There are a lot of troubled commercial real estate properties and they are causing a lot of problems for banks, particularly small- to medium-sized banks and we're watching them very carefully," he said.

To the extent that small and medium-sized regional banks are hurt by CRE-related losses, he said the supply of credit could be further restricted.

Bernanke spoke in his prepared testimony about the Fed's ability to sell securities at some point to shrink its balance sheet and the supply of reserves, but he gave no indication he is eager to do that in response to questions.

On the contrary, Bernanke said the Fed will continue to hold the MBS it has bought and said this will "continue to hold down mortgage rates."

"It is true that we will stop buying new mortgage backed securities at the end of this quarter, but we continue to hold one and a quarter trillion dollars of agency mortgage backed securities, and taking that off the market in itself will keep mortgage rates below what they otherwise would be," he said. "So we believe that there will be stimulus coming from our holdings of those securities as well as our low interest rates."

"So we believe the economy as apposed to the money markets for example still requires support for recovery," he added.

Bernanke reinforced his easy money message by stressing the nation's unemployment problems and downplaying inflation risks.

In the prepared testimony, he said labor markets remain "quite weak" and said inflation "likely will be subdued for some time." In response to questions, he asserted, "unemployment is the biggest problem we have."

In fact, Bernanke did not rule out the possibility that deflation risks could revive. "Right now, we don't see deflation as an imminent risk," he said, adding that "inflation expectations are around 2% or higher." But he added, "there are scenarios in which it (deflation) could become more of a concern."

In addition to its traditional and unconventional monetary easing procedures, Bernanke made clear that the Fed is also using its supervisory powers to "get credit flowing again." He strongly suggested that the Fed is leaning on banks to make more loans.

In its examinations, he said the Fed has been asking banks questions to make sure that "creditworthy borrowers," especially small businesses, are not being denied credit.

Bernanke said the Fed is "working very hard" to make sure small business has adequate credit availability. He said the Fed has "incensed information gathering" to find out "how many loans have been turned down."

"There are some cases where tighter (lending) standards are justified," he said, but he added that the Fed "want(s) to make sure creditworthy (borrowers) are not being turned down ... . We don't want banks to made bad loans ... but where a borrower is creditworthy we want banks to make loans ... . We're working very hard to make sure that is not the case."

As he did in prepared testimony, Bernanke stressed again that the Fed's 25 basis point increase in the discount rate last week does not constitute monetary tightening, nor does it signal it.

"The reason we took action was to reduce the subsidy" to banks borrowing from the discount window, he said, adding, "I do not expect any effect whatsoever" of the discount rate hike on money market rates.

In his prepared testimony, Bernanke said that "by increasing the interest rate on reserves, the Federal Reserve will be able to put significant upward pressure on all short-term interest rates."

In response to questions, he suggested that raising the rate of interest on excess reserves will suffice to put a floor under the federal funds rate. "We think that the interest rate we pay on reserves will bring along with it the federal funds rate within tens of basis points, not a tremendous difference," he said.

His comment would seem to suggest that the Fed will not necessarily abandon the federal funds rate as its main monetary policy instrument or target and replace it with the IOER.

Without the additional tools the Fed has developed -- interest on reserves, large reverse repurchase agreements, a proposed term deposit facility -- Bernanke said that "with so many reserves in the system, we wouldn't be able to raise the federal funds rate.

But with those tools, he said the Fed should be able "to raise interest rates notwithstanding the fact that we have a large balance sheet."

Bernanke said "none of them (the tools) has been completely tested," but he said the Fed has a "belt-and-suspenders" capability. He said "interest on reserves itself could be used to tighten policy" but said the Fed could supplement that tool if necessary by using other tools to drain reserves.

Bernanke acknowledged that raising the interest paid on reserves (now 25 basis points) "would reduce our profitablility a little bit." But he said "since we're making 4% plus on MBS we would still have quite a bit of margin there." The Fed paid the Treasury a record $46.1 billion in 2009 out of net earnings on its operations.

Regarding the possibility of the Fed issuing its own debt -- so-called "Fed bills" -- Bernanke said the Fed is "not proposing that now." He said the Fed does plan to auction term deposits but only to financial institutions that hold reserves at the Fed.

As he has before, Bernanke warned about the long-term unsustainability of federal budget deficits. As currently projected, he said deficits will range between 4% and 7% of GDP even after the economy has recovered. He said it is "very important that we look at the trajectory" of deficits and reduce them as a percent of GDP.

Bernanke said deficits affect market interest rates not just in the future but "today." He warned that if bond markets lose confidence in U.S. fiscal policy long-term rates could rise in a counterproductive way. So he said "it would be helpful if there were a credible plan for fiscal exit."

A loss of confidence in longer term fiscal policy would push up long rates and be "a drag on the economy, he warned.

What's more, if confidence is lost, "the dollar could decline, which would have potential inflationary impact," he added.

Chairman Bernanke is right to worry about deflation. He's looking over at what's going on in Japan where Bank of Japan Deputy Governor Hirohide Yamaguchi earlier on Wednesday said the BOJ is ready to act to act as deflation weighs:

Yamaguchi, a career central banker seen as close to BOJ Governor Masaaki Shirakawa, said the BOJ's key task was to boost demand and show its determination to beat deflation so that the public doesn't take the view that price declines will persist and then hold off on spending.

"To overcome deflation, patient treatment of its root cause, which is a lack of demand, is necessary," Yamaguchi said in a speech to business leaders in Kagoshima, southern Japan, on Wednesday.

"It's important to make sure corporate sentiment doesn't shrink, so that deflation doesn't trigger economic weakness and further aggravate deflation."

The government, hobbled by a huge fiscal debt, has been pressuring the BOJ to support the fragile economy even as most other major central banks mull rolling back stimulus steps put in place during the global crisis.

The central bank has said it is committed to fighting deflation but it hasn't said how it will go about it.

Many analysts say it could pump more money into the banking system or offer cheap longer-term funds to bring down longer-dated interest rates such as six-month rates, particularly if the yen rises further and threatens to deepen deflation.

"The BOJ can't escape the fact that prices are still declining," said David Cohen, director of Asian economic forecasting at Action Economics in Singapore.

"The BOJ would be happy to stay on hold indefinitely, but they could do something to lower short-term rates to appease the government. Price declines will narrow as long as the global economy continues to recover. But a decline is a decline."

The core consumer price index likely fell 1.4 percent in January from the previous year, with annual price falls accelerating for the first time since they slumped by a record in August, according to a Reuters poll. The CPI data is due out on Friday.

The Japanese yield curve has steepened as expectations the BOJ could ease monetary policy further has kept shorter-dated yields low, while longer-dated maturities suffer from concern about Japan's fiscal condition.

Yamaguchi said recent economic developments have not changed much the public's long-term price expectations.

But he said the BOJ needs to ensure that price expectations remain stable and don't swing towards the view that deflation will last for a very long time.

Deflation hurts the economy as households put off spending on hopes that prices will fall further, forcing companies to cut prices to lure consumers.

One person who believes that deflation is coming in the US is Bob Prechter who says that the extraordinary action taken by the Federal Reserve to bail out the economy will not lead to runaway inflation.

"Deflation is gaining the upper hand very, very slowly, but it's happening," Prechter the founder of Elliott Wave International tells Tech Ticker. Of course, as anyone familiar with his work knows, he's been saying this for years.

Why should we believe him now?

For the first time since 1982 core inflation fell in January as measured by the consumer price index. Prechter says it's even more noteworthy that it's happening "in the face of this tremendous amount of stimulus...from the government and a real attempt at stimulus from the central bank."

Prechter describes the forces of deflation as a "socio-nomic" shift in social mood that will prevent Federal Reserve Chairman from printing too much money. "At some point, the voters - as you can already see from the Tea Parties - are going to start saying we've had enough" with government spending and bailouts.

How should you invest in a deflationary environment? Mr. Prechter believes nobody should be taking risk right now and thinks the bond market is the "biggest bubble in the history of the world":

"What has happened is a complete change in psychology from extreme negativity [a year ago] to extreme optimism" heading into the market's recent top in January, Prechter says.

Among the many sentiment indicators he watched, Prechter cited the very low levels of cash at mutual funds, which is approaching levels seen near major tops in 1973, 2000 and 2007.

"Nobody should be taking risk right now. This is a time to be safe," he says.

But considering U.S. equity funds suffered about $46 billion of outflows from August to December 2009 while bond funds took in about $198 billion, according to ICI, aren't investors already playing it safe -- a bullish contrarian signal?

"The individual investor has been more or less abandoning stocks" and buying bond funds, Prechter concedes. "I think that is going from the frying pan into the fire. The bond market is the biggest bubble in the history of the world. "

Corporate debt, municipal debt, mortgages and consumer loans will all suffer in the great deflation Prechter believes is already underway, as detailed in his book Conquer the Crash.

So is there any way for investors to protect themselves from the carnage? Mr. Prechter thinks in a deflationary environment, cash is king. If his predictions come true, many investors, including those that are overweight gold, will get creamed.

As you listen to the interview below, keep in mind that many pension funds investing trillions in risk assets will also get creamed if deflation sets in. Bernanke knows this, which is why he's not prepared to raise rates before he sees solid gains in employment and a pick-up in inflation expectations.

**UPDATE: Why Prechter is Wrong on Deflation***

On Thursday, renewed concerns about Greece's credit rating and the future of the EU gave the dollar a boost, with commodities and equities suffering as a result. Broadly speaking, the market action seems to justify Prechter's warning.

Not so fast, says Peter Boockvar, equity strategist at Miller Tabak, who believes inflation remains a bigger long-term threat to the market and U.S. economy.

"It's the reaction to the potential deflation that gets to the inflation," Boockvar says. "The more deflationary type steps we see, the more money printing that will go on around the world that will set us up for that inflation. More deflation will eventually get us more inflation."

It may seem somewhat convoluted logic, but Boockvar's point is that global policymakers will do anything and everything to fight deflation, most definitely including Fed chairman Ben Bernanke.

See Peter Bookvar's interview by clicking here.


Tuesday, February 23, 2010

Will the Lesser of Two Evils Prevail?


David Pett at the National Post reports that Euro worsens deflation risk:

Since the Great Recession, there have been fears that the U.S. economy would follow in the footsteps of Japan, where economic activity and investment have been stagnant for more than two decades.

More recently, however, prospects for recovery south of the border have improved and it is the European Union, struggling with a growing sovereign debt problem that could be headed for Japanese style deflation.

"The recent string of debt crises in Southern Europe has revealed the true financial frailty of the euro area economy," said Chen Zhao, managing editor, BCA Research Inc. " In fact, the economic snapshot of the eurozone looks very disturbing."

Over the past two months, markets around the world have been rattled by the growing unease surrounding Greece's well-documented debt woes, but also by other eurozone nations, such as Portugal and Spain, also burdened by highly levered balance sheets.

While the past few weeks has seen bond spreads fall and the euro rebound against the greenback on tentative plans for a Greek bailout, Europe's economy remains tenuous. The OECD said growth in gross domestic product in the euro area slowed to 0.1% in the fourth quarter of 2009 and will expand by just 0.9% this year.

Mr. Zhao said the intense debt-deflation pressure being felt in Europe has many similarities to the post-crash environment in Japan in the early 1990s.

Even as the country's very own asset bubble was beginning to burst in 1989, Japan mistakenly believed the biggest risk to the economy was inflation, not deflation, and continued to raise rates until September 1999. Continuing to run a surplus until 1992, its fiscal policy was also a drag on the collapsing economy and it was not until 1995 that Japan's deficit hit 5% of GDP.

Similarly, the European Central Bank was slow to react to the recent global financial crisis, raising rates as late as July 2008 when stock markets had already fallen 30%. The implementation of a fiscal stimulus package was also late in coming.

Since then, Europe's monetary and fiscal policy has been much more aggressive and proactive than Japan's response, but Mr. Zhao said the recent collapse was also much more severe than the slump in the Japanese economy in the early '90s.

"So judging by the severity of the Great Recession, it is not obvious whether the stimulus in the eurozone has been aggressive enough at all," he said.

In addition to parallel policy responses in both episodes, Mr. Zhao said the strong euro has greatly increased the risk of weak economic recovery, price deflation and loss of competitiveness in Europe, as did the strong yen during Japan's post-crash struggles.

To make matters worse, the common currency makes it impossible for member countries struggling with excess debt to devalue their own currency.

Chen Zhao has always been one of the more interesting Managing Editors at BCA Research. When I was working there, I didn't know how he was able to constantly produce so many thought provoking pieces. Chen is a tireless workhorse who never shies away from making big calls.

I saw the slowdown in Europe coming when I visited Greece this past summer. There were hardly any tourists and the strength of the euro didn't reflect strong European fundamentals, but relatively weak US fundamentals at the time. One Greek cab driver told me: "we're going to starve this winter." They're not starving but Greece's fiscal woes are going to require some sacrifices ahead for most Greeks.

And risk of deflation are not just in Europe. In Japan, bonds advanced for a second day as concern deflation will deepen in the world’s second- largest economy boosted demand for government debt.

Bond futures approached the highest level this year as stocks slid worldwide after a U.S. report yesterday showed confidence among consumers declined to the lowest in 10 months. Consumer prices in Japan dropped for an 11th month in January, according to a Bloomberg News survey of economists before the government report this week.

“Given the huge slack in supply and demand conditions, Japan will be mired in deflation,” said Akitsugu Bandou, a senior economist at Okasan Securities Co. in Tokyo. “This will make it easier for investors to keep spending money on bonds.”

The yield on the benchmark 10-year bond fell 1.5 basis points to 1.315 percent as of the 11:05 a.m. morning close in Tokyo at Japan Bond Trading Co., the nation’s largest interdealer debt broker. The 1.3 percent security due December 2019 gained 0.130 yen to 99.869 yen.

Ten year bond yields at 1.35%! As bad as that sounds, it's better than the ravages of deflation, which wipes away returns from risk assets like stocks and corporate bonds.

In England, Gov. Mervyn King said on Wednesday that the Bank of England may still have to pump more money into Britain's fragile economy after the central bank forecast inflation standing well below target in two years' time.

Finally, the jury is out on whether the US will escape deflation. Some people feel that deflation risks still exist in the US while others see bond trading reflecting two views on US inflation:

Bond markets are jittery and investors have reasons to be nervous.

The decision last week by the U.S. Federal Reserve Board to raise the discount rate - the interest it charges on the emergency loans it makes to banks - suggests the days of easy money marked by the Fed's zero-interest rate policy are numbered.

The Fed raised the discount rate by one-quarter of a percentage point, to 0.75 per cent.

While that signals another step in the return of financial markets to a more normal state, given the weak economy it will likely be some time before the Fed begins to raise its key federal funds rate. That is the rate that helps to hold short-term interest rates down in order to stimulate economic growth.

And it is that policy that has bond investors antsy. The worry is that the continuing low interest rate and loose monetary policies of the Fed will fuel inflation.

So far, inflation pressures as measured by the consumer price index have been relatively tame, if rising gasoline and food prices are excluded. The U.S. core consumer price index (excluding food and energy) on a year-over-year basis was 1.6 per cent in January, compared with 1.8 per cent in December.

However, overall the annual inflation rate is 2.6 per cent, reflecting higher gasoline prices and the beginning of higher food prices resulting from the impact of the Florida freeze on fruit and vegetables, according to BMO Nesbitt Burns Inc.

Bond investors are being torn between the safety of holding U.S. Treasuries and the risk of seeing their savings eroded by inflation. Recent action in the bond markets illustrates the forces at work.

The short-term action has been dramatic.

The U.S. Treasury Inflation-Protected Securities bonds, or TIPs, are securities that provide a return tied to the CPI data, including food and energy. TIPs have experienced a sharp selloff during the past few weeks, after a year in which they outperformed conventional Treasuries by more than 10 per cent. The recent drop has lowered the out-performance to about 7.6 per cent.

"I have been aggressively selling TIPs during the past month, and have been selling since some time last year," said Mihir Worah, a managing director and head of the real return bond desk for Pacific Investment Management Co., or Pimco, the world's largest fixed-income manager.

A year ago, Pimco saw TIPs as an excellent investment opportunity because they were priced as if there would be deflation for six or seven years. "Let's hope this call is right, too," Mr. Worah said.

Let me repeat that given the choice between the lesser of two evils, the Fed will err on the side of inflation. There is a concerted effort to reflate financial assets which they hope will translate into "mild inflation".

Pension funds are betting trillions of dollars that inflation will ultimately prevail. Let's hope they're right on that call because if they're not, millions of pensioners will be feeling the squeeze of reduced pension benefits.

The Ultimate Pension Plan?


Just came back from Calgary and I'm tired so will keep this short. First, let me thank Ashton Embry and his wonderful wife for hosting me on Sunday evening. Ashton is the founder of direct-ms.org and is simply a great guy. His wife Joan cooked up a storm (absolutely delicious) and I got to meet two of his sons, their wives and his grandchildren. I truly enjoyed the evening and learned to drop vitamin D pills and go for vitamin D drops which I can add to my morning coffee.

In pension news, Hester Plumridge of the WSJ reports that BMW Drives New-Age Hopes for Pensions:

The U.K.'s pension nightmare is seemingly never-ending. But BMW's innovative deal with Deutsche Bank to insure £3 billion ($4.64 billion) of its pension liabilities, or the entirety of its pension-drawing work force of about 60,000, against increased longevity, offers hope to companies eager to reduce exposure to volatile pension deficits. It also offers a potential fresh lease on life to the U.K.'s stalled fledgling pension-buyout industry.

During the boom, a number of start-up funds raised money in the expectation that companies would take advantage of narrowing deficits to shed their pension liabilities to an insurer. But the financial crisis caused deficits to balloon again as asset prices fell and bond spreads widened, increasing the value of liabilities. That made a full pension buyout prohibitively expensive for most fund sponsors.

BMW's deal with Deutsche's Abbey Life subsidiary gets around this issue by passing on only one element of risk to the insurer: longevity risk. The assets and liabilities, including responsibility for the pension fund's deficit, last valued at £545 million in 2007, will remain on BMW's balance sheet, although Abbey Life will assume payments to the pensioners. BMW will pay Abbey Life a fixed premium.

The two parties in the deal need not differ radically in their mortality assumptions for the pensioner group. For BMW, the cost of the deal is likely to be about 5% of the insured liabilities, or about £150 million, but is worth it to reduce the fund's volatility. Abbey Life believes the premiums it charges will be more than the forecast risk assumed.

Besides, if asset prices recover and bond spreads narrow, there is nothing to stop the car maker from seeking a full buyout in the future. Other U.K. companies will want to take note.

Bloomberg citing the FT, said this is the largest deal yet in corporate longevity insurance, effectively doubling the size of the market. BMW is not the only firm to have recently looked to the longevity swap market as a way of covering the risk posed by people living longer:

Last May, Babcock International became the first British company to do such a swap deal using Credit Suisse as counterparty to hedge 500 million pounds.

Then, in December, Swiss Re undertook a longevity swap in a deal in the UK with the Royal County of Berkshire Pension Fund, which was the first transaction by a public sector pension scheme. The longevity swap covered around 1 billion pounds of its pensioner liabilities.

Consultants Hymans Robertson issued a report on Feb. 17 that predicted the longevity swap market would hit $10 billion in 2010.

Hymans said it expected two other longevity swap deals worth well in excess of 1 billion pounds, which were expected to close in the first half of 2010.

"Premier Foods have been reported to be in negotiations over a longevity swap deal covering around 2 billion pounds of Rank Hovis McDougall's pension scheme's liabilities," the report said.

Deutsche Bank is a member of the newly formed Life and Longevity Markets Association (LLMA). The LLMA wants to transfer the UK's 2 trillion pounds of pension liabilities to the capital markets to help pension schemes and insurers manage the financial pressure of increased life expectancy.

Hewitt's Bird predicted another $15 billion in longevity swap deals to come by the end of 2010.

"Most of the capacity of the BMW deal was through reinsurance, but as more standardisation around longevity structures comes into the market, the use of index solutions will increase, which will open up a route veto the capital markets," he said.

Will longevity swaps take off now that BMW and others have entered into these deals? I believe that companies looking into such arrangements should carefully consider the pros and cons, but it's clear that if they're looking to reduce exposure to volatile pension deficits, then such deals may make perfect sense.

Of course, if everyone starts entering into longevity swaps, they may be creating another potential problem down the road without addressing other structural factors that exacerbate pension deficits. In other words, longevity swaps are not the magic pension pill that the media makes them out to be, so buyers beware.

***Comment on longevity swaps***

Posted on Zero Hedge, this was an excellent comment on longevity swaps:

I've done some research on this in the past. For general reference (to a question above) longevity swaps work like any other swap, with the underlying security for calculation of payments to and fro being a longevity/mortality index. The buyer of the swap makes fixed payments to the hedge provider. The hedge provider pays floating based on index performance (the longer people live, the more the hedge buyer receives from the hedge provider). One problematic aspect of it all is that all longevity/mortality indexes are imprecise and capture a much larger population pool than any given pension fund or life insurer's risk pool - but that's only a technical difficulty.

The larger problem that I have with these instruments is that they are a perversion of the whole idea that swaps are used to hedge risks that is not tied to the buyer's core competence/ business. So, for example, airlines are not in the business of oil trading but are in the business of transporting people. A legit hedge in my book is when an airline buys a swap, future or a forward against oil price fluctuation. A ridiculous swap is when that airline tries to buy a hedge against fluctuations in the quantity of passengers that it'll have over the next few years.

The use of longevity swaps by pensions and especially life insurers is much closer to the ridiculous category. Managing longevity risks is their business for chrissake. So when they offload that risk to someone else - the question arises inevitably - who is the ultimate holder of that risk? Banks? But why? Are banks better than pension funds at assessing actual longevity risk profile of a pool of beneficiaries? Obviously not. And no one else is either - so these lazy pension fund managers should suck it up and start doing some actual work.

Last but not least - if the present crisis taught us anything about the use of derivatives is that they never solve a problem if there is on. They only hide it for a while, enabling someone to make a quick buck in the process. But shit hits the fan eventually and when it does it inflicts too much collateral damage. The subprime moment of these longevity hedges may end up being some medical breakthrough (e.g., cancer treatments) that rather dramatically lengthens expected lifespan of current and future retirees. Just what we need then - more bailouts, in this case for Deutche Bank.

Sunday, February 21, 2010

Pension Systems on the Brink?


Robert Powell, editor at Retirement Weekly, wrote an editorial for MarketWatch on pension systems on the brink:
A train wreck waiting to happen. That's the only way to describe the mess that state pension systems are in right now, according to a report published today by the Pew Center on the States. According to Pew, there's a $1 trillion gap between the $3.35 trillion in pension, health care and other retirement benefits states promised their current and retired workers as of fiscal year 2008 and the $2.35 trillion they have on hand to pay them.

What's worse, the gap may be even higher given that the study was conducted prior to the market collapsing in 2008 and given the way most states allow for smoothing of investment gains and losses over time.

How did this come to pass? And more importantly, what can be done to solve it?

Investment losses account for part of the funding gap. But the bigger problem, according to Pew, is that many states simply fell behind on their payments to cover the cost of promised benefits -- and that was even before the Great Recession.

"Many states shortchanged their pension plans in both good times and bad, and only a handful have set aside any meaningful funding for retiree health care and other non-pension benefits," Susan Urahn, managing director of the Pew Center on the States, wrote in her report.

And now, state policy makers who ignore the current shortfall do so at their own peril. Indeed, states that fail to address under-funded retirement systems face the very real possibility of raising taxes or taking taxpayer money that could be used for education, public safety, and other necessary services just to pay public-sector retirement benefit obligations.

To be fair, not all states are in the same pickle. Illinois and Kansas are in really bad shape. Those states each have less than 60% of the necessary assets on hand to meet their long-term pension obligations, Pew said. Illinois is in the worst shape of any state, with a funding level of 54% and an unfunded liability of more than $54 billion. Meanwhile, nine states had pensions funded above 90% and Florida, Idaho, New York, North Carolina and Wisconsin all entered the current recession with fully funded pensions.

Most experts suggest at least an 80% percent funding level. Pew found that 21 states were funded below that recommended level in 2008. Of those 21, eight had more than one-third of the total liability unfunded: Connecticut, Illinois, Kansas, Kentucky, Massachusetts, Oklahoma, Rhode Island, and West Virginia.

In all, Pew said just 16 states are "solid performers"; meanwhile, 19 are in serious trouble.

Other benefits pose similar problems

As for retiree health care and non-pension benefits, Pew said that's another huge bill coming due. In fact, the total needed to pay for current and future benefits is $587 billion. Unfortunately, only $32 billion -- or just over 5% of the total cost -- was funded as of fiscal year 2008. Half of the states account for 95% of the liabilities. As with pension funding, some states are worse off than others.

"Only two states had more than 50% of the assets needed to meet their liabilities for retiree health care or other non-pension benefits: Alaska and Arizona," Pew said. "Only four states contributed their entire actuarially required contribution for non-pension benefits in 2008: Alaska, Arizona, Maine and North Dakota."

Bridging the gap

What can be done to make up the $1 trillion gap? In a word, reform. Not extreme reform. Rather, reform that brings the public sector more in line with the private sector. Here's what Pew recommends:

1. Keep up with funding requirements

According to Pew, generally, the states in the best shape are those that have kept up with their annual funding requirements in both good and bad times. Arizona and Connecticut are required to fully fund their obligations. But that's just part of the battle.

"States also need to make sure the assumptions used in calculating the payment amount are accurate -- for example, estimating the lifespan of retirees or the investment returns they expect." For instance, many states based their assumptions on investment returns of more than 8%. By contrast, the top 100 private pension plans had an average assumed investment return of 6.36% as of December 2008.

Yes, some states, Utah and Pennsylvania among them, are reducing the assumptions on investment returns. But more states need to address funding requirements and investment return assumptions.

2. States should reduce benefits or increase the retirement age

Most states can't reduce pensions for retirees or current employees, but they can for new employees. And that's exactly what several states are doing now. According to Pew's report, Nevada, New York and Rhode Island recently reduced benefits for new employees either by altering the pension formula or raising retirement ages. More states need to examine and consider this tactic.

3. States should share the risk with employees

A few states, the Pew report notes, have taken a page out of the private sector's pension world. They are "sharing more of the risk of investment loss with employees by introducing benefit systems that combine elements of defined-benefit and defined-contribution plans," the report said. "These hybrid systems generally offer a lower guaranteed benefit, while a portion of the contribution -- usually the employees' share -- goes into an account that is similar to a private sector 401(k)."

Nebraska and Georgia have hybrid plans in place for new employees, while Michigan and Alaska have 401(k) plans in place for new workers. But movement away from defined-benefit plans to defined-contributions plans is easier said than done. "Because unions and other employee representatives often have vigorously opposed defined-contribution plans, it is unclear whether any state will find such a switch viable, or if such plans are primarily being proposed as a starting point for hybrid plans or other compromises," the Pew report said.

4. Increase employee contributions

Employees already contribute about 40% of non-investment contributions to their own retirement. "But states are looking toward their workers to pay for a larger share," the Pew report noted. "In many states, the employee contribution is fixed at a lower rate than the employer contributions." But some states have put in place reforms to change that. Arizona, for instance, has a system where employee and employer contribute the same amount. And other states, such as Iowa, Minnesota and Nebraska, have the ability to raise employee pension contributions if needed.

What's more, Pew noted that several states also began asking employees and retirees to start making contributions for their retiree health-care benefits -- just as happened with retirees from the private sector.

5. Improve governance and investment oversight

In recent years, Pew noted that "some states have sought to professionalize the complex task of pension investments by shifting oversight away from boards of trustees to specialized bodies that focus on investment." Other states have worked on making sure boards of trustees for pensions are well trained, that the division of responsibilities between board and staff makes sense, and that the composition of the board is balanced between members of the system and individuals who are independent of it. States being praised for reforms in the right direction include Vermont, Oregon, and even Illinois.

To be fair, states aren't standing still when it comes to reform. According to Pew, 15 states passed legislation to reform some aspect of their state-run retirement systems in 2009, compared with 12 in 2008 and 11 in 2007. Still, it would seem that more need to get on the reform bus. Especially given the alternative.

In the absence of paying down this $1 trillion deficit, Pew said the debt will increase even more significantly. "This will leave the states, and tomorrow's taxpayers, in even worse shape, since every dollar needed to feed that growing liability cannot be used for education, health care or other state priorities," the Pew report said.

You can read the Pew report by clicking here. You can also read Mike Shedlock's analysis of this report, by clicking here.

I do not plan on going into great details on this report as its findings didn't surprise me. Instead, I want my readers to keep in mind of certain basics governing pension funding:

  • First, pensions are not just about assets, they are there to meet future liabilities. In other words, it's all about asset-liability matching. This is important because while pension fund managers try to "shoot the lights out", often taking excessive risks to meet their actuarial rates of return (which are way too high), they expose funds to serious downside risk.
  • Second, there is a growing gap between public sector pensions and private sector pensions that is fueling anger and discontent out there. In an era of fiscal deficits, there will be increasing pressure to reign in all benefits, including public sector pensions. is this justified? In some cases, yes, but in other cases no. Governments will use any excuse to reign in public sector pensions but they allowed this situation to spiral out of control.
  • Third, and most importantly, governance matters. I can't stress this last point enough. Governance means that there are appropriate checks and balances governing pension funds and all their activities.
The last point is important because since last March, stocks have been on a tear, and many public pensions funds, including New York state's Common Retirement Fund (CRF), are moving up again:
The New York State Common Retirement Fund (CRF) announced it has returned 22.3% through the first three quarters of 2009. As of Dec. 31, 2009, the end of the fiscal third quarter for the pension, the plan’s holdings were valued at $129.4 billion. That was good for a 3.4% rate of return in the third quarter.

New York State Comptroller Thomas DiNapoli has been working hard at increasing the transparency of the CRF since he took office following the resignation of Alan Hevesi. Part of DiNapoli’s effort has included releasing quarterly performance reports to the public. This plan was started last year. Prior to that, the plan released annual performance reports.

DiNapoli has also released monthly investment reports for the fund. In those reports, DiNapoi discloses where CRF capital has been committed, the amount and the date of the closing of the investment.

In the plan’s latest monthly investment report for November 2009, the CRF closed seven transactions worth more than $591 million. Nearly all of that capital was committed to alternative investments.

The CRF closed two deals in its private equity portfolio worth $40 million, three deals in its absolute return strategy totaling $300 million, and one deal in its opportunistic alternatives portfolio valued at $250 million. The remaining deal included a real estate transaction worth $1.4 million.
Notice how pensions are now moving back into alternative investments, meaning more hedge funds, more private equity and more "alternatives" like commodity funds. While I'm not against moving some assets into alternatives, I warn public pension funds that they carry their own sets of risks and most U.S. public plans are at the mercy of their pension consultants when investing in these alternative investments. And many of these pension consultants do not properly understand how to evaluate these alternative investments in a portfolio context.

The NYT reports that New York City’s freshly elected comptroller, John Liu, announced this week what he called major reforms in the way the city’s pension fund works. Mr. Liu said he wants to ease a ban on the placement agents to help mostly smaller funds, including those run by women and minorities, that don’t have the staff or expertise to win contracts on their own.

I remain highly skeptical on placement agents as most offer no value added whatsoever. These smaller pension funds should not even exist. They should be rolled up into a larger plan which has proper oversight and expertise to manage pension monies.

Finally, the NYT published an AP article, Missouri Auditor Calls for More Pension Oversight:
Lawmakers considered a bill Thursday to give the Missouri state auditor legal authority to monitor state pension systems.

The bill comes in response to a recent court ruling that found the state auditor only has the authority to review internal audits completed by the pension systems. A Cole County Circuit Court judge quashed a subpoena from the auditor to review more documents and interview employees with the state's Local Government Employee's Retirement System.

The auditor's office has appealed the court's decision.

The bill's sponsor, Sen. Jason Crowell, R-Cape Girardeau, told the Senate pensions committee that many other state retirement systems allow the auditor to perform a full audit despite the ambiguous language.

His bill would permit a full audit of any retirement plan created by the state.

State Auditor Susan Montee said Missouri has performed audits on pension funds without a problem since the 1980s, but it is better to clean up the language.

''The ability to have oversight into our retirement systems is beneficial,'' Montee said.

The state auditor goes beyond a simple fiscal audit to examine whether agencies spend money properly. This includes looking at bidding processes and travel expenses.

Montee said it doesn't make sense for her office to only review fiscal audits completed by independent auditors.

''It's an exercise in futility for us to come in and look at someone else's work,'' she said.

Officials with other state retirement funds spoke in favor of the change, saying they encourage the extra level of accountability.

A Pew Center on the States report released Thursday found that Missouri's overall pension system is considered healthy despite the state's current economic woes.

The report states that the systems ''need improvement.'' Missouri is still better off than neighboring Kansas and Illinois, which had less that 60 percent of the necessary assets on hand in 2008.

Interestingly, the Board at the Missouri State Employees' Retirement System (MOSERS), recently announced it is reviewing staff compensation structure:

The MOSERS board voted to revise the MOSERS staff compensation structure for the fiscal year that begins July 1, 2010. At the November meeting, the board directed staff to develop a compensation proposal that included recognition of the investment performance of the system’s assets but limited incentive payments to staff to only those years when the fund’s return is positive.

Executive Director Gary Findlay offered a proposal at the January 21, 2010, meeting to eliminate the performance-based pay plan and instead, adopt a base pay compensation structure that is market-based. The proposal was adopted by the board. The board will consider hiring a compensation consultant to evaluate and recommend market-based pay levels for all staff positions.

I am following compensation structures at public plans very closely and I have a feeling what is happening at MOSERS will affect other plans too. Also, like in other states, the fiscal situation is dire in Missouri, and they're tightening their belt:
As part of the most recent announcement of additional expenditure restrictions necessary to balance the state budget, the State of Missouri, Division of Budget and Planning announced yesterday that the employer incentive (match) associated with the State of Missouri Deferred Compensation Plan (the Plan) will be suspended at least through June 30, 2010.
Please keep in mind that MOSERS is one of the best public pension funds in the United States. Their governance puts most other US plans, and Canadian plans, to shame. They don't just talk transparency, the actually deliver on it.

Are pensions on the brink? The answer to this question ultimately depends on whether the Fed, central banks and governments around the world are able to re-engineer inflation through asset reflation. If they fail, and we run into a protracted period of deflation, the majority of pension funds that are highly exposed to private/public equities, real estate, and alternatives like hedge funds are cooked. All other pension reforms are useless if deflation sets in.