A Basket Caisse?
I am going to follow-up on yesterday's comment on the Caisse's $40 billion train wreck. Let me start off by answering some of Diane Francis' questions in her article, No way to run a piggyback. Here are her questions and my answers:
Diane Francis: Why were there no internal controls in place to ensure that such huge, unhedged bets were made? Is this occurring in other pension funds, too?
Answer: Of course it's occurring in other pension funds. If it wasn't we would see billions of dollars evaporating into thin air. Most pension funds suffer from a bad Caisse of risk management theater. The risk managers are just there for show and the front office guys laugh at them and tell them to bugger off when they exceed their VaR. All show, no substance. It's time to adjust those risk models.
Diane Francis: Is it true that several teams of portfolio managers were fired for catastrophic results and not replaced?
Answer: Some were fired for bad performance but others for internal political reasons. I heard several internal portfolio managers lost hundred of millions in 2008 and they still have their jobs. I guess they were on the right side of the political fence. Isn't time the public finds out exactly who lost what at the Caisse? Just publish the performance of each and every internal and external portfolio manager and use numbers if you want to conceal their identities.
Diane Francis: Why did the Caisse chairman and chief executive get huge bonuses for 2007 and 2008 despite such mishaps?
Diane Francis: Is it true that the Caisse does not have sufficient computer systems to monitor investments in real time? And that huge amounts of money have been spent on outsourced computer contracts that have done little to fix the problem?
Answer: Yes, their back, middle and front office systems need to be evaluated by independent firms that specialize in operational risk. The same goes for each and every pension fund out there. If governments are going to get serious about pension governance, they need to implement independent performance and operational audits, above and beyond the financial audits by accounting firms or the provincial (state) and federal auditors. Again, even the best systems will be rendered useless if the risk managers sit on their hands.
The complexity of some pension activities and the mounting costs to generate "alpha" were at the heart of Bill Watson's article, Basket Caisse:
As a future Quebec pensioner, though probably now later rather than sooner, I find the Caisse de Depot et Placement's announcement yesterday that in 2008 it lost $39-billion or 25% of its -- my -- portfolio value painful enough. But the irrational responses that seem bound to result may in the long run end up hurting more.
In the case of the Caisse, a lot of attention is being paid to the Charest government's decision in 2005 to require it to focus more on maximizing shareholder return -- they actually call us "depositors" rather than "shareholders," though we don't actually have the option of not making a "deposit" -- and less on responding to the latest industrial-policy investment fad seizing Quebec, Inc., the powerful politico-industrial complex that, in the 1960s and 1970s, shoved aside the Catholic Church in the province's influence structure.
In view of the disappointing results, a lot of people seem to believe we should go back to the old model of crony capitalism. As a "depositor," I sure hope not. While it's always nice to see fellow Quebecers get generous financing for their latest industrial schemes, it's nicer still to see my retirement account in the black.
The know-nothing rejoinder to that argument is, well, now we tried it the market way and you're no better off, maybe even worse off, than you would have been under the old system of crony capitalism. So crony capitalism must be OK.
In the same vein, many wise observers in the United States must be pointing out that if George W. Bush's plan for individual social security accounts had been adopted, many retirees would have been hit hard by last fall's crash. Much better to keep the system whereby we simply impose steep taxes on our kids and grandkids in a pay-as-you-go (or, rather, they-pay-as-we-go) pension scheme. (Actually, the Bush scheme would have been so new in 2008 that very few future retirees likely would have been affected.)
The same kind of thinking -- a big problem in one part of the governing social order justifies ditching most of the rest of it -- seems to be guiding President Obama. As long as we're fixing housing, finance and autos, let's also do energy, health and education, the entire status quo now having been discredited by, as someone wrote the other day, severe mortgage problems in four U. S. counties.
Well, no. That we've had a very bad outcome in the financial sector doesn't mean the whole social and economic system needs to be thrown out. In fact, a case could be made that, once the short-term bailouts are over, pretty much nothing more needs to be done. The system is busy fixing itself. People have already learned lots of lessons. They're now being even more prudent than they should, which is why everything economic is slowing down. To paraphrase Larry Summers, President Obama's chief economist, three years ago there was too much risk in the system and not enough fear, fear being the most effective regulator, and now there's too much fear and now enough risk.
The Caisse certainly seems chastened. It's clearly not going to do anything like asset-backed commercial paper again anytime soon. As its president put it, "In hindsight, we placed too much confidence in these securities .... It was a mistake to accumulate so much ABCP."
Beyond simply being more cautious in future, big pension plans might want to reconsider their whole approach to investment --not just what they buy but what they're trying to do. The Caisse spent $314-million last year -- $263-million on its own operations and $51-million for outside experts --in order to lose its $39-billion.
My own personal investment plan outdid the Caisse by 10 percentage points last year and did so with an administration cost of exactly zero: I did no trading at all but simply gritted my teeth and held what I'd bought some time ago.
Granted, unlike the Caisse, my personal depot et placement operation didn't hedge my (two) foreign investments 100% and therefore wasn't affected when that strategy generated losses to offset the exchange-rate component of the foreign gains, an outcome that presumably will be reversed for the Caisse when in future the dollar changes direction. And I didn't take a bath in asset-backed commercial paper the way the leading-edge money-market buyers at the Caisse did. Like most people, until two years ago I didn't actually know what ABCP was and therefore never thought about taking advantage of its miraculous investment properties: lower risk, higher return.
To be sure, in several recent years my much more conservative investment strategy did not outperform the Caisse. But I was raised on Burton Malkiel's A Random Walk Down Wall Street. You can't actually beat the market. If a $20 bill falls to the street it probably will have been picked up before I get there. How exactly is it that individual market players, or even an individual province's market players, are supposed to outperform the market?
In Quebec we produce great singers, hockey players, politicians and aircraft engineers. It's no shame if we don't lead the world in stock-pickers, too.
Bill Watson is right, most "active managers" are closet indexers who charge fees. The same goes for most hedge fund managers who charge 2% management fee and 20% performance fee to deliver beta.
But unlike long-only managers, the very best hedge funds deliver risk-adjusted absolute returns and if they do not perform, they don't get performance fees until they recoup the losses. They are subject to high-water marks which is why most hedge funds fold if they have a disastrous year (and some managers resurface under a new fund).
There is however, another point behind Bill Watson's article that we should all be thinking about. These multi-billion dollar pension funds that incur all sorts of costs, how are they performing relative to a portfolio of 50% stock/50% bonds or even 60% stocks/40% bonds?
If you want to push it even further, how are they performing relative to a portfolio of 100% government bonds? I have already written on how Turkey's pension funds led the world in 2008 because they were largely invested in safe government bonds. More recently, I wrote about how South Korea’s National Pension Service, the nation’s biggest investor with 225 trillion won ($151 billion) in assets, broke even last year.
It's a humbling thought, but in an age of deflation, most active managers and even those "superstar" alternative investment managers will underperform good old boring government bonds.
But instead of recognizing systemic risk and shifting more into government bonds, over at Quebec Inc., it was a Caisse of wild expectations:
Led by opposition politicians and many media pundits, Quebecers were wringing their hands and shaking their heads yesterday over the news that the Caisse de dépôt et placement du Québec lost $39.8 billion last year.
That's about 25 per cent of the Caisse's whole value 14 months ago. The decline is much worse than the average drop in Canadian pension plans, which was 15.9 per cent.
Take a deep breath. Remember, as you try to get to sleep at night, that while the $40 billion figure is staggering, it's not catastrophic. The Caisse's total nest egg remains at $120 billion, more than it managed in 2004. And 56 per cent of the reported loss represents current holdings at market prices: a stock-market recovery would move those values back up, though surely not as fast as they have fallen.
Still, this is certainly the kind of news that generates angry questions. The Caisse manages Quebecer's pension funds, a matter our aging population takes seriously. What are we paying all those people in that over-priced building to do? National Assembly hearings will be necessary to get some answers, although there's a real danger that these will become a partisan sideshow.
The Caisse says it has two broad objectives, "generating a return that meets its depositors' expectations" and "limiting the risk of its overall portfolio." What happened over the fat years before 2008 was that these two goals became mutually exclusive as everyone's expectations rose.
In a sense all parts of Quebec society share the responsibility for this debacle, and the unfortunate results that might well flow from it. Everyone shared in the willful blindness of boom times - and walked blindly off the risk cliff late in 2007 and last year.
Look at the overall returns the Caisse reported under Henri-Paul Rousseau: 15.2 per cent in 2003, 12.2 per cent in 2004, then 14.7 and 14.6 per cent in the next two years. No Canadian pension fund did better. Those numbers look surreal from today's perspective, don't they? But in fact they merely mirror the boom in stock prices through those years.
We can see now that there was a "don't ask, don't tell" ethos at the Caisse, as across Canada and around the Western world. Nobody challenged the cornucopia of good news. Nobody asked about bubbles. We certainly didn't hear Quebec opposition parties, so vocal today, ask hard questions about those fat returns. Nor did we in the media. Nor did the investment industry, or just about anyone else.
So who should now answer for this eye-opening $40 billion loss of value? Certainly Caisse executives, starting with Rousseau, have some explaining to do. We know already that asset-backed commercial paper was a debacle, and the Caisse bet wrong on currency movements, too. Some detail about what went into these decisions would be welcome.
The Caisse is now without a permanent CEO. Rousseau abandoned ship last year, and his successor Richard Guay soon left, citing exhaustion. A new CEO, preferably from outside the organization, is urgently needed.
What's not needed is any review of the Caisse's basic mission. The Parti Québécois wants a Caisse vigilant to "protect Quebec's interests" by which that party always means interfering politically in ways designed to minimize economic integration with the rest of Canada. That kind of meddling was wrung out of the Caisse's mandate in the Liberal government's first term; it should not be revived.
The Parti Québécois is politicizing the results, demanding to to haul Premier Jean Charest and finance minister Monique Jerome Forget in front of the National Assembly Finance Committee to explain the $40 billion losses. The PQ put Mr. Rousseau at the helm and if they want answers, they should read the last few paragraphs of yesterday's comment and forget about Caisse Sera Sera.
Another article that caught my eye today was the Konrad Yakabuski's article in the Globe and Mail, Rousseau-era repercussions just starting for the Caisse:
A year ago, Henri-Paul Rousseau credited currency hedging tactics adopted by the Caisse de dépôt et placement du Québec for adding $3.5-billion to the bottom line in 2007.
The hedging was one of the “smart moves” that led the Caisse's board of directors to grant Mr. Rousseau, then the Caisse's chief executive officer, $750,000 in combined annual bonus and extra distributions under a long-term incentive plan. The additional sums were paid out on top of Mr. Rousseau's $490,000 salary “to recognize the Caisse's superior performance between 2004 and 2007.”
Mr. Rousseau, whose total compensation soared to $1.8-million in 2007 from $650,000 in 2005, was hardly alone in getting the recognition. Bonuses ballooned during the six years Mr. Rousseau, who has since departed for a job at Power Corp. of Canada, was at the helm of the Caisse.
The other shoe dropped yesterday, however, and Mr. Rousseau – who was largely responsible for the investment strategies that led to a disastrous 2008 performance – was nowhere in sight when his successor disclosed that no Caisse employee will get a bonus for 2008.
That may not be surprising in light of the Quebec pension fund manager's minus 25 per cent return, which is equivalent to a $39.8-billion investment loss. In a year where almost all funds performed horrendously, the Caisse managed to do much worse, ending up in the fourth quartile among large Canadian pension funds.
The foreign exchange hedging activities that paid off so handsomely in 2007 cost the Caisse $8.9-billion in 2008 as the fund made a wrong-way bet on the Canadian dollar. Another $4-billion in provisions, on top of a previous $1.9-billion writedown, on the Caisse's $12.8-billion in non-bank asset-backed commercial paper (ABCP), and multibillion-dollar losses realized on stock sales and futures contracts, also distinguished the Caisse from the pack – and not in a good way.
Under the circumstances, bonuses were hardly called for. Interim Caisse CEO Fernand Perreault surprised many, however, with the glass-half-full interpretation he put on the 2008 results. Over five years, he pointed out, the Caisse earned a 3.1-per-cent return, good enough to move the fund up a notch to the third quartile in the industry. And over 10 years, he insisted, the effect of currency hedging on the Caisse's overall results is neutral as yearly gains and losses cancel each other out.
If that is the case, then why were Mr. Rousseau and his team pocketing record bonuses during the years when the currency bets paid off? And why aren't they required to return their windfalls to ravaged Quebec pensioners this year?
Such are but a couple of the questions Mr. Perreault, Mr. Rousseau and Richard Guay – the CEO whose rocky four-month reign ended in January – will be asked to answer in coming weeks as Quebec prepares for an extended session of Caisse analysis.
Every Quebecker has a direct stake – and not just a monetary one – in the Caisse. The fund, now reduced to $120-billion in net assets, has traditionally been a symbol of Québécois economic can-do. It manages the assets of 25 provincial pension and insurance funds, including the Quebec Pension Plan, which was created in 1965 in a breakaway move from Ottawa.
The QPP suffered the biggest loss of all the Caisse's depositors last year, crevassing in value by 26.4 per cent. By comparison, the fund that manages the federally administered Canada Pension Plan suffered a 14.4-per-cent loss for the 2008 calendar year.
Premier Jean Charest's government, itself at the centre of the storm for its oversight of the Caisse, tried to quiet the opposition by agreeing yesterday to hold special parliamentary hearings into the Caisse debacle. All three past and current CEOs and Caisse chairman Pierre Brunet, who conceded yesterday that his mandate will not be renewed by Mr. Charest, will be among those called to testify.
It may not be enough to quell the ire, however, as groups representing various Quebec pensioners are now seeking a full public inquiry into the errors of the Rousseau era. Mr. Perreault's lack of contrition yesterday will only fuel those demands.
Though he conceded “it was a mistake to accumulate so much ABCP” – a financial product shunned by other big Canadian funds, including the Ontario Teachers' Pension Plan and the Canada Pension Plan Investment Board – Mr. Perreault insisted the Caisse's risk management “is as good as its peers'.”
How can we know? Mr. Perreault refused to make public a consultants' report commissioned by the Caisse on its risk management practices. Susan Kudzman, the Caisse executive vice-president responsible for risk management, meanwhile, admitted that “most of the models” used by the Caisse to manage risk “have not held up.”
The 2008 results are also bound to cast doubt on the very utility of the Caisse. The so-called “active management” that costs Caisse depositors hundreds of millions of dollars in annual fees has not proved its worth. Depositors would have earned better returns in recent years had they invested their funds on their own in a representative basket of low-risk stocks and bonds.
One of those depositors is already suggesting it may now seek to withdraw some or all of its assets from the Caisse, which by law has a monopoly on the management of certain Quebec pension and insurance funds. Others may follow.
The repercussions of the Rousseau era, which was supposed to turn the Caisse into a world-beating pension fund, are just beginning to be felt.
The article above raises an excellent point on the Caisse's currency hedging activity. If some investments are 100% passively hedged, then why pocket bonuses when the Canadian dollar swings your way? (Answer: all upside, no downside!)
It's ridiculous and the foreign exchange losses should be examined more carefully by independent experts who can gauge whether they were due to passive hedging or active hedging gone awry. Something does not add up when you lose billions in "passive" currency hedging activities.
It's obvious that risk management fell asleep on the switch as they were not monitoring and mitigating F/X losses.
One former treasurer from a bank wrote me the following comment on the Caisse's F/X hedging activity:
"...when you are hedging a foreign denominated asset, and the foreign currency goes through the roof, your currency gains on the underlying should equal the loses incurred on the hedging vehicle. As a bundle it should be a wash. In the beginning these two values are equal, but as time progresses if the price of underlying (equities) drops you have big problems if the foreign currency continues to appreciate. I believe this is what happened to these guys. You cannot hedge a Treasury fixed income portfolio the same way you would hedge an equities portfolio. They know this, they over sold the USD, they were cryptically trading, and they lost."
And one more thing about the so-called "passive hedging activities". If you are buying $1 billion of real estate portfolio in the U.S., then by fully hedging currency risk, you are selling short USD at the time of buying. If that real estate portfolio falls by 20%, you are still hedging $1 billion a full $200 million more than what you initially bought it for. Why not just buy 5 or 10 year currency swaps to fully hedge that risk?
It is very confusing because we know currency swings exacerbated the losses of private equity, real estate, hedge funds, and commodities, but the Caisse did a poor job explaining how much was due to currency going against them and how much was due to the decline in the value of the underlying investments.
As far as hedge funds are concerned, the Caisse needs to separate out the performance of the external hedge fund managers and the internal absolute return managers. The Tremont index is a joke because it contained Madoff and if these hedge funds are charging huge fees for absolute returns, then why did that portfolio lose 20%? I guess it has now become a relative game! Sigh!
Officials went out of their way yesterday to insist that Quebec pensions are safe:
The Caisse's interim chief executive officer, Fernand Perreault, said pension plan participants shouldn't panic over his organization's record-breaking minus-25-per-cent return in 2008.
"It's not a good thing to panic in a bad year," Perreault said. "These (pension) funds are capitalized on a long-term basis."
Finance Minister Monique Jérôme-Forget offered assurances that Quebecers should not worry that they will lose their provincial pensions.
"It is guaranteed," Jérôme-Forget said.
The Caisse manages the assets of 25 depositors, including the Quebec Pension Plan and public employee pension plans as well as other provincial asset pools, including the automobile insurance corporation's reserve.
The chief actuary of the Quebec Pension Plan said yesterday the Caisse's losses would have no short-term impact on the plan's contribution or benefit levels.
"We don't react immediately to any year of low or negative return," Pierre Plamondon said.
Plamondon noted negative returns at the Caisse in 2001 and 2002 were cancelled out by strong performances between 2003 and 2007.
"What we expect is that in the future the markets will go up and recover most of the losses of 2008," he said. "The Quebec Pension Plan is a long-term scheme, and we have time to see what the markets will deliver."
However, John Greenwood of the National Post writes that pension loss puts taxpayer on the hook:
By the time Canada's public sector pension plans have finished reporting results for last year, they will be sitting in a sea of red ink, experts say. And because those pensions are typically guaranteed by the government, taxpayers will likely find themselves on the hook for much of the cost of fixing the damage.
The loss tally for last year "could easily exceed $100-billion," said Malcolm Hamilton, a principal at Mercer Human Resources.
Yesterday the Caisse de depot et placement du Quebec posted a $40-billion loss for 2008, the worst ever performance for any public-sector pension plan in Canada. The loss was blamed on a currency hedging program that went wrong and a disastrous investment in asset-backed commercial paper.
Observers say that unless the markets stage a miraculous recovery, taxpayers will end up facing a double whammy: Not only will they be forced to deal with declines in their own retirement plans -- which mostly means RRSPs -- they must now put money into the retirement plans of public servants.
"That's the irony of the system," Mr. Hamilton said.
On Monday OMERS, which manages pensions for Ontario municipal employees, reported a loss of 15.3%, or $8-billion, for 2008.
The Public Sector Pension Investment Board, with more than $30-billion under management, has yet to come forward but observers predict big losses there too.
"These are big, scary numbers, and it's going to create a crisis," said Kevin Gaudet, federal director of the Canadian Taxpayers Federation.
He predicted governments across Canada will seek to raise taxes to deal with the wave of unprecedented losses at public-sector pensions.
But that might prove difficult, he warned, given that so many Canadians are already reeling from collapsing house prices and losses in their RRSPs. Since their peak last summer, stock markets in Canada, the United States and Europe have lost about half their value.
"These are lavish plans where people can contribute for 25 years and draw an income for 35 years, all indexed to inflation," he said.
Fewer than 40% of Canadians are part of employer-sponsored retirement plans, according to a recent report by the CD Howe Institute. The remainder are dependent on their own savings and the Canada Pension Plan.
The royalty of the pension world are those with so-called defined benefit plans -- most common in the public sector.
In years when the economy was doing well, most of these plans were able to rely on investment returns to meet their obligations. Players such as the Caisse de depot, the Ontario Teachers Pension Plan and OMERS moved into the markets aggressively, placing huge bets in hopes of a big payoff.
But amid the financial turmoil, many of those bets have gone wrong and the plans are now facing staggering shortfalls.
The plan managers are left with few options. They can hope that markets improve so the losses can be made back, which is considered unlikely for some time. In some cases they can ask plan members to increase contributions. But the easiest solution from the managers' perspective is to go to government, cap in hand.
Recently the Alberta government provided a top-up of several billion dollars for a public school teachers pension plan after it lost money, well in excess of the amount it was required to put in under the contract.
"It was the easiest way for the government because they just wanted labour peace," said Mr. Gaudet.
The government was concerned not only about possible labour action by the teachers but also about maintaining the appeal of working as a teacher at a time when many industries were experiencing worker shortages.
Such behaviour is often the preferred route for governments because taxpayers rarely find out the truth, observers said.
"We don't exactly have a transparent system when it comes to public sector pensions," Mr. Hamilton said.
One of the biggest concerns is figuring out the true level of losses.
In recent years many big plans moved billions of dollars aggressively into credit derivatives, real estate and other private markets. Some of those markets have stopped trading, forcing investors to estimate the value of their assets.
But often those estimates prove overly optimistic, said Mr. Hamilton.
Given the current environment, it may be some time before the level of real losses is known. It will likely take even longer before those numbers are made public.
Experts say that this lack of transparency makes it almost impossible for taxpayers to find out the true cost of the public sector pension plans they pay for.
The lack of transparency is a scandal. If President Obama can get a website up and running detailing government spending, then there is simply no excuse as to why these pension funds can't publicly disclose the following on their websites:
- Granular breakdown of the benchmarks governing investment activities
- Quarterly performance of each and every internal and external manager
- Board minutes and resolutions 9we want to know what they discuss and how they voted)
- Administrative costs associated to running the pension fund
- Salaries, bonuses and pension benefits should be fully disclosed
- Detailed disclosures on soft dollar arrangements and a breakdown of which brokers you deal with and how much you pay them (ditto for pension consultants and all other vendors).
***Update: S&P puts Caisse credit on watch
Credit rating agency Standard & Poor's put Quebec's embattled pension fund manager on credit watch negative, meaning it could downgrade its excellent credit marks.
Also, Quebec Premier Jean Charest says he won't be swayed by Opposition calls to testify at legislature hearings into the nearly $40-billion loss posted by the Caisse de depot et placement in 2008.
He is also blaming the Parti Quebecois for a warning on the Caisse issued by bond-rating agency Standard & Poor's. Charest says Standard & Poor's advises against more government interference in the Caisse's operations, something he says the PQ wants.