Where is the Fear?

I begin with a message from Diane Urquhart:
You are welcome to put links on your Pension Pulse blog to these letters between Parliamentary Secretary of Finance Ted Menzies and myself. They are about whether preferred status for pension fund deficits and severance would increase the cost and availability of credit. I say it does so on only a nominal basis and so the Federal Government should amend the BIA Act to give preferred status to pension fund deficits and severance.

I have stored the letters to and from Menzies at the following web pages. These links can be added to the LinkedIn Groups' and NRPC's website.



I do not have an active website, but you may be interested in the videos on securities corruption and securities crime policing that I have put up at www.ismymoneysafe.org.

I will then turn your attention to Luc Vallée's latest comment on the tsunami of corporate refinancing:

Did you see this graph in the Wall Street Journal yesterday? It is enough to make you want to read the accompanying article by SerenaNg and Kate Hatwood. I also reproduced it below with all proper credit for those who would have a hard time getting access.

In my blog yesterday (see Chronicles of a Second Wave of Foreclosures based on Ross Mckitrick's "Green Shoots Reality Check"), I commented on another incoming large wave of home foreclosures that could bring a new series of bank failures and renewed financial distress and, as a result, prolong the current economic recession well beyond 2010.Well, it appears that once we are over this second wave, a tsunami of corporate debt refinancing is going to hit us. It maybe hard to see in the distance, hiding behind two large waves of foreclosures: The first one falling on our head right now and the second one due to hit us with full strength in about 18 months.

Starting in 2001, but really getting momentum in 2012 and peaking in 2014, hundreds of billions of dollars of debt are due to be renewed. Already the mountain of debt on the horizon is pushing some desperate firms to attempt debt rescheduling exercise to avoid the crowd in 20013 and 2014. For the lucky ones who have already succeeded or who will succeed in the coming months, this means heavy concession to lenders usually under the form of higher interest payments. It may be good management risk practices but it also means reduced profit outlook for the next few years as interest payments immediately jump. Not very bullish for the Stock market.

Read on.
Reuters Loan Pricing Corp reports that U.S. syndicated loan issuance fell 37 percent in the second quarter from a year earlier, plumbing historic lows in the wake of last year's credit crunch:

Overall issuance fell to $156 billion from $248 billion a year earlier, with investment-grade issuance down by 27 percent to $70 billion and leveraged loan issuance down by 25 percent to $68 billion, according to RLPC.

High-yield bond issuance rose 39 percent in the second quarter to $46 billion.

JPMorgan was lead book-running manager in the second quarter, with $51.6 billion in deals, or 33 percent market share; followed by Bank of America Merrill Lynch, with $30.9 billion, or 20 percent market share; and Citigroup, with $16.7 billion, or 11 percent market share.

Some signs of stability emerged in the second quarter. In the leveraged loan market, prices of the 100 most widely traded loans rose by nearly 15 percentage points to 86 cents on the dollar.

Investors, however, had little opportunity to put cash to work on new deals. Issuance for leveraged buyouts, until recently a key source of new supply, dropped by 95 percent from a year earlier to $590 million in the quarter.

In the investment-grade area, a lack of merger and acquisition financing kept issuance down after the market cleared a number of jumbo deals in the first quarter, such as a $22.5 billion loan for Pfizer Inc.

But things may not be as bad as they seem. The distressed debt ratio is at its lowest point in nine months, dropping to 34% from a high of 85% last December, according to a study released today by Standard & Poor’s.
The amount of affected distressed debt dropped to $177 billion from $232.8 billion in May, according to S&P. The total number of companies with bonds trading at spreads of 1,000 bps ore more is now 268. At the end of May there were 338 such companies.

The speculative-grade corporate bond spread reached 946 bps on June 15, down from 1,136 bps May 15.

The distressed levels in leveraged loans have decreased also. The S&P/LSTA Leveraged Loan Index distressed ratio fell to 47.5% in May from 54.8% in April.

These developments are positive for distressed debt markets and the overall credit markets. In the stock market, growing confidence that the U.S. economy is putting the worst recession in decades behind it has pushed the index known as Wall Street's fear gauge to its lowest level since just before Lehman Brothers collapsed last September:

The CBOE Volatility Index .VIX, known as the VIX, provides investors with portfolio insurance against fluctuations in the S&P 500 index .SPX. It soared to historic highs in the weeks after Lehman's rapid failure pushed financial markets to the brink and left an already crippled economy in tatters.

But amid numerous signs the economy is on the edge of a recovery, coupled with the best quarter for stocks in more than 10 years, the VIX has begun to look like its old self again.

"Investors see a lesser need for protection going forward; it looks like they don't see a revisit to the March lows," said Andrew Wilkinson, senior market analyst at Interactive Brokers Group in Greenwich, Connecticut.

The VIX, which is calculated from Standard & Poor's index options, tracks the market's expectations of volatility over the next 30 days. It often moves inversely to the S&P benchmark and goes up as options premiums are raised.

The S&P 500 .SPX hit a more than 12-year low in early March, down more than 57 percent from the record high it set in October 2007, after the bursting of the housing bubble spiraled into a credit crisis and then into a global recession.

The VIX hit an intraday record high of 89.53 in late October, but on Monday it closed at 25.35, its lowest level since September 11, 2008, before the weekend when Lehman collapsed.

"The path forward appears a less treacherous one according to what the VIX is telling us," Wilkinson added.

Stabilization of key economic indicators such as payrolls, home prices, bond yields and consumer confidence, as well as the Obama administration's plan to reactivate the recession-hit economy, have boosted bets on the economy's outlook. Investors are looking forward to this week's key housing and job market data on expectations that it will show further signs that the worst is over.

"I think (the VIX) is down primarily because the expectation is the economy is going to recover and we've started a bull market," said Hugh Johnson, chief investment officer of Johnson Illington Advisors in Albany, New York.

The S&P 500 has risen up to 40 percent from its March lows, and is on path to close its best quarter since the fourth quarter of 1998. But even as some market players expect a correction in the near term, the reading of the VIX suggests that that correction may not happen.

"The bears are beginning to throw in the towel on expecting a substantial stock market decline, so investors are beginning to sell implied volatility," Wilkinson said. "Investors do not perceive there's going to be another big crash."

But although the VIX has returned to levels similar to those seen before financial markets imploded, analysts said that does not mean the economy has recovered from the hit it took last year.

"We've gone through such a change in the economy that has required such drastic steps from both the Federal Reserve and the government that it is going to create a very different landscape going forward," added Wilkinson. "We can't relate (today's) VIX measures to were we've come from."

In the Australian, Charlie Aitken of Southern Cross Equities writes that investors should get ready for the next leg higher:

OUR market was watching the Dow Futures closely here yesterday, which pointed to a 50-point weaker night on Wall Street.

I have no idea why anyone watches the Dow Futures trading on a Sunday night. Similarly, shorters decided some random comments from some Chinese source about commodity prices was a good enough reason to short commodity stocks in the afternoon session here yesterday.

Both ideas look flawed this morning, with the Dow Jones Industrial Average closing a net 140 points higher than the Dow Futures were predicting, and the commodity complex having a good night led by oil and copper.

While rising oil prices (+$US 2.23 a barrel to $US71.47) aren’t a great thing for the US economy, the market point is that Exxon Mobil (+2.2 per cent) is the largest weighting in the S&P 500, while Chevron and Exxon are both Dow components.

Also, for some reason, oil and financials appear to be closely correlated at the moment (risk?) and every time oil rises, so too do the US financials (KBW Bank Index +1.5 per cent). By the end of a summerish volume session (that is, relatively light), the Dow gained 90 points (+1.1 per cent) to 8529 while the S&P 500 gained 8.3 points (+0.9 per cent) to 927.

The markets seemed to like the fact that Bernie Madoff was sentenced to the maximum penalty of 150 years in jail for his ponzi scheme and it was a nice touch to see his own wife stick the boot into him after the sentencing. In good times and bad, hey, Ruth?

More interestingly, the Chicago Board Options Exchange Volatility Index (VIX) continued to fall (25). A close reading of both the VIX and Dow Jones Industrial Average shows to me that the much larger chance is the Dow plays catch-up to the VIX’s collapse and I think that will be the case in the second half of this year. Last time the VIX was 25 points, the Dow was over 11,000. Food for thought.

The truth is that you can create all sorts of nasty scenarios but if the U.S. economy does surprise to the upside, stocks will keep grinding higher and the only fear that will dominate the big fund managers is the fear of underperforming the major averages.

Finally, Karen Mazurkewich of the Financial Post writes that the bonus flap puts Canada Pension's strategy at risk:

When the Canada Pension Plan Investment Board disclosed two weeks ago a $24-billion loss for the previous fiscal year, it sparked a political furor in the House of Commons over hefty executive bonuses.

Now, there may be a higher price to pay from the fallout: the fund's progressive investment strategy could be in jeopardy.

Analysts worry that a parliamentary backlash could put the pension fund's cost-effective strategy at risk if it loses its ability to attract highly talented managers.

Going "cheap" on talent would save a few million in bonuses, but it would also add 10s of millions of costs to the running of the plan because the fund would be forced to rely more on outside fund managers and consultants who charge high fees to handle alternative assets such as private equity and infrastructure funds.

The financial services industry has a bad rap these days, and bonuses "is a strong political plum to bite into," said Keith Ambachtsheer, director of the Rotman International Centre for Pension Management at the University of Toronto and the co-founder of CEM Benchmarking Inc. "In general, we pay our [pension managers] better in Canada, but we do it for the right reasons."

CPPIB and other multi-billion-dollar plans are now boosting performance by direct investing in alternative classes such as private-equity, hedge funds, real estate and infrastructure. Such a strategy requires a high calibre of manager.

"Canadians need to make a choice," mused Mr. Ambachtsheer. "Do they want top of class or go cheap?"

A better barometer for politicians is how well the plan can streamline fees and reduce operational costs.

CEM Benchmarking, a Toronto-based research firm that collects data on 408 pension funds around the world, has calculated that in 2007 CPPIB's operational costs were lower than those of its peers. It cost CPPIB 33.2 basis points (pb) to run its pension fund compared with an average of the 36.9 pb to run similar North American funds in comparable asset classes.

The savings of 3.7 bp translated to $44-million savings - meaning that CPPIB managers negotiated better fees or managed their funds more efficiently in-house.

Those savings are even greater when CPPIB is compared with a pension plan that farms out all its alternative assets to outside fund managers. According to CEM, a North American fund of similar size to CPPIB paid 54 bp in 2007 for the management of their fund. Not only were a large majority of its assets managed externally, but 20% was invested in expensive asset classes: real estate, hedge funds and private equity. That means CPPIB saved 20.8 bp, or $248-million by comparison.

Giving Canadian pension executives hefty incentive packages to run multi-billion funds was a trend that began 19 years ago, when Claude Lamoureux was recruited to run the Ontario Teachers' Pension Plan (OTPP). Mr. Lamoureux, who retired from OTPP in December 2007, remains a defender of that policy:

"When [former executive vice-president investments and chief investment officer] Bob Bertram and I started [at OTPP], we wanted to run money internally because we felt we could do as well as external [managers]. If you look at the economics, it's a fairly compelling case to manage internally."

Mr. Lamoureux said that he faced off with critics who challenged OTPP's salaries, which are some of the highest in their field. In 2006, for example, Mr. Bertram made $6.17-million in compensation - although his total package was shaved to $2.49-million for 2008 after the fund lost $21.1-billion in assets. But his reduced salary in bad times is still many times higher than the average salary for a top manager at California Public Employees' Retirement System (CalPERS), which ranges between US$400,000 and US$600,000.

Mr. Lamoureux argued that when funds reach a certain size, it makes more economic sense to reward top managers internally, while paying less to external funds whose fees in certain asset classes are becoming "prohibitive."

Not only do companies such as Kohlberg Kravis Roberts & Co. (KKR) and The Blackstone Group charge 2% management fees plus 20% of the profits, "they've found new ways to charge fees for practically getting out of bed in the morning," he added. Their real fees are more in the 5% range.

So while CalPERS executives receive less compensation, the real cost of running alternative assets through third-party funds is kept hidden. "In the case of private-equity, these fees never show up in the [operation] expense column of the pension funds because they are deducted from the earnings," said Mr. Lamoureux. He has argued for years that the cost of those fees should be transparent. As a result, "when parliament criticizes the [bonuses] they don't know what the alternatives are," he added.

Mark Wiseman has been in the eye of the political storm. As senior vice-president, private investments, with the CPPIB he was one of a handful of top executives singled out for a compensation package that totalled more than $2.4-million this year. However, Mr. Wiseman argues that his team is saving many more millions that would otherwise be paid out to external fund managers.

Take CPPIB's private-equity arm alone. Over the past three years, CPPIB did $3.5-billion worth of direct investments. If Mr. Wiseman's team had paid 2% in management fees on that sum, it would have cost the fund $70-million annually. That doesn't even include what CPPIB would have to pay their external manager when the investment was realized. If its $3.5-billion investment doubled over time, the pension plan would have to pay $700-million - 20% of its profit - to its outside manager. By contrast, it costs CPPIB about $20-million annually in compensation, office allocation and travel, to run its in-house direct private equity team.

These savings are just a small part of the picture. CPPIB is also beefing up its internal capabilities in all other classes including infrastructure, real estate and private-debt - in hopes of saving hundreds of millions of dollars. By contrast, CalPERS "pays hundreds and hundreds of millions of dollars in fees to external managers," Mr. Wiseman points out.

Success for CPPIB's direct investment teams means earning returns at least as good as those achieved by third-party funds. "And that requires a highly qualified team," said Mr. Wiseman.

That's why the political firestorm over the bonuses has him worried: "I think it would be a shame if these issues forced us to take a different path as an institution, because at the end of the day I think it would be Canadian pensions that would lose."

I can't stand reading this nonsense. What progressive investment strategy? What are the bloody benchmarks for private equity and do they accurately reflect the leverage, liquidity and credit risk of the underlying investments?

And by the way, those "direct investments" in private equity were probably co-investments so don't be so impressed with the headline performance figure. If they are that great, let them start a PE fund of their own (good luck).

The bottom line is CPPIB lost $24 billion and they have the audacity to claim that they deserve bonuses?

As for Mr. Lamoureux, the guy who told me to "shut up" after I testified on Parliament Hill and exposed all these bonus shenanigans based on bogus benchmarks, he is obviously going to defend current compensation practices because he made millions while he was at the helm of Ontario Teachers.

And Mr. Ambachtsheer should come clean and state who pays his salary. Is it the big funds or the pensioners they invest on behalf of?

Should we really fear that the "top talent" will leave Canadian pension funds to join hedge funds and private equity funds?

Give me a break. I say this to all the pension "all-stars" who lost billions in 2008: stay where you are because unlike most pensioners, you obviously have no fear of underperforming these markets. You get all the upside in good years and in terrible years, you can hide behind a four-year rolling return.

These pension fund managers have the best gigs in town and the only fear we should have is that they continue pulling the wool over their stakeholders' eyes and get away with huge bonuses for delivering mediocre performances.