The Bigger Short?

Lawrence Delevingne of CNBC reports, This is the new 'big short':

Billionaire investor Paul Singer says he has spotted the next big thing to bet against: bonds.

"Today, six and a half years after the collapse of Lehman, there is a Bigger Short cooking. That Bigger Short is long-term claims on paper money, i.e., bonds," Singer wrote in a letter to investors of his hedge fund firm Elliott Management obtained by CNBC.com.

"Bigger Short" is a play on "The Big Short," the book by Michael Lewis describing how a tiny group of investors made huge sums of money for their contrarian bets against mortgage-backed securities before the collapse of the housing market in 2007 and 2008.

"Central bankers have chosen, and doubled down on, a palliative (super-easy money and QE), which is unprecedented and extreme, and whose ultimate effects are unknowable," Singer wrote of governments stimulating markets, in part through the purchase of bonds.

Singer has long been a critic of mainstream economic policy, particularly taking on high debt to spur financial recovery.

"Asset prices are skyrocketing because of massive public-sector purchases. The tinkering and experimentation that characterizes each round of novel central bank policy leads to more and more complicated unwanted consequences and convolutions," Singer wrote. "Central bankers are, in our view, getting 'pretzeled' by all this flailing, yet they deliver it with aplomb and serene self-confidence. Are they really taming volatility with their bond-buying, or just jamming it into a coiled spring?"

That makes for risk that many don't see, according to Singer.

"Bondholders ... continue to think," he wrote, "that it is perfectly safe to own 30-year German bonds at a yield of 0.6 percent per year, or a 20-year Japanese bond (issued by the most thoroughly long-term-insolvent of the major countries) at a little over 1 percent per year, or an American 30-year bond at scarcely above 2 percent per year."

The opportunity, then, is to short bonds.

"Today, the Bigger Short is in a much larger marketplace," Singer wrote of bonds compared to subprime mortgages, "so it can be undertaken in whatever size one can stomach, and the cost of effectuating it during the waiting period is really low."

"However," Singer added, "the power of the herd on the current upward bond price stampede is beyond anyone's control, so one can lose money waiting for the trade to work out."

A spokesman for Elliott declined to comment.

The firm managers more than $26 billion and invests across a range of asset classes, including bonds, stocks and commodities. Its main fund, Elliott International Limited, fell 0.5 percent over the first quarter, according to the letter.

The fund has produced annualized returns of 12.3 percent since inception in December 1994, easily beating stocks and bonds over the same period.

Add Paul Singer to a growing list of skeptics, including Bill Gross, who think the end is near and that the scary bond market is about to get a whole lot scarier.

The short-selling, cataclysmic, dimwit gold bugs over at Zero Edge pounced on Singer's "Bigger Short" thesis to once again make the case that the world is ending and people should all go out and buy "gold, silver and bullets."

Is Singer right? Are bonds the "Bigger Short"? Let me first go over this passage which Zero Hedge posted (added emphasis is mine):

Our view is that central bankers have chosen, and doubled down on, a palliative (super-easy money and QE), which is unprecedented and extreme, and whose ultimate effects are unknowable. To be sure, the collapse in interest rates all along the curve, and a bull market in equities, “trophy real estate” and other assets, has had some effect on job creation.

However, the effect is indirect, and in our opinion the benefits of complete reliance on monetary extremism are overwhelmed by the negatives and the risks. To begin with, such policies are inefficient in actually creating jobs and growth, and they worsen inequality: Investors prosper and the middle class struggles. The goal of leaders of developed nations and their central bankers should be more or less the same: enhanced growth and financial stability. 

But somehow the principal policy goal of both has become to generate more inflation. Both extreme deflation (credit collapse) and extreme inflation (which forces citizens to forego normal economic activities and become traders and speculators in a desperate attempt to keep up with the erosion of savings and value) are threats to societal stability, and we don’t actually think there is much to choose from between those extremes. But central bankers are completely focused on erasing any chance of deflation, and the tool to do so – currency debasement – is certainly near to hand. Therefore, the likelihood of deflation is highly remote. By contrast, the central bankers’ universal belief that inflation is easy to deal with if it accidentally overheats is arrogant and not supported by the historical record.

Furthermore, we fail to comprehend how owners of claims on money (that is, bondholders) can continue to ignore the fact that the goal of generating more inflation is aimed precisely at reducing the value of their capital. Central bankers obviously do not understand that the modern financial system is almost impossible to “manage,” and is fundamentally unsound as currently structured and leveraged. Given that reality, why should bondholders believe that central banks are capable of creating just enough inflation, and not a farthing more, in their current quest to rebubble-ize the world? We also question why bondholders believe that if inflation bursts its dictated boundaries despite central bank scolding, that policymakers can indeed, as a former Fed chairman and now immodest citizen blogger and incoming hedge fund advisor (Ben Bernanke) has said, cure it in “10 minutes.” We call to your attention the hand-wringing and agonizing now underway about raising U.S. policy rates by 25, 50 or 75 basis points over the next few months. Imagine the caterwauling in global financial markets if inflation surprises everyone on the upside and the right policy rate should be 2%, 4% or higher. Given the fragility of the financial system and its still-extreme leverage, even a few points of inflation and a few hundred basis points of increase in medium- and long-term interest rates could cause a renewed financial crisis.

Inflation is more or less a generalized diminution in the value of money. A bond is an instrument by which a promise to return, in the distant future, a fixed-in-currency amount of invested money is supplemented by periodic interest payments in the meantime. That’s it, and that’s all you get. Such interest payments are meant to compensate the investor for the use of his or her money, taxes (if any) and expected inflation. At currently prevailing interest rates in the developed world, if there is ANY inflation in the next 10 to 30 years, investors who buy or hold bonds at today’s prices and rates will have made a bad deal. And if inflation emerges from the stone-cold dead and walks, trots or (heaven forbid) gallops into the future, they will have made a very, very bad deal.

Equity values depend to an important degree on confidence that policymakers will continue to allow private enterprise, profits and private ownership of assets. But bonds, in our view, represent a greater leap of confidence. It is so much easier to purloin value from bondholders, and so tempting to rulers; in fact, the current leaders and policymakers have said in so many words that there is not enough debasement (that is, inflation) underway at present. You don’t need a weatherman to know which way the wind blows (according to Bob Dylan), but bondholders nevertheless continue to think, up to basically this moment, that it is perfectly safe to own 30-year German bonds at a yield of 0.6% per year, or a 20-year Japanese bond (issued by the most thoroughly long-term-insolvent of the major countries) at a little over 1% per year, or an American 30-year bond at scarcely above 2% per year.

Asset prices are skyrocketing because of massive public-sector purchases. The tinkering and experimentation that characterizes each round of novel central bank policy leads to more and more complicated unwanted consequences and convolutions. Central bankers are, in our view, getting “pretzeled” by all this flailing, yet they deliver it with aplomb and serene self-confidence. Are they really taming volatility with their bond-buying, or just jamming it into a coiled spring?

Don't you love it when overpaid and over-glorified hedge fund gurus who made their vast fortune charging public pensions excessive fees come out to talk up their book and publicly criticize central banks for fueling inequality? Meanwhile QE has been a boon for elite hedge funds and private equity funds.

I'm not sure if Singer is playing the global reflation theme but I did peer into his fund's top holdings and added it to my list of top funds I track every quarter. You can view the top equity holdings of Singer's fund, Elliott Associates, as of the end of March by clicking here and on the image below:

Keep in mind, however, that Elliott Associates is more of a global distressed debt fund that invests in a lot of assets, not just equities. Singer is most famous for his ongoing tango with Argentina. Still, his fund is long 53 stocks which represent roughly $7 billion of his $26 billion fund.

Among his top holdings, you will see Hess Corporation (HES), Juniper Networks (JNPR) and EMC Corporation (EMC), which tells me he's positioned the equity portfolio for global reflation but again, I don't know if he's long or short bonds. He publicly states that bonds are the "bigger short" but unless you're privy to his entire book, you don't know how he's positioned.

But for the sake of argument, let's say he is short bonds, joining the ranks of many other bond market skeptics, is he right? Are they right? I don't think so and have publicly stated that I don't buy the global reflation story and fear that investors ignoring the very real threat of global deflation are going to get clobbered in the decade(s) ahead. This is especially true for delusional U.S. pension funds holding on to unrealistic investment projections. Deflation will decimate them.

"But Leo, Singer says the likelihood of deflation is remote and its inflation we should worry about." I couldn't care less what Singer says and neither does the bond market. I'm telling you there is no question whatsoever in my mind that  the titanic battle over deflation will not sink bonds. Moreover, if the Fed makes a monumental mistake and starts raising rates too soon, it will all but ensure deflation because this time is different.

Having said this, there is one area of the U.S. bond market that increasingly concerns me. It's not junk bonds, it's pension obligation bonds. Suzanne Bishopric sent me an article written by the New York Times' Mary Williams Walsh, Borrowing to Replenish Depleted Pensions:

Facing a shortfall of more than $50 billion in his state’s pensions, and with no simple solution at hand, Gov. Tom Wolf of Pennsylvania is proposing to issue $3 billion in bonds, despite the role that such bonds have already played in the fiscal woes of other places.

And he is not alone. Several states and municipalities are considering similar action as they struggle with ballooning pension costs.

Interest in so-called pension obligation bonds is expected to intensify in the wake of a recent Illinois Supreme Court decision that rejected the state’s attempt to overhaul its severely depleted pension system. The court ruled unanimously that Illinois could not legally cut its public workers’ retirement benefits to lower costs, forcing lawmakers to scramble for the billions of dollars it will take to keep the system intact.

While the Illinois ruling is not binding on other states, analysts think it may influence lawmakers elsewhere to look to alternatives to cutting public pensions. The Illinois justices offered a list of all the times since 1917 that state lawmakers had ignored expert warnings and diverted pension money to other projects. They said, in effect, that the lawmakers had to restore the money.

Pennsylvania and other states and cities fear similar restrictions.

“My reaction was, ‘Yeah, that’s going to play here,’ “ said John D. McGinnis, a lawmaker in Pennsylvania, which has also been diverting money from its pension system, setting the stage for a crisis as more and more public workers retire. The state has no explicit constitutional mandate to protect public pensions, as Illinois does, but that is irrelevant, said Mr. McGinnis, a Republican and former finance professor at Pennsylvania State University.

“The judiciary in Pennsylvania has been solidly of the belief that there are ‘implicit contracts,’ and you can’t deviate from them,” he said. If lawmakers in Harrisburg were to unilaterally cut pensions now, he said, they could be taken to court and be dealt a stinging rebuke, like their counterparts in Illinois.

Against that backdrop, pension obligation bonds may appear tempting, even though such deals have contributed to financial crises in Detroit, Puerto Rico, Illinois and other places.

The deals are generally pitched to state and local officials as an arbitrage play: The government will issue the bonds; the pension system will invest the proceeds; and the investments will earn more, on average, than the interest rate on the bonds. The projected spread between the two rates makes it look as if the government has refinanced its pension shortfall at a lower interest rate, saving vast sums of money.

But that’s just on paper. In reality, the investment-return assumption is just that — an assumption, and a deceptive one at that because it does not take risk into account.

Fiscal analysts say it is possible, in theory, to shape a pension obligation bond deal responsibly, but that is not what they usually see.

Instead, the deals are typically used to make troubled pension systems seem a little less troubled for a few years, allowing elected officials to celebrate a pension reform without having to make the system sustainable over the long term.

The flood of cash from the bonds may also tempt officials into taking a break from their pension-funding schedule — the very action that has caused so much pension distress to begin with. Skipping annual pension contributions produces an off-balance-sheet debt that can start growing exponentially.

“These deals are being done as a budget gimmick,” said Matt Fabian, a managing director at Municipal Market Advisors, who keeps a database of municipal bond defaults and other mishaps. “They should not be done at all.”

But that has not stopped officials from pursuing them. Kansas recently authorized a $1 billion pension obligation bond and is seeking an underwriter. Alaska has been mulling the idea, although the governor, Bill Walker, opposes it. Hamden, Conn., recently borrowed $125 million for pensions, and the Atlanta school district wants to borrow up to $400 million to revive a dwindling pension plan for bus drivers and cafeteria workers.

In California, Orange County recently borrowed $340 million for pensions; South Lake Tahoe borrowed $12 million; and Riverside and Pasadena each took out new pension obligation bonds to refinance their old ones.

Municipalities are borrowing for their pension funds even in Michigan, where local governments are said to carry the stigma of Detroit, which dealt steep losses to its bondholders in bankruptcy. How a state handles the distress of one city is seen by credit analysts as the implicit policy for all municipalities in that state.

After declaring bankruptcy in 2013, Detroit sought to have $1.4 billion of pension obligation bonds voided outright, saying they had been sold illegally in 2005 and were not enforceable. Ultimately, Detroit settled the debt for about 13 cents on the dollar, the lowest recovery rate of any of its bonds.

Michigan now takes extra precautions with pension obligation bonds, requiring local governments to be rated at least Double-A and to close their pension plans to new employees before borrowing. That has not thwarted Ottawa County, Saginaw County and Bloomfield Hills.

And outside Michigan, San Bernardino, Calif., has told its bankruptcy judge that it wants to settle its pension obligation bonds for just a penny on the dollar.

Investors evidently see the risk as acceptable, but it is still there. The governments typically invest the proceeds aggressively in their efforts to capture the widest spread. But success is more elusive than it looks in the presentations to officials.

The Center for Retirement Research at Boston College tracked a sample of 270 pension obligation bonds issued since 1992 and found that governments were borrowing in the wake of market run-ups, investing when asset prices were high, and reaping losses in subsequent corrections.

The center also found that the greater a government’s fiscal problems, the likelier it was to attempt the arbitrage play.

“Those least able to absorb the risk were most likely to do so,” said Jean-Pierre Aubry, the center’s assistant director of state and local research.

There are signs that at least some state and local officials are taking such findings to heart. In Kentucky, a plan to borrow $3.3 billion for the state-run teachers’ pension fund fizzled in March. In Colorado, a plan to borrow up to $10 billion was derailed by three Republican senators just before the legislative session adjourned.

But in Pennsylvania, Governor Wolf, a Democrat elected last year, sees the risk as acceptable. Five years ago, the state enacted what it called a pension reform that set up a new, cheaper pension plan for the public workers hired from 2011 onward; everyone in the existing plan continued to accrue the richer benefits. In the heat of the election campaign, Mr. Wolf called for giving the plan more time to work.

Indeed, a reform affecting only future employees will take decades to achieve appreciable savings because it will take decades for the current public workers to complete their careers, retire and be replaced by new workers with the cheaper benefits.

Pension obligation bonds look appealing as a stopgap measure. They are, in fact, illegal in Pennsylvania, but proponents say that is not a problem because the statute can be amended.

The idea has bipartisan support. Last year, a Republican state representative, Glen Grell, called for borrowing $9 billion for pensions, saying it “would save $15 billion over 30 years.” His proposal mustered considerable support, but then Mr. Grell resigned to become executive director of the state pension plan for public-school employees.

Barry Shutt, a retired state worker, has been staging a one-man vigil against pension obligation bonds at the state capitol in Harrisburg. He had a sign that said: “Borrowing money is not a fix. It kicks the can down the road and steals from our children and grandchildren.”

Mr. Shutt is a retired accountant who began his career as a state auditor and later administered food programs. He said there was little doubt as to when and why the state pension system went off the rails: In 2001, lawmakers increased everybody’s pensions retroactively, causing a huge, wholly unfunded increase in the state’s obligations.

The lawmakers figured that booming stock-market returns would pay for the costly increase, a mistake made by officials in many other states and cities as well. Two stock crashes later, the mistake is apparent, but it is too late to reverse the increase — it is deemed it an “implicit contract” that cannot be breached.

Pension obligation bonds would only make the problem worse, Mr. Shutt said. “When you’re borrowing money for pensions,” he said, “you’re getting a new credit card to pay off the old one, and you still haven’t paid off the old one.”

Mr. Shutt is absolutely right, pension obligation bonds will not solve the deep structural problems affecting delusional U.S. pension funds, they will only make matters worse. Same goes for their big bet on alternatives, it simply won't pan out.

Keep an eye on the issuance of pension obligation bonds, it just might be the next bigger short nobody is looking at. But when it hits the fan, there will be huge losses and taxpayers will once again be called upon to clean up the mess.

Below, CNBC reports that hedge fund manager Paul Singer says he's spotted the next big thing to bet against: bonds. I wish Paul Singer, Bill Gross and everyone else in the world shorting bonds the best of luck and remind them that continued weakness in the eurozone, the China bubble, and U.S. dollar strength will only intensify global deflationary pressures.

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