This article appears in the July 6, 2007 issue of Executive Intelligence Review. New Pension Crisis Seen In Credit Markets Crash by Paul Gallagher
TheInternational Trade Union Confederation (ITUC) released a report June22 to its members in 153 countries, urging them to pull their pensionfunds' investments out of hedge funds and private equity funds. TheITUC, with many examples, showed that pension funds' returns frominvesting in these locust funds have done no better, or lagged behind,ordinary stock market investments: in the case of private-equity-fundinvestments, for nearly a decade; and in the case of investment inhedge funds, since 2005. It also warned that private-equitytakeovers—heavily using pension funds' invested assets—have beenshrinking the stock markets for public stocks into which pension fundshave traditionally been invested; that they pit older workers'interests against those of younger workers in the pension plans; andthat the debt bubbles these funds are building up, are threatening acollapse of financial markets "as soon as credit conditions change." Creditconditions are now rapidly changing for the worse (see p. 62), andpension funds—with between 3% and 5% of their investments in hedgefunds (including hedge "funds of funds") alone, depending on thereport—are directly in the path of disaster. In the past two years,many public pension funds in the United States have added to theirhedge-fund investments, their own direct purchase of the super-riskymortgage-backed securities (MBS) and their derivative collateralizeddebt obligations (CDOs) with which hedge funds and investment banksplay. Analysts at real estate investment trusts and banks, warn EIRthat the huge losses seen coming in these housing-bubble securities(losses in the hundreds of billions of dollars) are going to create asecond-wave pension crisis in the United States. Thefirst wave was low returns and corporate cutbacks of pensioncontributions from the 1997-98 financial crises through 2005, worsenedby Fed chairman Alan Greenspan's drastic lowering of interest rates.The second wave will be outright losses, stemming from pension funds'efforts to "make up" for the earlier crisis by plunging into hedgefunds and private equity funds, looking for high-return "junk" toinvest in. From junk, they have progressed to "toxic waste." OnJune 30, the buyout gambling reached a suicidal high when a pensionplan funded two private-equity funds in the biggest announced takeoverever, of Canada Bell (BCE) for $48.7 billion. The Ontario TeachersPension Plan threw in roughly $4 billion of its $100 billion assets;the buyout firms, Providence Equity and Madison Dearborn Partners LLC,will put in about $3 billion. But $17 billion existing debt is being assumed and $25 billion in new debt is to be borrowed by the buyers of CBE, in a package supposedly to be arranged by Citigroup, Royal Bank of Scotland, Deutsche Bank, and Toronto Dominion Bank. Inother words, the debt in this monster deal will equal 7.7 times thegross annual earnings of the target company, BCE. This is almostgoading the junk credit market to collapse on top of this deal, as thatmarket has lately been rejecting "aggressive deals featuring debt thatexceeds seven times [gross] earnings," according to Leverage World editor Howard Fridkin on July 2. Debt service alone will equal 6.7 times BCE's annual netearnings. As the Providence Equity representative acknowledge to themedia, "making this deal work is going to require greatly increasingthe performance of the company," Project Alpha Itstarted with the General Motors/UAW pension fund's "Project Alpha,"launched in 2003. That year, GM, behind in its contributions to thepension fund, floated a large corporate bond issue in order to make aneven larger, $19 billion contribution—planning not to contribute againuntil 2011, and initiating a "secret" investment strategy managed by ateam at Goldman Sachs, which other pension managers soon concluded wasputting the GM investments into hedge funds. "Alpha" is the Wall Streetterm for above-average returns—exactly what the ITUC study, and anin-depth earlier study by MIT and the University of Chicago, concludedyou don't get from private-equity funds, and now hedge funds. By2007, according to a June 18 report by Greenwich Associates, 24% of allthe hyper-leveraged assets managed by large hedge funds ($1 billion ormore) internationally, belong to pension funds and endowments. This averageis just below the 25% limit at which an individual hedge fund, underthe Employee Retirement Income Security Act (ERISA) as modified in2006, becomes an investment advisor with fiduciary responsibility forthe pension fund doing the investing—something hedge funds obviously donot want to do.[1]But in addition to that, pension funds provide some 20% of theinvestments in "hedge funds of funds"—operated by banks, and highlyleveraged—which in turn provide another quarter of the investments intohedge funds. So the pension fund/endowment share of hedge funds' assetsis really about 30%. Some 40% of the newflow of assets into the hedge funds is currently coming from pensions.And in fact, the overall flow of capital into hedge funds has droppeddramatically at the same time—from $40 billion each quarter overJanuary-September 2006, to just $12 billion in fourth quarter 2006, and$20.7 billion in first quarter 2007. In other words, pension fund moneycoming in, is allowing "smart" money to get out of the hedge funds.Numerous reports, including a new one from Chicago-based Hedge FundResearch, Inc., have shown "high net-worth individuals" reducing theirnet hedge fund investments by half, between 2006 and 2007—investinginstead into real property and stocks. They now account for only about20% of the assets of hedge funds, which were supposedly made for them. Lookedat from the other standpoint, the proportion of pension fundinvestments which are in hedge funds and "hedge funds of funds" hasrisen to about 3%, according to Greenwich Associates. But among publicemployees' pension funds in the United States, the portion is higher,between 5% and 6%. The largest of all, the $245 billion CaliforniaPublic Employees Retirement System (CalPERS), which now has 2% investedin hedge funds, on June 19 raised its hedge-fund investments to 4% andits targetted range to 8%. That's a lot of pension money to lose. Yet,the Colorado Public Employees Retirement Association (PERA), which hasa pension liabilities deficit to make up, has, since 2004, realizedhigher returns each year, investing exclusively in conservative publicstocks, than has CalPERS with its hedge funds, or GM with its "ProjectAlpha." And large losses have already begun. The San Diego CountyEmployees Retirement Association invested and lost over $100 million,2% of its assets, in the large Amaranth Advisors hedge fund, whichcrashed in October 2006. The San Diego fund was one of seven pensionfunds hit with Amaranth losses, including those of the state employeesof Pennyslvania, New Jersey, and Maryland; city employees' pensionfunds of Philadelphia and Chicago; and the 3M Corp. Butdespite such losses, some of the same public pensions are making orplanning bigger plunges into hedge funds. The San Diego County pensionhas 15% of its assets in hedge funds and "alternative investments." TheNew Jersey State Employees' plan, in a fit of desperation for"junk"-level returns to make up a large deficit, is investing $20billion into hedge funds. Richmond, Virginia's employee pension fund,already 5% invested in hedge funds, is "studying" raising that to 7%.The Pennsylvania state employees' fund increased its hedge-fund levelto 4%, after losing $33 million in the Amaranth collapse. TheBoeing Corporation employees' pension fund raised its investment inhedge funds and private-equity funds to 14% of its portfolio in 2006,according to a report by the Congressional Research Service (CRS). NewYork City's pension plans, which have never invested in hedge funds,are making plans to do so. Thesedecisions are being made as the failures of large hedge funds aresuddenly proliferating due to the spread of the MBS/CDO contagion fromthe meltdown of the U.S. housing bubble. Just the past two months haveseen the collapse of the two multi-billion-dollar Bear Stearns funds;the shutdown of the billion-dollar Caliber Capital Management fund inLondon; the shutdown of UBS bank's largest hedge fund with $130 millionlosses; and large losses by the big Goldman Sachs "fund of funds"called Global Alpha—to mention only the biggest cases. The So-Called Toxic Waste Inthe virtual panic ("can't sell 'em") which now has leaped from the U.S.MBS pit and seized the global markets for CDOs and even more exoticderivatives, the talk is all of securitized bets on categories of junkdebt called investment grade, mezzanine, subprime, and equity—the lastalso known on Wall Street as "toxic waste." These bonds have beenbought because S&P, Moody's, Fitch, and other ratings agenciesrated them, apparently, falsely. A list of U.S. pension funds whichhave bought the last-to-be-paid "equity" tranches of CDOs includes,according to financial analyst John Mauldin on June 27: "The New MexicoInvestment Council ($222 million, and another authorized $300 million,for 3% of its total fund); the General Retirement System of Detroit($38.8 million); the Teachers Retirement System of Texas ($62.8million); CalPERS..." (the amount, not noted by Mauldin, is $541million). Over a decade, pension funds and endowments have bought 7% ofall the "toxic waste" investment banks and hedge funds had on offer.Why? Because of promised, very high returns. Some of thesesubprime-rated tranches paid a huge 10% over the London InterbankBorrowing Rate (LIBOR). Some "equity" portions offered 20% above LIBOR. Mauldinanalyzed one large MBS issue of 2006, typical of those bought by thepension funds' feeding-frenzy for high returns, and found that in May2007, some 54% of the loans it was based on were more than 60 daysdelinquent, and 17% of them were already in foreclosure. Bloomberg Marketsmagazine, in a late June article called "The Rating Charade," tracedback one such CDO security, issued in 2000 by Crédit Suisse, andcombining primarily MBS into five basic "tranches" of debt. The bigthree ratings agencies named above rated 95% of the whole CDO,investment grade, triple-A or double-A. And what was the fate of thosewho bought the CDO tranches in 2000? The AAA and AA tranch buyers, orthe insurance they bought, lost 25%; all the rest of the CDO was acomplete loss. In total, $120 million was lost, or 35%, on the entireCDO, which had been issued with a 95% AAA rating. OnJune 29, 2007, Bloomberg News reported it had done a broad review ofMBS issues of debt based on the U.S. mortgage market, and found that65% of them needed to be downgraded by the ratings agencies. "Take the300 bonds that are used in the ABX indexes, the benchmarks for thesubprime mortgage debt market," researcher Mark Pittman wrote. "190fail to meet the credit support standard [the ratings agencies useduntil 2005], according to data released in May by trustees responsiblefor funneling interest payments to debt investors. Most of those,representing about $200 billion, are rated below AAA. Some contain somany defaulted loans, that the credit support is outweighed bypotential losses. Fifty of the 60 A-rated bonds fail the criteria, asdo 22 of the 60 AA-rated bonds and three of the 60 AAA-rated bonds." Asthe credit crunch hitting the worldwide CDO markets intensifies, itwill be impossible for many of these "investment assets" of the pensionfunds to be sold at any price. Hedge funds, as they get into trouble inthis crisis, block their investors from withdrawing capital for up to60-90 days, at which point it has usually been too late, as in theAmaranth, RefCo, and Bear Stearns cases. Thisis why inside observers of the mortgage and MBS meltdown, watching itfrom within financial institutions in New York, London, Boston, etc.,warn of a new and much larger pensions crisis. They understand that thewaves of MBS and CDO losses, perhaps up to near $1 trillion, will hitthe hedge funds and investment-bank "hedge funds of funds" above all.But they see the hedge funds' managing partners using the Summer andFall months of the crisis to continue "working themselves out" fromthese losses, with the foolish assistance of the pension funds that arecontinuing to "work themselves in." IPOs by private equity funds, andhuge funds of pension money into hedge funds, are two aspects of thissame process. [1]ERISA does not require pension funds to list their hedge fundinvestments or their amounts, so the concentration of a pension'sinvestments in one or two hedge funds, cannot be regulated. And theTreasury's philosophy, under Secretary Henry Paulson, is the "marketcorrection" view, as expressed by Assistant Secretary Emil Henry,quoted in the CRS report noted above: "As pensions continue to investin hedge funds, the industry will further adjust and further imposeupon itself ... a risk-management strategy which should—at somelevel—mitigate risk." Pensions may soon find how low that "some level"is, unless they cease to be the hedge funds' main flow of investments. | |
