Friday, February 27, 2009

The Model That's Killing Pension Funds?


Terence Corcoran of the Financial post wrote an excellent article, The model that's killing pension funds:

This week's big losses at the Caisse de depot et placement du Quebec triggered the usual round of calls for the heads of the organization's top executives to be set out on platters. While public decapitation of investment experts who make mistakes is entertaining work, it hardly gets to the real issues exposed by the Caisse's 25% loss in value.

Those issues are, in no special order: 1) Why does the Caisse exist in the first place? 2) Why are pension managers risking taxpayer money on volatile equity markets and even more problematic investments? 3) How long will average voters put up with public pension operations that nationalize savings and, in many cases, reward a few and pass the risk on to taxpayers when things go wrong--as they will?

The Caisse, moreover, isn't the first, nor will it be the last, big name public pension plans to reveal disastrous investment returns and loss of value over the last year. The same questions could be asked of OMERS, one of Ontario's two pension giants, which reported a 15.3% loss for 2008. OMERS represents 380,000 unionized municipal and other public sector workers.

Ontario Teachers' Pension Plan doesn't disclose its disaster until later. The Canada Pension Plan Investment Board, which is relatively new to playing the stock market and other high-flying investment risks, reported a 13.7% plunge in investment returns for the first three quarters of its latest fiscal year. That comes after a zero-return clunker the year before and doesn't include a breakdown of the "fair value" writedown of its non-marketable investments.

As the Financial Post's Karen Mazurkewich reports today, these and other public pension managers could report cumulative losses totalling $100-billion for the year. They will all blame bad markets and the global financial crisis. None will look at the possibility that they are operating under faulty investment models and wonky actuarial theories. In the view of many economists who study pension funds, these plans are time bombs of risk whose losses taxpayers will inevitably have to pay for.

But first, the question is why do these giant public pension plans exist? They are, essentially, wealth confiscated by governments. The CPPIB and parts of the Quebec Caisse invest funds to provide basic pensions for all citizens, using money taxed from all their constituents. The rest of the public pension investment activity is on behalf of unionized monopoly government service providers --hydro workers, police, municipal employees, teachers. All are set to receive relatively lavish pensions paid for by Canadian taxpayers who have no comparable pension plans.

That gap is serious enough. But when it turns out that taxpayers will have to bail out the lavish union pension plans, or that their government pensions will require higher and higher cross-generational premiums, the morality of the gap widens even further.

At the heart of the pension meltdown is the investment model. The investment managers who led the Caisse into its 2008 meltdown were simply following the dominant investment theories of our time: Equity markets theoretically will provide solid average returns over the long term. Judicious stock picking can help a fund get better-than-average returns. More recently, all fund managers also came to believe that still higher returns could be found in other fields, including asset-backed securities and private investment markets.

As we've noted in this space many times over the last few years, in the view of financial economists the first part of the model -- that equities provide guaranteed returns over the long term -- is untenable.

Among the leading debunkers of the conventional model are U.S. consultants Lawrence Bader and Jeremy Gold. In a relatively recent paper, The Case Against Stock in Public Pension Funds, published in the Financial Analysts Journal in 2007, they warned that government pension operations are engaging in risky investment strategies. "Current funding and investment practices are costing taxpayers dearly," they wrote. By investing so heavily in equities, pension managers were putting taxpayers at risk on the assumption that long-term gains would overcome short-term meltdowns. Such equity premiums, they say, do not exist with any certainty.

As shown during the stock market crunch earlier this decade, the risks are large. The Ontario teachers plan is still being bailed out this year and next as the Ontario government pays close a $1-billion directly into the fund in part to cover past losses.

Pension funds will have to cover their equity losses, plus make up for losses from their more recent investment fads, namely, the theory developed in the U. S. that even bigger investment gains could be squeezed out of private investment deals. Equities were overvalued, they said, and the real money would now be made buying real estate in Munich, sewer systems in Brazil and private companies that had no trading value. Now that theory is also under a cloud.

So far, there are no signs that public pension funds are ready to reshape their basic approaches to pension management. The new losses are just a blip, they say, the function of a global financial crisis. You need to focus on the long term. Financial economics suggests this is the long term.

Bravo! I couldn't have said it better myself. The pension model is broken and along with it the "culture of equities" and the broken dreams of lifelong absolute returns from alternative investments.

The biggest problem with alternative investments is how pension funds value them. Karen Mazurkewich of the Financial Post writes for pension plan results, look to valuations:

The Caisse de depot et placement du Quebec saw its assets under management plummet $40-billion and the total tab for public pension losses last year could top $100-billion, but how much of that is subjective?

As it turns out, a whole lot.

In the case of the Caisse, more than 56% of the writedown is unrealized or paper losses that are based on an estimated value of the assets the plan is holding. Although the Caisse is not selling most of those assets, it still recorded significant losses based on a valuation.

And it ends up valuations on private companies and real-estate holdings have a lot of magic to go with the mathematics.

Which brings us to the yearend results posted by two pension funds this week. In announcing its losses, the Caisse recorded significant writedowns of 31%, 22% and 44% in its private-equity, real estate and infrastructure portfolios, respectively.

By contrast, Ontario Municipal Employees Retirement System (OMERS) , which announced its yearend results, registered a more modest return of negative 15.3%. While the plan notes a 13.7% decline in private equity, it posted 6% growth in real estate (meaning it had no write-downs) and a positive 11.5% return for its infrastructure arm.

It's hard to imagine that two pension plans, each with widely diversified portfolios, would have such huge disparity in their results. While some of that gap could be explained by leverage ratios and other factors, another factor is valuation strategies.

"When it comes to valuation, there's a huge amount of discretion that can be applied," says one Toronto-based private-equity manager.

Auditors prefer to determine the value of a company by comparing it to similar publicly listed firms, but the problem is that they have to choose which companies to compare themselves to.

Other ways to value a company or assets are to use a calculation based on future cash flows, simply use the last purchase price, or even a combination of all of the above.

Auditors have the latitude to use different techniques.

Says one chief financial officer of a large Canadian privateequity firm, you could take the same portfolio and get a 20% range in the valuation.

And that is one of the reasons the pension plan gaps may be so large.

Take the private-equity portfolio of OMERS. Patrick Crowley, the chief financial officer, says his group arrived at its 13.7% writedown by analyzing its own direct investments, and by interviewing 60% of the privateequity funds where it has investments who gave them an up-to-date-valuation on their funds. These include such firms as Onex Partners, Kohlberg Kravis and Co. and Apax Partners Ltd. They then prorated those interviews with the rest of their outside managers to arrive at their figure.

The Caisse, by contrast, determined the value of its private-equity portfolio using a complicated index, but 60% of it was made up of the battered S&P 500. It took a much bigger hit.

Then, there is the question of agendas. For the new top executives at the Caisse, it makes more sense to write down a greater part of the assets and start fresh.

OMERS executives, however, may be less inclined to take a conservative approach to valuation.

So what does the magical mystery tour of valuation all mean to the average pensioner?

The bad news is that it's difficult to compare institutional funds' performances. The good news, if you are a pensioner in Quebec, is that a chunk of that $40-billion loss is a figment of some auditor's imagination.

It isn't a figment of some auditor's imagination because if they absolutely needed to sell those assets today to pay for pension benefits, I can assure you that $40 billion might have been closer to $50 billion.

But Ms. Mazurkewich has caught on to the valuation tricks that senior pension fund managers love to play. Mr. Rousseau and other presidents were good at this game of taking massive write-offs on some assets one year, only to write them up the following year when markets recovered. Presto! Instant "alpha" with the magical stroke of some accountant's pen.

Finally, the Financial Post's Jonathan Chevreau writes Pension envy no more:

The revelation that Canada's largest pension fund -- Caisse de Depot et Placement du Quebec--lost a quarter of its $155-billion pension fund assets in 2008 is a timely reminder that even retirees in cushy defined-benefit plans should worry about the financial crisis.

Less fortunate members of defined-contribution corporate pensions, or those who run their own pensions in the form of RRSPs, know how much the worldwide bear market has hurt their retirements. Desjardins Financial found most Canadian workers have pushed back their retirement by almost six years.

I've used the phrase "pension envy" to describe how pension "have-nots" feel about the fortunate few seemingly insulated against market risk: In defined-benefit plans, employers absorb market risk and in public sector plans like the Caisse, the ultimate backstop is taxpayers.

Most experts do not believe Caisse pensioners are in danger of suffering shortfalls in benefits. "That thing will be here long after our great, great, grand kids are dead and buried," says Gordon Lang, chief actuary for Calgary-based Gordon B. Lang&Associates Inc.

Far less rosy are the prospects of corporate definedbenefit plans that are not as gold-plated as their public-sector counterparts.

Robert Brown, professor of actuarial science at the University of Waterloo, estimates a dozen corporate pension plans may have to tap Ontario's Pension Benefits Guaranty Fund (PBGF). They include the Canadian units of Detroit's big three auto makers and close-to-bankrupt former giants like Nortel. Mr. Brown says governments may face political headwinds if the proposed bailouts of auto makers includes salvaging those pensions -- the 79% of taxpayers who do not enjoy Cadillac employer pensions would most likely be outraged subsidizing those that do.

Mr. Brown would not worry if he were a Quebecer expecting his Caisse pension, but he definitely would if he were a Nortel retiree. Bankruptcy doesn't mean pensioners get stiffed, since pension assets are held separately in trust.

"What's happening is we're realizing some of these companies we thought would go on forever could actually go bankrupt," says Brian Fitzgerald of Capital G Consulting Inc. If a pension is only 70% funded and the employer runs out of cash, the issue is how to make up the deficiency. "The risk of losing all your pension is extremely remote," Mr. Fitzgerald says. "Typically, the risk is you get only 90% of what you were promised."

In Ontario, the PBGF tops up deficiencies to a maximum of $1,000 per month per pensioner, but there are limits to how many pensions it can bail out. Mr. Brown says Algoma Steel already took a $330-million loan from the fund.

Malcolm Hamilton, an actuary with Mercer's, says all pension funds had bad results in the past year. "The fact the biggest fund has the worst loss isn't surprising." The CPP Investment Board lost just 13.7% for the last nine months of 2008. The Caisse loss of 25% was proportionately worse because of exposure to asset-backed commercial paper.

There is a continuum of individual exposure to pensions. Federal government defined-benefit plans are unaffected because the ultimate backstop is the taxpayer. Ontario teachers are supported by the province, but members share the pain if higher contributions are required. Those in union-sponsored multi-employer pension plans may see lower benefits if returns sag.

There are two camps of single-employer defined-benefit pensions, Mr. Hamilton says. At strong firms, shareholders take the hit as employers make up pension deficiencies. But those in plans sponsored by financially weak companies are vulnerable since the employer may not be around to make up the deficiency.

An example is automaker General Motors Corp. Depending on its funded status, pensioners might get just 50¢ or 60¢ on the dollar, says Keith Ambactsheer, president of Toronto-based KPA Advisory Services Ltd. Ironically, if that occurred, that would put them in the same position as individuals who have lost 30% or 40% in their RRSPs.

If markets don't recover soon, even public pensions may not be able to keep their pension promises. Mr. Ambactsheer cites the dire straits some U. S. state and municipal pensions are in.

In the end, all pensions depend on a healthy economy and stock market. Despite talk of diversifying among alternative assets, the pension game is still tied to capitalism and the idea of "stocks for the long run."

The system could sustain another year or two of huge losses, but if the recovery doesn't kick in after that, all bets are off and pension envy will be a thing of the past.

If so, we'll have bigger problems to deal with than worrying about a leisurely old age.

Unfortunately, the pension crisis is here to stay. It's the reason why I started this blog and why I strongly feel that we need to radically change the governance at public pension funds.

The current model is killing them and unless something is done, taxpayers will be called upon to bail out public pension funds.

Thursday, February 26, 2009

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?

Answer: The fat cats at the top get all the glory and if things go wrong, they get golden parachutes. All upside, no downside. No wonder the pension model is broken.

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).
Finally, please take the time to watch YouTube video below of Diane Urquhart on Canada AM discussing the Caisse's losses. Diane played an instrumental role in fighting on behalf of retail investors that lost money in non-bank ABCP and she is a fiercely independent analyst who speaks the truth. I think she should be Canada's pension czar, if such a position were ever created.

***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.


Wednesday, February 25, 2009

Caisse's $40 Billion Train Wreck?


The Caisse de dépôt et placement du Québec, one of North America’s biggest pension funds, saw the value of its investments shrink by a quarter last year, the worst performance in its 44-year history:
Although much of the loss was due to the turmoil in global markets, the Caisse was also hit by its heavy exposure to the meltdown in Canada’s asset-backed commercial paper market. In addition, it posted large foreign-exchange hedging losses as the Canadian dollar fell in line with the slump in commodity prices.

Depositors’ assets shrank to C$120.1bn ($95.7bn) as of December 31 from C$155.4bn a year earlier. Total assets under management fell from C$257.7bn to C$220.5bn.

The reversal comes amid renewed controversy over the role of the Caisse, a Quebec government agency that manages the assets of 25 provincial, municipal and sectoral pension and insurance funds.

The agency operates in a politically charged atmosphere, torn between its role of promoting the economic independence of Canada's French-speaking province and its obligation to seek the highest returns for the investments that it manages.

DBRS, a Toronto-based credit ratings agency, forecast on Wednesday that last year’s setback in its performance would attract considerable political attention.

“This will likely trigger internal changes,” DBRS said. But it added that the Caisse maintained “a very strong credit profile”, buttressed by its mandate to manage an array of public assets, its sizeable liquidity and its large investment portfolio.

The agency is without a permanent chief executive. The previous incumbent, Richard Guay, left in January after less than a year in the job, including several months on “exhaustion leave”.

The financial cost of the Caisse’s political role was highlighted nine years ago when it threw its weight behind a hostile takeover bid by Quebecor, a media group based in Montreal, for Groupe Videotron, the province’s biggest cable TV operator. Videotron had favoured a rival offer by Rogers Communications, a cable TV group based in Toronto. Both Quebecor and the Caisse were later forced to take hefty writedowns on the investment.

The Caisse has also been a force in expanding Quebec’s pharmaceuticals, telecommunications, biotechnology and software industries.

It has increasingly moved beyond its Quebec roots during the past decade in a quest to become a global asset management powerhouse. Among other investments, it has built a large presence in the US commercial property market.

The Quebec legislature is expected to hold a special hearing on the Caisse’s performance within the next few months. The separatist Parti Québécois has blamed the Liberal government for the fund manager’s problems by allowing it to expand its investments outside the province.

The province’s finance minister said this month that she would seek to appoint a government representative to the Caisse’s board, overturning an earlier policy designed to put more distance between the agency and its political masters.

Fernand Perreault, acting chief executive, said the Caisse had increased its holdings of liquid assets, pushing the share of equity investments down from 36 to 22 per cent, while increasing its exposure to fixed income investments from 30 to 44 per cent.

Mr. Perreault also addressed the liquidity concerns:

"At no time during this period did the Caisse run short of, or come close to running short of, liquid assets," Perreault said in a release.
The Globe and Mail reports that in light of the record losses in 2008, Quebec's Finance Minister announced sweeping changes to the pension fund's management and requested a National Assembly committee hold special hearings to examine the debacle as early as next week:

“I'm very disappointed. It's a major loss, … it's obvious it is not something I wished for,” Monique Jérôme-Forget said. “Let's put some perspective on this; let's remember that all the funds have lost a lot of money, between 18 and 20 per cent. In fact some funds in the U.S. and in Europe have lost 27 per cent. That doesn't make our situation any better.”

Within weeks or even days, the provincial government will appoint new members to the Caisse's board of directors and approve the appointment of a new president and chief executive to replace interim president Fernand Perreault.

“All of this will present itself in the coming days, even in the weeks ahead but not in months,” the Finance Minister said during a news conference Wednesday.

Ms. Jérôme-Forget said the National Assembly committee will hear testimony from the Caisse's former president, Henri-Paul Rousseau, as well as current managers. Mr. Rousseau presided over the pension fund's decision to invest massively in the money losing asset-backed commercial paper (ABCP).

“What we are going to get from the management of the Caisse and from Mr. Rousseau, I'm sure, are indications as to what happened and what they feel should be done in the future. I'm sure they have opinions as to what could be done, what should done and how it should be done,” the Finance Minister said.

Ms. Jérôme-Forget said she will not testify before the commission nor will she support opposition calls for an independent inquiry into the pension fund's heavily indebted position into ABCP.

The close to $40-billion in losses put the government in a difficult political situation. It has been largely blamed for allowing the Caisse to take unnecessary risks with money received from depositors such as the Quebec Pension Plan, the Auomobile Insurance Board or the Workmen's Compensation Board in order to increase short-term benefits.

Increases in pension fund contributions or automobile insurance rates may be required to make-up for the shortfall. “You will have to ask each of these groups what they intend to do,” the Finance Minister said, stressing that pension payments under the Quebec Pension Plan will not be affected by the loss in revenues.

Pierre Plamondon, chief actuary of the Quebec Pension Plan, said 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," he said.

Plamondon acknowledged higher QPP contributions might be necessary to respond to the demographic challenge, but that would come only after a public consultation in the next year.

Former Caisse official, Michel Nadeau, said markets will normally rebound strongly after a 50 per cent plunge from top to bottom, and such a recovery would put pension plans on the road to health.

But if there are negative returns in the neighborhood of 15 per cent or more this year, tough decisions might have to be considered on contribution increases or trimming of benefits, he added.

"What happened last year was exceptional, once in a century," said Nadeau, who is now executive director of the Institute for Governance of Private and Public Organizations.

The former head of the Ontario Teachers Pension Plan Board, Claude Lamoureux, said that there should be no gloating about the massive losses reported by the Caisse:

You're competitive but at the same time you don't like your competitors to look bad and to lose money for their members or not to do well for their members because we all lose when that happens," Claude Lamoureux said in an interview.

The country's largest pension fund manager said Wednesday it lost $39.8 billion or 25 per cent of its $155.4 billion asset base last year as a result of a weak stock market and losing investments in asset-backed commercial paper and currency hedges.

Lamoureux said the fundamental tenet of being a large investor is to take risks and the Caisse's performance must be viewed in the context of the worst year since 1973.

'I think there's a bit of hysteria at this point," he said before the Caisse disclosed its worst performance ever in 2008.

Anyone who had invested in the Toronto Stock Exchange lost 33 per cent while world markets were down 42 per cent in local currency or 28 per cent in Canadian dollars, he said from Toronto.

The Teachers reports its annual results April 2. The Ontario Municipal Employees Retirement System said this week it lost $8 billion on its investments, representing a minus 15.3 per cent rate of return. The median return for Canada's large pension funds was minus 18.4 per cent.

Getting burned by weak performances shouldn't prompt pension fund managers to be overly cautious in the face of a recession and sliding stock markets, said Lamoureux, who retired in 2007 after overseeing its assets grow to $106 billion as of the end of 2006 from $19 billion in 1990.

'When everybody is euphoric, time to be careful and when everybody is pessimistic, I think that it's time to invest."

Former Caisse executive Michel Nadeau said while risk is a cornerstone of a money manager's skills, Quebec's investing giant erred in taking too many big bets at the same time.

'That will be the lesson that you should always try to manage the negative impact of your potential bets," he said in an interview.

Large U.S. university endowment funds at Yale and Harvard made the same mistake as the Caisse by making huge bets on alternative investments, subprime markets and currency, said Nadeau.

He expects the Caisse will probably be more prudent in the short-term before the natural drive towards risk to generate higher returns resurfaces.

The use of sophisticated mathematical models that failed to capture the risk of a market meltdown will also likely be reviewed by the Caisse after they failed to work in 2008, added Nadeau.

Each of Canada's five large pension fund managers has its own investment personality and style. Most have one client. But the Caisse invests for 25 different provincial, municipal, sectoral pensions and insurance funds, which have different investment criteria and weightings among bonds, stocks and real estate.

Last year, the fund received $4.5 billion from contributors.

Between 2003 and 2007, the Caisse had the Midas touch, generating the strongest annual results among the large Canadian pension fund managers, at 12.4 per cent average return.

But being Canada's largest investor comes with a price - suggestions of political interference.

For years, many in English Canada viewed the Caisse with skepticism. As a creation of the Quiet Revolution, it was seen as being an investment wing of the government. Known as Quebec Inc., its mission was to support francophone companies and advance Quebec's economic growth.

Originally modelled in 1965 on the Canada Pension Plan, its early investments included Quebec government and Hydro-Quebec bonds. Former premier Jean Lesage's goal was for the Caisse to have $2.6 billion of net assets by 1976, a feat that was far surpassed.

In 1967, its first stock market investments included purchasing 3,000 shares of aluminum giant Alcan and 193,000 shares of what has become the National Bank of Canada.

By 1974 it had the largest Canadian equity portfolio in the country with investments in Gaz Metropolitain (TSX:GZM.UN), Canam Manac and Domtar (TSX:UFS).

Concerns reached a peak in the early 1980s when the Caisse tried to buy the Canadian Pacific conglomerate - then Canada's largest company - in a leveraged buyout with Quebec financier Paul Desmarais. The federal Liberal government of Pierre Trudeau was initially persuaded to limit ownership of transportation companies by provincial crown corporations but later withdrew legislation.

Former PQ premier Bernard Landry recently wrote that many Quebec businesses have thrived because of the Caisse's intervention while others, including television network TVA, would no longer be owned by Quebecers without the pension fund.

Jean Charest changed the Caisse's mission in 2005 when the focus was clearly set on maximizing returns.

Critics of government say the Caisse's dismal performance in 2008 can be traced to this policy change.

But defenders of the Caisse said its motives were never well understood, especially by English Canadians.

'Every decision taken by the Caisse was financially motivated," said Nadeau, No. 2 at the Caisse when he retired in 2002 with the arrival of Henri-Paul Rousseau.

Landry said the sale of grocery chain Provigo to Toronto-based Loblaws (TSX:L) demonstrates that accusations of manipulation are unfounded.

The purchase of 30 per cent of Canada's commercial paper investments for $12.6 billion will likely go down as the biggest financial blunder in the fund's 43-year history.

It took a $4-billion writedown on its asset-backed commercial paper holdings in 2008, after taking a $1.9 billion charge in 2007 once the market froze up that summer. The Caisse sold billions in equities after it faced a cash crunch from losses on currency hedging and derivatives.

Previous failed bets are tame by comparison. They include forays into fashion, resources giant Noranda and an attempt to buy the Quebec-based Steinberg's grocery chain.

In 1989, the Caisse bought property developer Ivanhoe to secure Steinberg's real estate assets.

The Caisse's $3 billion investment in Quebecor's (TSX:QBR.B) cable subsidiary Videotron has yet to pay off. It wrote off 85 per cent of the investment in 2002. But the company's rising value has only meant that the investment has taken longer to recoup the money, said Nadeau.

Nadeau said the Caisse's best moves were investments in Quebec companies and real estate. By 1996 it had become the largest real estate owner in the province and second largest in Canada. It also profited after once being the largest owner of office space in Paris.

The investment in British airports such as Heathrow has been so lucrative that the government has ordered the splitting up of the British Airport Authority.

While I agree with Mr. Lamoureux that there is a bit of hysteria at this point, I disagree with his assertion that it's time to invest because everybody is pessimistic.

Importantly, unlike the dips that Mr. Lamoureux witnessed while at the helm of Ontario Teachers, this time is different and it will take a lot longer to recover than in past episodes.

Also, Mr. Lamoureux invested heavily into alternative investments, made millions in the process and exited right before stocks and alternative investments imploded. Great timing, wouldn't you say? Even better timing than Mr. Rousseau who got out of the Caisse before the storm's full fury hit. Mr. Lamoureux saw the writing on the wall and bowed out gracefully.

As far as Mr. Nadeau, why wasn't he talking up governance and risk management when he was second in command at the Caisse? Has he forgotten about the Caisse's Nortel debacle and other poor investment decisions that took place when he was second in command at the Caisse?

Back on topic. Most of the articles written today were hysterical, calling for the Caisse's abolishment or just screaming for heads to roll. I think the nearly $40 billion headline figure got people very nervous but the 25% loss was in line with what other large global pension funds lost.

For example, at the beginning of December, the California Public Employees' Retirement System (CalPERS) portfolio had lost 31.1 percent of its value since peaking last fall, a staggering $81.4 billion drop. The reality is that the downturn clobbered public pension funds, especially those that were highly exposed to public equities and alternative investments like private equity, hedge funds and real estate.

But the 25% haircut in total assets, has raised concerns about the security of Quebec pensioners. It also has people in the financial sector calling for a re-evaluation of risk models adopted by the Canadian institutions.

"It's clearly a staggering loss in absolute dollars," says Tawfik Hammoud, partner and managing director of The Boston Consulting Group in Toronto. "The government should mandate a bottom up review of their asset model, risk strategy and organization" he says. He adds: They also need a strong full-time CEO who can develop a credible path to recovery and deal with the various stakeholders."

With its risk strategy under attack, it seems certain that the Caisse will take a more conservative approach in the future. Already, Quebec's Finance Minister has announced an overhaul of the organization, and has requested a National Assembly committee hold special hearings to examine the issue of losses.

All asset classes -- with the exception of the best government securities - recorded steep losses at the pension plan. In addition to a significant writedown due to hedging its foreign exchange risk on assets outside the country, the Caisse took a huge financial blow investing in asset-backed commercial paper (ABCP). The Caisse was forced to write down 43% ($5.6-billion) of its $12.8-billion investment in the toxic paper.

In a statement to the press, Fernand Perreault, president and chief executive of the Caisse, did a mea culpa: "The risk management policy had not set overall limits on the amount of AAA-rated money market instruments that could be held. In hindsight, we placed too much confidence in these securities."

Speaking to the issue of the Caisse's ABCP loss, Finance Minister Jim Flaherty was quick to point out that had the government not come to the rescue, the losses "would have been much worse." But for pension watchers like Keith Ambachtsheer, director of the Rotman International Centre for Pension Management at the Rotman School of Management, the losses only speak to poor oversight.

"These institutions need to do their own due diligence," he said. "Just because the agencies rate them as AAA doesn't mean they are," he says.

Not all the Caisse's $40-billion losses were real. While the pension plan realized losses on the sale of its investments of $23.2-billion, over 56% of its losses were unrealized decreases in value, otherwise known as paper losses. While the real estate portfolio generated more net rental income in 2008 than the previous year, the fund estimated that the mark-to-market value of real estate declined 22%.

[Note: Unrealized losses - or paper losses - can become realized losses if things get very ugly for a prolonged period.]

So far the Caisse's losses stand in dramatic relief to losses at the other pension funds and calls into question the performance of the managers. The Caisse had a benchmark portfolio of a 18.5% loss, but posted a 25% loss. That's 650 points below its benchmark and a shortfall that is considered disastrous by pension fund managers. By contrast, Ontario Municipal Employees Retirement System (OMERS) declared a negative 15.3% return for 2008 compared with a benchmark of negative 13.2% which represents 210 basis points below benchmark.

Despite Wednesday's bad news, "the Caisse continues to have a strong liquidity position and they still have a massive amount of capital," said Huston Loke, co-president of DBRS Ltd. While the rating agency looks at how funds do in relation to their peers, Mr. Loke likes the fact that the Caisse appears to be recalibrating its risk models and focussing on assets that "are more understood."

The Caisse announced it has suspended its "asset allocation operations" a risky portfolio (although non-transparent portfolio) that contributed to $2-billion in losses last year.

At the end of the day, pension insiders don't think the province is going to throw the Caisse out with the bathwater.

"The province is so proud of the Caisse," said one analyst. "They put them through the ringer in front of the General Assembly, but at the end of the day they will simply ask them to strengthen internal controls and make some changes," he said.

One word of caution. As I stated before you cannot properly compare pension funds unless you know the benchmarks that govern the underlying investments. And even though they aren't perfect, the Caisse's benchmarks are much tougher than any other pension fund in Canada.

In her article, Caisse de depot's trainwreck part 2, Diane Francis writes the following:

Now we know that the Caisse de Depot et Placements du Quebec lost a staggering $39.8 billion in 2008, or around 25% of its value -- and possibly more down the road -- through a combination of internal mismanagement, poor controls and an inappropriate appetite for gambling.

These huge losses were unreported until the provincial election was over and those responsible bailed out, or went on sick leave, with big bonuses.

I exposed the grave financial problems, and lack of reporting transparency, with the help of whistleblowers close to events on December 4. A second appeared in January. But these stories were ignored by the Canadian, and Quebec, media alike. They were also attacked by a Caisse public relations spokesman in a letter to The Financial Post.

My articles appeared in early December just before the Quebec provincial election. They should be re-read.

It was clear that the Caisse's management did not have proper personnel or controls. It was clear that the Caisse gambled the nest egg of Quebeckers. The beginning of the problem was its huge purchase of real estate assets at bubble prices then asset-backed paper, both of which turned out badly in today's markets.

To make matters worse, the fund behaved like a speculator by making multi-billion dollar bets that blew up in its face, betting the U.S. dollar would fall and that commodities would remain at peak prices. Both bets were very wrong and possibly made in order to recoup the asset-backed losses which surfaced in August 2007. Whatever the explanation, no pension fund should ever be allowed to get involved in such naked gambling maneuvers.

It's not just the Caisse

My two articles are well worth reading because they point out other issues that should be investigated by Quebec provincial authorities in their legislative committee process which was announced by Premier Jean Charest today.

All other provinces and the federal government should also take note because regulations obviously must change. Here are some questions and some suggestions:

-- Why were there no internal controls in place to insure that such huge, unhedged bets were made? Is this occurring in other pension funds too?
-- Is it true that several teams of portfolio managers were fired for catastrophic results and not replaced?
-- Why did the Caisse Chair and CEO get huge bonuses for 2007 and 2008 despite such mishaps?
-- 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 with outsource computer contracts that have done little to fix the problem?
-- Is it true that the Caisse is over-staffed compared to other large pension funds? Are other pension funds the same?

It's also important to point out that the Caisse is not the only worrisome, large pension situation around. I have serious concerns about the recent behavior of the Ontario Teachers Pension Plan with its move into a vastly leveraged, high-risk private equity takeover involving BCE. Fortunately the deal failed or else Canadians would have a second giant pension fiasco to backstop and replenish.

Among reforms that should be undertaken by all governments:

1. I believe that pension commissions in governments should be overhauled and do the job they are supposed to do. The Ontario Pension Commission allowed Ontario Teachers Fund to make a takeover even though there are restrictions limiting ownership by pensions to no more than 30%.
2. Governments must break up the biggest funds into smaller pieces. This will greatly reduce risks.
3. Governments must outsource pension portfolio managements of these smaller entities in order to be able to ruthlessly, when necessary, fire and hire better brainpower.
4. Governments must require pension funds to report as often and as fully as public corporations must report. This means quarterly reports with full, complete and timely disclosure.
5. Governments, because tax dollars are backing up these losses, must require full, timely and complete disclosure of material facts as is the case with public companies. If major losses occur, publicly-backed pension funds must issue immediate press releases. In this case, the Caisse was able to avoid disclosure of huge and serious losses for many months after these occurred, thus allowing both management, directors and politicians a chance to postpone the bad news.

This is no way to run our affairs and the pension sector must be reined in immediately by all unions, provinces, corporations and the federal government.

Now, let me end with my analysis. Ms. Francis is right on some points and wrong on others and I will try to go over the major points below.

Please go to the Caisse's website to view the press release and the accompanying financial statements. You can also click on the image above to view the returns of the specialized portfolios.

As you can see, Canadian public equity did slightly better than its index, returning -32.4% versus -33%. Both the hedged U.S equity and foreign equity did a lot worse than the unhedged portfolios mainly because of the 20% drop in the Canadian dollar in 2008.

The decline in the Canadian dollar also hit alternative investments like private equity (-31.4%), real estate (-21.9%) and real estate debt (-7.6%), hedge funds (-20.9%) and commodities (-25.4%).

Importantly, these alternative investments are 100% hedged, meaning they were 100% hedged back into Canadian dollars, so as the value of the Canadian dollar lost ground, this exacerbated to the losses in alternative investments, which all got clobbered last year.

It is worth noting that the Caisse was aggressive in writing down its illiquid private market assets, much more than OMERS and probably any other pension fund out there. As far as hedge funds, this includes several internal absolute return strategies that blew up and lost hundreds of millions in 2008 and their Tremont index had some Madoff in there (ask the red-faced Man Group about poor due diligence.)

What Diane Francis got wrong is that these are not active decisions, but passive hedging decisions which were predetermined by the Caisse's depositors.

What I would like to know is why don't they just hedge 50% their F/X exposure and/or why did they buy currency options to partially mitigate these foreign exchange losses? Didn't they see the bubble in commodities and deduct that the Canadian dollar was going to get hammered too?

That leaves us with the last sticking point - ABCP. I will quote Andrew Willis of the Globe and Mail, How ABCP plays into Caisse loss:

As bad as the Caisse de dépôt et placement du Québec's performance numbers look, its 25 per cent loss actually understates a miserable year for the pension fund.

A large part of the Caisse's loss in 2008 came on its $12.8-billion portfolio of asset-backed commercial paper, which was written down by a further $3.8-billion last year. Over all, the Caisse's ABCP program is now valued at $7.2-billion, or 57 cents on each dollar of face value.

Now, if you're a pessimist, you'd argue that this valuation is generous. When ABCP that's been restructured in a Caisse-backed rescue finally starts to trade, bond desks will tell you that the new notes are going to change hands at around 30 cents on the dollar. The exact price is going to reflect the quality of the underlying assets owned by investors - all ABCP is not created equal - and the sophistication of the seller.

As it gets rolling, the ABCP market promises to be ugly (or inefficient, to use a less loaded description), which is why banks hung up in the ABCP mess are advising clients to sit tight on the paper. But if this debt is in fact trading at 30 cents on the dollar, the Caisse is down far more than advertised.

Now, if you're of an optimistic bent, then the ABCP situation is improving. A lengthy and complex restructuring is now complete, and commercial paper has been transformed into notes that mature in eight years. For investors who don't need to cash in right away, holding on to ABCP means making back paper losses.

That positive attitude prevails at the Quebec fund, as the Caisse said Wednesday in a release that it “believes that a large portion of this cumulative provision will be reversed in the years to come.”

Most fixed-income investors agree that, over time, the Caisse will make back some of its ABCP losses. But the pain caused by this outsized holding in flawed assets stands as a permanent stain on the records of Caisse executives, including departed CEOs Henri-Paul Rousseau and Richard Guay.

As acting CEO Fernand Perreault said Wednesday: “The ABCP episode is without doubt a difficult page in the Caisse's history.”
I happen to think that ABCP was generously valued and the Caisse is hiding its real losses. Even PSP Investments, which also took a sizable haircut on ABCP in its FY2008, was more aggressive in writing this paper down.

Speaking of PSP Investments, Andrew Willis writes that it dipped into the bond market:

Lousy returns on investments haven't undermined faith in Canada's pension funds, as PSP Capital showed Tuesday with a $400-million bond issue.

The Public Sector Pension Investment Board, which cares for the retirement savings of Mounties and federal civil servants, raised money to fund its operations: Other public sector plans have similar programs to finance activities such as real estate investing.

PSP Capital initially targeted a $300-million sale of bonds that mature in 2013, with TD Securities as lead underwriter. The issue was bumped up to $400-million in the face of strong demand, and there is now $1-billion of this debt outstanding.

In awarding these bonds a top, triple-A rating on Tuesday, DBRS said “PSP is expected to have been notably impacted by the equity market downturn, like most of its peers.”

“Nevertheless, PSP continues to exhibit very strong credit fundamentals bolstered by its exclusive mandate to manage assets… as well as its large investment portfolio, solid cash flow outlook and a robust liquidity position” said the credit rating agency.

This access to bond funding means the public sector funds can continue to be active players in the capital markets, despite weak return in 2008. While PSP has not released its numbers from last year, it's logical to assume that the fund will post performance in line with the 15.3 per cent loss announced Monday at OMERS.

Lousy returns on investments haven't undermined faith in Canada's pension funds, as PSP Capital showed Tuesday with a $400-million bond issue.

The Public Sector Pension Investment Board, which cares for the retirement savings of Mounties and federal civil servants, raised money to fund its operations: Other public sector plans have similar programs to finance activities such as real estate investing.

PSP Capital initially targeted a $300-million sale of bonds that mature in 2013, with TD Securities as lead underwriter. The issue was bumped up to $400-million in the face of strong demand, and there is now $1-billion of this debt outstanding.

In awarding these bonds a top, triple-A rating on Tuesday, DBRS said “PSP is expected to have been notably impacted by the equity market downturn, like most of its peers.”

“Nevertheless, PSP continues to exhibit very strong credit fundamentals bolstered by its exclusive mandate to manage assets… as well as its large investment portfolio, solid cash flow outlook and a robust liquidity position” said the credit rating agency.

This access to bond funding means the public sector funds can continue to be active players in the capital markets, despite weak return in 2008. While PSP has not released its numbers from last year, it's logical to assume that the fund will post performance in line with the 15.3 per cent loss announced Monday at OMERS.
PSP Investment's fiscal year ends on March 31st, just like that of the Canada Pension Plan Investment Board (CPPIB). Barring some miracle in the stock market, they will post negative returns too and tapping the bond market is not a good sign.

I will end my comment on the Caisse's results with some thoughts on the hearings that will take place in Quebec. These should be public hearings that shed some light on the performance of each internal and external investment manager at the Caisse. If there were internal or external blow-ups, they should be publicly disclosed. Period.

As far as ABCP, I think several people should testify, including Henri-Paul Rousseau, Richard Guay, Gordon Fyfe, the President & CEO of PSP Investments and former President of World Markets at CDP. Last but not least, the politicians should invite Luc Verville, the vice-president with responsibility for money markets at the Caisse when the ABCP back box exploded.

They should ask Mr. Verville who was responsible for taking leveraged positions on ABCP and why for so long nobody asked him whether he was taking on too much risk relative to the T-bills benchmark that governed his activities. Who was overseeing his activities and why didn't they pull the plug earlier, before the credit crisis hit? Didn't they realize that taking leveraged positions in illiquid securities is flirting with disaster?

The answer is that as long as everybody was making money beating a bogus benchmark, everyone kept their mouths shut. Now that the music has stopped, they have some serious explaining to do.

I think it's time the public finds out exactly what happened at the Caisse. Once the truth is exposed, the new board should implement sound governance policies to make sure that this type of reckless risk-taking never occurs again (go back to read my entry on Clearing the Pensions Fog).

One thing is for sure, if the politicians and new board of directors handle this right, the Caisse will reemerge as a global financial powerhouse. If they bungle it up, the Caisse is doomed to repeat the same costly mistakes and Quebecers will be called upon to bolster the Quebec Pension Plan.

Note: Make sure you read the follow-up post, A Basket Caisse?

Tuesday, February 24, 2009

Coping With "Reverse Affluenza"?


In his first speech to a joint session of Congress, President Obama outlined an ambitious agenda to revive the economy, saying it's time to act boldly "to build a new foundation for lasting prosperity":

President Obama says the United States will overcome its current economic struggles.

Obama focused on the three priorities of the budget he will present to Congress later this week: energy, health care and education.

The president said he sees his budget as a "vision for America -- as a blueprint for our future," but not something that will solve every problem or address every issue.

Obama said his administration already has identified $2 trillion in government spending cuts that can be made over the next decade.

Obama said he would cut spending considered wasteful, and invest in programs that will help the economy recover.

The president touted the $787 billion stimulus plan he signed into law last week, saying it will invest in areas critical to the country's economic recovery.

The United States has "fallen behind" other countries when it comes to producing clean energy, he said, but thanks to the stimulus, he said the United States will double its supply of renewable energy in the next three years.

Obama asked Congress to send him legislation that places a market-based cap on carbon pollution and drives the production of more renewable energy in America.

He said to support that innovation, the country will invest $15 billion a year to develop new technologies.

Saying the United States can no longer afford to put health care reform on hold, Obama said his budget proposal will include a "historic commitment" to it.

Obama said he will be assembling representatives of business, labor, doctors and health care providers next week to begin discussing the reforms.

Obama also called for all Americans to commit to at least one year of higher education or career training.

"This can be community college or a four-year school; vocational training or an apprenticeship," he said.

"But whatever the training may be, every American will need to get more than a high school diploma."

He pointed to the billions for education -- from early childhood education expansion to college-loan programs -- in his recently approved economic stimulus package and set a goal of having the highest college graduation rate in the world by 2020.

Obama opened his speech by telling the nation "we will rebuild, we will recover, and the United States of America will emerge stronger than before."

Obama urged Americans to "confront boldly the challenges we face," saying that the answers to the country's problems "don't lie beyond our reach."

"They exist in our laboratories and our universities; in our fields and our factories; in the imaginations of our entrepreneurs and the pride of the hardest-working people on Earth," he said.

Obama described the nation's financial woes as a "reckoning" for poor decisions made by both government and individuals.

"A surplus became an excuse to transfer wealth to the wealthy instead of an opportunity to invest in our future," Obama said.

"Regulations were gutted for the sake of a quick profit at the expense of a healthy market.

"People bought homes they knew they couldn't afford from banks and lenders who pushed those bad loans anyway. And all the while, critical debates and difficult decisions were put off for some other time on some other day."

"Now is the time to act boldly and wisely to not only revive this economy, but to build a new foundation for lasting prosperity," Obama said.

Obama also sought to assure people that their money is safe in the banks.

"Your insurance is secure; and you can rely on the continued operation of our financial system. That is not the source of concern," he said.

Instead, the source of concern is that "if we do not re-start lending in this country, our recovery will be choked off before it even begins," he said.

Making sure the nation's lending industry is strong is crucial to jump-starting its economy, Obama said, even as he acknowledged anger over the government banking bailout Congress approved last year.

"I know how unpopular it is to be seen as helping banks right now, especially when everyone is suffering in part from their bad decisions. I promise you -- I get it," Obama said.

[Note: I am not sure he "gets it" because his Treasury Secretary is trying to kick-start securitization, the very process that got us into this mess! There is one guy in Washington who actually gets it.]

"But I also know that in a time of crisis, we cannot afford to govern out of anger, or yield to the politics of the moment."

He said he plans a new lending fund to provide college, auto and small-business loans and a housing plan that will help struggling families refinance and pay smaller mortgages. He said he wants to continue propping up the nation's largest banks when they're in danger, but will hold them accountable for how the money is spent.

"This time, CEOs won't be able to use taxpayer money to pad their paychecks or buy fancy drapes or disappear on a private jet," Obama said. "Those days are over."

Those days are over. Just ask investment bankers and hedge fund managers who have seen their riches dwindle as the global economic crisis has taken grip and are now turning to professional counselors to cope:

Mayfair-based investment consultancy Allenbridge, which offers a psychologist service for young people who inherit wealth, has instead found itself facing a growing demand for the service from struggling hedge fund managers and investment bankers.

Anthony Yadgaroff, chairman of the wealth management firm, told financial publishing group Citywire that "a couple of hedge fund managers have problems and we are expecting to see more come in".

"The last person we had in to the service was a hedge fund manager who was dealing with having had so much and losing it," Mr Yadgaroff said.

The development follows a disastrous year for the hedge fund sector, with the decimation in value of many funds prompting a flood of redemption notices, while thousands of investment banking positions have fallen victim to the global slowdown.

Citywire investment editor Charlie Parker said City bankers had been "the fastest growing group of wealthy people in Britain and now they are the fastest shrinking".

"Many were financing hugely expensive lifestyles through taking on large amounts of debt intended to get them through the year, in the hope that their bonus, when it came, would pay off the debt," Mr Parker said.

"As bonuses have collapsed they have been forced to radically reappraise their lifestyles and I would imagine it would require a pretty dramatic change in mindset."

Most clients of the Allenbridge service, which has been dubbed "Affluenza and Wealth" and is headed by Los Angeles-based psychologist Dr Ronit Lamit, are wealthy families. Mr Yadgaroff said a "Reverse Affluenza" service was emerging for bankers and hedge fund managers who lost their wealth or jobs.

Forgive me a minute as I digress. My father is a 77 year old psychiatrist who still works ten hours a day helping patients from all socioeconomic backgrounds suffering from serious mental illness.

I do not want to minimize nor ridicule the plight of these investment bankers and hedge fund managers, but take it from a 37 year old who has battled a serious illness for over a decade, there are more important things in life than money, fame and status.

Nobody has ever died from "Reverse Affluenza" and you will learn the beauty of keeping your life simple, never living beyond your means. In fact, a lot of people - not just investment bankers and hedge fund managers - need to get a grip and reevaluate their priorities in life. Bigger houses, bigger cars, big spending trips will invariably lead you to big headaches.

[Note: Take the time to carefully listen to CBC Radio's interview with Richard Florida on how the recession will reset the way we live.]

Now, getting back on topic, with the drumbeat for hedge fund regulation getting louder, from Berlin to Washington to Connecticut, the industry is going on the defensive:

Hedge funds are already “rigorously regulated” in Europe, the Alternative Investment Management Association said, a week after European leaders agreed on the need for additional oversight of the industry as part of a far-reaching set of proposals to change the global financial system. AIMA’s statement sought to downplay the need for additional regulation, and to combat the image of hedge funds as freewheeling and unsupervised.

“It is important to stress that hedge fund managers in Europe are currently rigorously regulated at both national and European levels,” Andrew Baker, CEO of AIMA, said. “The industry is also subject to a whole range of European directives. It is part of the solution, not part of the problem.”

Hedge funds are seeking to deflect the threat of tougher regulation:

“It is important to stress that hedge fund managers in Europe are currently rigorously regulated at both national and European levels,” Andrew Baker, the chief executive of the Alternative Investment Management Association (AIMA), said. “The industry is also subject to a whole range of European directives. It is part of the solution, not part of the problem.”

Hedge funds, already hurt as falling markets, dwindling lending and redemptions from their investors erode their profitability and drive many to close, have been fighting politicians to try to stave off regulation. Last month, some of the industry’s top luminaries, including TCI’s Chris Hohn and Paul Marshall, the co-founder of Marshall Wace, faced a grilling from British MPs over their role in the financial crisis.

The funds have historically made their money by looking around for niches to invest in, such as derivatives, where other financial institutions do not trade, and the fear is that excessive regulation could curb the industry’s strength, built on such flexibility.

The AIMA statement came as reg-ulators and central bankers across the developed world push for a global regulatory framework in the wake of the financial meltdown that has shaken the planet in the last year and a half. Hedge funds, credit rating agencies and all other important market players should be subject to this global approach, the European Central Bank’s president, Jean-Claude Trichet, said at a conference yesterday.

“The current crisis is a loud and clear call for extending regulation and oversight to all systemically important institutions – notably hedge funds and credit rating agencies – as well as all systemically important markets – in particular, the OTC [over the counter] derivatives market,” M. Trichet said. “What is currently under discussion is the precise way in which these elements should be integrated within an overall regulatory framework,” he said.

The UK’s Financial Service Authority has said it wants a global framework. Global regulatory reform tops the agenda for a summit of the Group of 20 rich and big emerging economies in London in April.

Antonio Borges, the chairman of the Hedge Funds Standards Board, a voluntary UK body, said hedge funds had behaved responsibly, proven their value with lower losses than elsewhere in the market and had a better understanding of risk than almost anybody. “We have to conclude the hedge fund model will remain quite powerful. It has very low leveraging,” Mr Borges said.

And they are open to disclosing more to regulators:

The leading trade body, whose members manage more than 75pc of hedge fund assets across 43 countries, proposed that hedge funds would disclose all significant trading positions to global regulators, including short positions.

AIMA also said it would support the supervision of managers based on a model proposed by the Financial Services Authority and a new regulatory code based on proposals from various international bodies.

On Monday, European Central Bank President Jean-Claude Trichet said the financial crisis was a loud and clear call for extending regulation to all systemically important institutions, notably hedge funds and credit rating agencies. But AIMA hopes its pre-emptive concessions will be enough to divert bank-like rules which it claims would damage funds' ability to make money.

AIMA chief executive Andrew Baker said: "We want to dispel once and for all this misconception that the hedge fund industry is opaque and uncooperative. That's why we are declaring our support for the principle of full transparency of systemically significant positions and risk exposures by hedge fund managers to their national regulators."

Let me qualify that statement by Mr. Borges. The very best hedge funds have behaved responsibly and do have a better understanding of risk, but the majority of hedge funds are mediocre funds that charge alpha fees for "disguised beta."

How do I know this? Because I use to allocate to hedge funds and I saw all sorts of hedge fund managers peddling their "investment skills" to get a big allocation. I can't blame them for trying - who wouldn't want to collect a 2% management fee and a 20% performance fee for delivering beta?

Among the worst offenders were Long-Short equity managers who were typically long small cap stocks and short large cap stocks. This is why small caps are expected to benefit the most when hedge funds put cash back to work.

The problem was that very few managers knew how to make money in down markets. They all talked a big game but very few delivered the merchandise when you needed it the most.

As for the equity market neutral and arbitrage funds, they took a lot of leverage (often in illiquid securities) to deliver their returns and when systemic risk hit, most of them got slaughtered.

The global credit crisis is also hitting private equity funds, which are now learning to play a different tune as default risk rises:

As Guy Hands can no doubt attest, the problems facing private equity have certain parallels with the music business.

Customers of the two industries have suddenly stopped paying for services that for years they happily stumped up cash to receive.

As the founder of the Terra Firma buy-out house and owner of the EMI music group, Mr Hands will be familiar with the issues.

In the music industry, a new generation of consumers are downloading songs from the internet for free rather than paying for CDs.

In private equity's case, cash-strapped investors (the industry's equivalent of customers) are finding themselves short of money to meet the commitments they have made to buy-out funds.

When a private equity group raises a fund, investors make binding commitments, promising to provide the money when the group finds deal opportunities.

However, because the flow of returns from private equity has slowed to a trickle and investors are nursing big losses across their portfolios, it is becoming harder for some to honour commitments.

Different private equity groups have already come up with various ways to deal with the fact that some of their investors risk defaulting on future commitments.

Permira was first to grasp the nettle, agreeing to return undrawn commitments to its investors who could struggle to meet them in return for financial penalties, shrinking its fund from €11.1bn (£9.9bn) to €9.6bn.

TPG Capital followed, offering to return 10 per cent of the $20bn fund it raised last year to investors after losing money on one of its first investments in Washington Mutual, a US savings and loan group.

More recently, Candover unveiled plans to hand back much of the €3bn it raised from investors for its latest buy-out fund.

Mr Hands has developed an unusual technique of his own.

The 49-year-old buy-out boss and karaoke fan approached all 170 investors in Terra Firma Capital Partners III, the €5.4bn fund he raised in 2007, to ask if they faced liquidity problems that could prevent them meeting future uncalled commitments.

He found at least three that said yes and were willing to discuss a highly unusual deal to sell their commitments back to Terra Firma's management company, which is tightly controlled by Mr Hands.

The Terra Firma boss offered the investors, or limited partners, relatively attractive terms compared with what they would have received from more stingy secondary investors, who operate in the murky market for second-hand private equity interests.

It is an advantage for Mr Hands to keep the investors from selling to a less reliable party, who may not contribute to future fundraisings or object to proposed deals.

It also means Mr Hands - already one of the four biggest investors in his own fund with €200m committed - has even more riding on his latest fund, which has half its capital still to invest. This should be a reassuring sign for remaining investors.

Terra Firma refused to say what price it paid to buy the three investors out of their €50m interests in its latest fund, which leaves Mr Hands and other top executives at the buy-out firm liable for their €25m of undrawn commitments.

But people familiar with the transaction said it was done at a significant discount to the carrying net asset value of the €25m already invested in deals, such as its €3.2bn buy-out of EMI, whose artists include Lily Allen, the Beastie Boys and Coldplay.

As Terra Firma's latest fund, which also includes the merged AWAS and Pegasus aircraft leasing business, has already written down the value of some investments, this means the three investors received small beer for their holdings.

The EMI deal accounts for 30 per cent of Terra Firma's last two funds. Concerns that Terra Firma overpaid for the music group at the top of the market and used too much debt in the deal have weighed on the price that its investors receive for their interests in the secondary market.

But those investors sticking by Mr Hands will be pleased to see he is still prepared to put his money where his mouth is.

The shakeout in hedge funds and private equity has spawned a new sale platform:

Cash-strapped investors have put more than $540m (€420m) of private equity and hedge fund stakes up for sale on a new platform launched Tuesday, aiming to draw out possible buyers for the otherwise illiquid holdings.

The platform introduced by newcomers SecondMarket is a bold move to break the log-jam in markets for second-hand private equity and hedge fund stakes, where prices have plunged to record lows as sellers have far outweighed buyers.

Hundreds of pension funds, endowments, banks, insurance companies, and wealthy individuals are looking to sell their private equity and hedge fund holdings to cover losses elsewhere in their investment portfolios.

SecondMarket, which describes itself as the world’s largest marketplace for illiquid assets, said its trading platform would trade limited partnership (LP) interests in private equity, venture capital, hedge funds, and funds of funds.

The move was greeted with scepticism by specialist secondary investors, who said the idea had been tried before and failed because of the need for strict confidentiality in selling LP interests and the heavy restrictions placed on selling the assets.

However, Barry Silbert, chief executive of SecondMarket, said that, since it started advertising plans to launch the new platform last month, more than $500m of LP interests had been listed for sale on the website. He said $40m of new LP interests were put up for sale only Tuesday. More than 150 of SecondMarket’s 2,000 pre-qualified participants have registered their interest in bidding for some of the LP interests.

“There is billions of dollars of this stuff coming up for sale,” said Mr Silbert. “But it is a bit of a Wild West at the moment in the way it gets sold. We aim to formalise it.”

More than $130bn of private equity interests are expected to be put up for sale in the next two years, according to the specialist secondary investor Paul Capital. But there is only about $30bn of capacity among specialist secondary buyers. Because of the supply-demand imbalance, sellers of private equity assets have been receiving less than 50 cents in the dollar of the face value of their assets, according to a recent report from Cogent Partners, a secondary markets adviser.

SecondMarket has already traded more than $1bn of assets since its launch in 2005, including restricted and illiquid blocks of public equities, auction rate securities, and bankruptcy claims, such as those pending against Lehman Brothers.

It remains to be seen whether this SecondMarket will provide investors with the liquidity they are looking for their illiquid fund stakes. I am skeptical but at least we can get a sense of where these funds are trading on the secondary market.

And finally, there is commercial real estate, the next crisis. According to the Moody's/REAL National All Property Type Aggregate Index, commercial property prices fell almost 15% in 2008 amid the credit storm:
The benchmark measures investment activity and property sales trends in U.S. commercial real estate. "The market has not seen this price level since 2005, erasing three years of gains," said Neal Elkin, president of Real Estate Analytics LLC
Commercial real estate is in deep trouble. All you have to do is look at the stock price of Office Depot (ODP), which is back to its historic lows.

[There is an idea for pension funds. Instead of buying some illiquid real estate fund, just buy Office Depot shares and sit on them waiting for the economy to recover. I would just wait because the Feds are probing Office Depot right now.]

All this spells trouble for pension funds where losses in alternative investments are shaking up pension thinking:

An increasing number of employees are getting concerned that their pension benefits are in jeopardy, in some cases because plan managers took on alternative investments that were too risky.

In the United States, many plans fell victim to Bernard Madoff's hedge fund, an apparent Ponzi scheme that lost $50 billion US for investors.

And in Canada we had the Caisse de Depot pension plan, expected to have lost $38 billion last year due in part to investment in ill-fated asset-backed commercial paper. That has prompted calls for a change in the risk models used by Canadian plans to channel investments.

"Perhaps the only positive aspect to come out of this is that it's really shone the spotlight on risk, and managing that risk within defined-benefit pension plans," said Brad Bondy of Aon Consulting, during a recent address to the Northern Alberta chapter of the Canadian Pension and Benefits Institute.

Defined-benefit plans invest contributions and define expected benefits, but the percentage in Canada not fully solvent or able to pay all maturing obligations has risen from 64% in 2007 to 94%.

Some people leaving defined-benefit plans are getting only 65% of the commuted value of their pensions, with hopes of the rest later.

The federal government announced in November a proposal to extend the time that federally funded plans have to return their solvency to health from five to 10 years.

"I believe this will improve things, and that over the longer term equities are going to generate some decent returns. But I don't know when," Bondy said in an interview afterwards.

But pension money managers are caught in the trap facing all investors -- how do you recoup losses when equities are volatile or preserve capital when bond rates are low?

"I think there is a lot of interest in liability-driven investing, which means holding more long-term bonds and less equities. I think people are hesitant to make that move now, because interest rates are so low.

"But I think one of the things we need going forward is a transition plan, without basically locking in the horrendous returns we've had in equities, but gradually transitioning to a lower-risk strategy going forward."

He had some intriguing charts comparing three portfolios -- one of 100 per cent cash in T-bills, one of the traditional pension mix of 40% bonds and 60% equities, and one of 100% equities.

As expected, over one-year periods dating back to 1934, cash was the least volatile and equities the most. However, when you go to 20 year periods during that same time-span, equities actually were the least volatile.

Furthermore, a goal of generating annual returns of four per cent plus inflation each year was achieved by the T-bill portfolio 20% of the time and by the bonds-stocks mix 70% of the time.

What happens, though, is that when the S&P/TSX composite index turns in double-digit returns four straight years as it did from 2003 through 2006, pension money managers feel some pressure to increase returns, and look at alternative investments. Those include things like hedge funds, currency, infrastructure, private equity and real estate.

But if deflation sets in, more alternative investments will lead to more misery for pension funds. And alternative investment managers will find it hard to cope with "Reverse Affluenza".

The alternative investment party is over and those who were "hooked on debt" will hurt the most. In the new era of deleveraging, deflation, transparency and regulation, the new paradigm will be "small is beautiful."