Wednesday, September 30, 2009

Have Global Financial Risks Subsided?


Chris Giles of the FT reports that the IMF warns on further institutional losses:

Banks around the world still have to reveal about half their likely losses resulting from the financial and economic crisis, the International Monetary Fund said on Wednesday, warning there was still a “significant” risk of another downward lurch in the global recession.

A failure to reveal the true scale of the losses they are likely to face and boost capital held in the banks would undermine the economies of the US, the UK and the eurozone and could generate a renewed vicious spiral where weak banks damage economic prospects, raising default rates and further threatening the health of banks, the IMF said.

José Viñals, the Fund’s head of monetary and capital markets, said: “In order to provide the credit that the economic recovery will need, you need to have some muscle as a bank – that means having, among other things, sufficient capital.

“Banks need more capital – they need more capital in Europe; they need more capital in the US; they need more capital in other parts of the world in order to have enough strength to provide more lending.”

But the IMF reduced its estimate of the ultimate losses in the financial system in 2007-10 to $3,400bn (€2,300bn, £2,100bn) from $4,000bn in its twice-yearly Global Financial Stability Report .

Within banks, the Fund estimates that losses will total $2,800bn, of which they have so far recognised only $1,300bn. “US domiciled banks have recognised about 60 per cent of anticipated writedowns, while euro area and UK domiciled banks have recognised about 40 per cent,” the report said.

Losses are likely to prove largest in the US and UK – where banks held more toxic assets and the downturn in commercial property has been greatest – but US banks have been quicker to recognise them than those in the eurozone or UK. The Fund said delays in recognising losses generally related to a failure to make provisions for bad loans on banks’ books.

Mr Viñals urged banks not to squander the chance to preserve capital in banks by retaining profits and avoiding large dividends as well as raising fresh capital from markets.

He said such restraint was especially important this year as banks’ profits had been boosted by exceptionally low funding costs. “If in future you are going to have more capital and better capital, it is important that you start preparing for it now – so conserve capital and keep it inside the bank.”

To get to a healthy level of capital – seen by many as tangible common equity representing 4 per cent of total assets – the Fund estimates that US banks would have to raise $130bn in additional capital, eurozone banks $310bn and UK banks $120bn. Although the additional capital-raising in Europe’s banks appears greater than in the US, the sums reflect the fact that Europe does more business through its banks and the sector is much bigger than in the US.

As a proportion of total assets, the necessary capital-raising is similar in all three areas, with the greatest need for new capital evident in Scandinavian economies. The improvement in the prediction of likely losses reflects growing confidence in financial markets and higher assets prices, which have reduced mark-to-market losses on banks’ books, and an improved outlook, with lowered estimates of credit losses.

Capital would be drained by future losses, but the emergency measures implemented so far meant that “banks in all regions have achieved a degree of stability in their capital positions”.

Although banks have been profitable this year as their borrowing costs have fallen with exceptionally low interest rates and the rates charged on lending have remained higher, the IMF warned that this happy position for banks might not last. “In the medium term, banks are likely to suffer reduced margins from paying more for deposits and incur higher interest costs,” it said, so greater capital-raising measures were still necessary.

But the capital-raising exercises by banks and recapitalisation by government already undertaken have made banks more resilient to the losses they are likely to incur, the IMF added. Capital will be drained by future losses, but the emergency measures implemented so far meant that “banks in all regions have achieved a degree of stability in their capital positions”.

Massive public deficits also complicated the financial stability picture, the IMF warned. They implied that total borrowing needs in certain countries, particularly the US and UK, will exacerbate the difficulties in raising finance for the private sector, and imply the need to raise finance from abroad, potentially undermining the dollar and sterling, or raising long-term market interest rates.

“In terms of regional vulnerability, the UK appears most susceptible to credit constraints … given its significant reliance on the banking channel and the projected sharp decline in domestic bank balance sheets, as well as substantial public financing needs,” said the IMF.

[Note: The FT link has an interesting interview with Greenspan and Strauss-Kahn.]

Let me just say that the IMF's Global Financial Stability Report is an excellent document that every serious money manager needs to read carefully. It provides an outstanding overview of global financial system.

I went through it today and concluded that global financial risks have subsided but banks are by no means out of the woods. The semiannual report struck me as one of cautious optimism.

Tomorrow, the IMF will raise its forecast for 2010 global growth to about 3 percent from 2.5 percent, said Murilo Portugal, the fund's deputy managing director.

But any recovery in the global economy will be tepid and while the risks to the global financial system have subsided, banks still confront substantial challenges.

The report suggests that although their balance sheets have been stabilized, some of it because governments have injected capital, banks are not yet in a strong position to lend support to the economic recovery. A "financing gap" could arise—that is, projected credit capacity will be insufficient relative to the demands of sovereign borrowers and the private nonfinancial sector.

According to the IMF, such a situation constitutes a downside risk to the recovery and the report suggests that continued policy intervention may be needed to keep credit flowing.

***UPDATE: IMF Raises 2010 Growth Forecast***

The IMF says the global recovery is underway. Bloomberg reports that Asia leads the recovery:

The Washington-based IMF said the economy will expand 3.1 percent in 2010, more than a July forecast of 2.5 percent. China’s economy will grow 9 percent and India’s 6.4 percent. That compares with growth of 1.7 percent in Japan, 1.5 percent in the U.S. and 0.3 percent in the euro region.

You can track the IMF's World Economic Outlook updates by clicking here. Kevin Carmichael of the Globe & Mail reports that IMF predicts Canada to outpace rest of G7.

Tuesday, September 29, 2009

Are Hedge Funds Worth It?


Gregory Zuckerman of the WSJ writes that Pessimism Exacts Price on Skeptics:

Hedge-fund manager Peter Thiel is suffering, not because he lost money in the downturn, but because he missed the rebound.

Mr. Thiel, a billionaire co-founder of online payment company PayPal and an early investor in Facebook, thinks the economy is far from recovered and has bet with the bears amid the relentless rally. His fund has seen double-digit declines as other hedge funds have racked up gains.

"The recovery is not real," he says. "Deep structural problems haven't been solved and it's unclear how we will create jobs and get the economy growing again -- that's long been my thesis and it still is."

The contrarian view puts Mr. Thiel among a group of investors with impressive track records who are holding out, unwilling to buy into the notion of the economy's rebound.

In London, the largest fund of John Horseman's $4 billion hedge-fund firm is down 20% this year; "it is hard to build longer-term confidence when employment prospects and job markets are shrinking," he said in a client letter.

In New York, a large hedge fund run by investing power Renaissance Technologies dropped almost 12% through August by wagering on stocks with promising earnings prospects and betting against those seen as flimsier. And in Chicago, Benjamin Bornstein's smaller Prospero Capital Management lost almost 5% through the second quarter, but he is still shorting the market.

Heavy job losses, weak revenue growth for most companies, full stock-price valuations and an inability of the economy to grow without help from the government are all reasons Mr. Bornstein remains wary of stocks.

"I have rarely been so convinced that the next broader market move is down," says Mr. Bornstein, who avoided most of the market's troubles last year. "The problem is that governments do not create income or wealth, and current stimulus equates to a future tax liability. That will become a major concern in mid-2010 when the stimulus is done."

Mr. Thiel's Clarium Capital Management, which at one point last year had $6 billion in assets, has seen losses of nearly 16% through mid-September, compared with a 14% rise for hedge funds broadly through August, according to Hedge Fund Research Inc. Clarium now manages about $2 billion. In 2008, Clarium lost 4%, even as the Standard & Poor's 500-stock index fell 38%, and the firm has recorded annual gains averaging 22% since inception in 2002, according to investors. Last year, the fund was sitting on gains of more than 40% before the collapse of energy prices caught Mr. Thiel by surprise, making Mr. Thiel's contrarian stance in the face of losses seem more gutsy.

For the skeptics, the stakes are high. The hedge-fund business had its worst year on record last year; another year of disappointing performance could be the death knell for many funds that struggled last year.

Mr. Thiel wouldn't seem like an obvious poster boy for the market's worrywarts. A 41-year-old former nationally ranked scholastic chess player and graduate of Stanford Law School, he was chief executive officer of online-pay service PayPal earlier this decade and scored big in 2002 when eBay Inc. bought the company for $1.5 billion. Mr. Thiel added to his venture-capital successes with early investments in firms like Facebook and Palantir Technologies, a high-tech firm that hunts for terrorists.

In 2002 he launched Clarium and scored impressive gains for several years, largely by buying up energy investments on the view that growing global demand and more limited supplies would boost oil prices.

For much of this year, Mr. Thiel's firm placed a series of bets against the market, in part because valuations on a range of global equity markets have looked rich, he says. As markets have climbed higher, he has been forced to scramble to trim the positions, to avoid deeper losses.

He has bet on the Japanese yen, purchased safe bonds, wagered on the dollar, all in the belief fear will return to the markets. He has taken other conservative steps because "a real, sustainable recovery is not possible without productivity growth."

"The U.S. and much of the developed world are not very competitive globally -- that would require difficult improvements in technology that I'm not seeing enough of," he says.

The most exciting technologies being developed, including robotics, rockets, artificial intelligence and the next wave of biotechnology, are several years down the road, Mr. Thiel argues.

Mr. Thiel says he is sensitive to a challenge to pessimistic investors who prospered during the tough period of the past two years -- becoming overly negative. Some of his investors ask Mr. Thiel if he could lose serious money in the short term, he says, even if he is right over the long haul. He is sticking to his stance.

"The government has helped stabilize the banking system, but I'm not sure we have a path toward sustainable growth," partly because consumers are dealing with debt and other issues, even as an energy crisis looms, he says. "It always feels unpatriotic to be negative. But too few people are focused on the real problems."

While I respect the arguments put forth by Mr. Thiel and Mr. Bornstein, they risk getting crushed in the next market melt-up. What's that? Market melt-up? Huh? The MSCI Global Index is up 66% since March lows and as I write this comment, Australian and Japanese stock futures fell after prices for oil and U.S. equities retreated ahead of a U.S. employment report.

I have a feeling that the U.S. employment report will surprise to the upside (it could even be a monster report with upward revisions to the previous report) and the Dow will smash through the psychologically important 10,000 level in the days that follow. Remember, there is a lot of performance anxiety out there and all the "experts" are predicting a major market pullback in October. These experts are typically wrong.

The fact is the U.S. economy is slowly turning the corner. Yes, consumer confidence unexpectedly fell today, but confidence is fickle and driven mainly by gloomy job prospects. As the labor market slowly recovers, confidence will recover too. Moreover, even though U.S. durable goods orders dropped in August, it was mainly due to nondefense and defense aircraft orders. There were gains in primary metals, fabricated metals, machinery and communications equipment, all of which point to a cyclical recovery. When investment picks up, employment gains usually follow.

Now, back to hedge funds. A lot of them are hurting but most are doing well because they're riding the Beta Express up while charging alpha fees to their investors. Bloomberg reports that Geneva’s funds of hedge funds saw client inflows for the first time in 11 months in August, halting a slump that accelerated after losses related to Bernard Madoff’s Ponzi scheme.

Then you got China's $200 billion sovereign fund - China Investment Corp (CIC) - that just plopped a cool $200 million into Capula Investment Management and is set to pour a total of $2 billion into three U.S. distressed asset-focused funds, including one managed by Goldman Sachs.

[Note to CIC: Be very careful about how you deploy those billions. If I were you, I'd talk to Ron Mock at Ontario Teachers' Pension Plan (OTPP) and Leo de Bever at Alberta's Investment Management Corporation (AIMCo). They're two of the sharpest guys in Canada's pension fund industry and well worth speaking to.]

Finally, reporting for OnWallStreet, Elizabeth Wine asks Hedge Funds: Are They Worth It?:

Hedge funds, those opaque alternative investments designed to post positive returns regardless of how the overall market performs, created headlines for falling into the red alongside traditional investments in last year's brutal crash. The fall from grace was so sharp that many smaller funds have shuttered, and observers expect more to follow.

Not surprisingly, investors headed for the exits. Some analysts and financial advisors now say that hedge funds overcharge for the service they deliver. They say that last year's mauling showed that this emperor had no clothes.

Still, some investors are considering going back to the surviving funds. Strategists in the wirehouses and elsewhere say hedge funds were wrongly maligned, and that the good funds can still serve the purpose of diversifying a portfolio and reducing risk. Better still, they say hedge funds are positioned to do well in the coming months and years.

Indeed, a few hardy souls are dipping their toes back in the alternative waters. The combined intake of $41.4 billion for May, June and July was the first net inflow for a three-month period since December 2007, according to HedgeFund.net. This fresh cash comes after a drop of 37% from the peak of $2.94 trillion in April 2008.

Despite the recent inflows, the amounts are small enough that some analysts are loath to call it a trend. "Investors are taking a wait-and-see attitude; they are going to wait to see what happens to the money they put in," said Peter Laurelli, head of hedge fund industry research at Channel Capital Group, which runs HedgeFund.net. "Once you go through a difficult situation it's tough to come back with the same intensity," he said. He expects August to post another modest inflow.

It's easy to see the new allure of the funds. HedgeFund.net's aggregate index for all the strategies it tracks shows an increase of 12% for the year through July. The benchmark dropped 15.8% last year.

Many in the industry warn against trying to glean too much from one overall performance statistic because these funds track various investment strategies that are designed to perform differently in different scenarios. (One old saw has it that hedge funds are a billing class rather than an asset class, referring to the 2% management fees and 20% performance fees that most have in common.)

But a deeper look into HedgeFund.net's overall numbers shows that nearly every strategy practiced by the 7,100 funds and funds-of-funds in its database gained ground. Thanks to the rally in equities and commodities, the only losing strategy is practiced by short-based funds, which saw its index drop 12.4% through the end of July. The best performing index so far this year tracks the funds investing is India, which notched gains of 34.7%.

ABSOLUTE RETURNS

The increase in performance this year is a welcome change for investors, but why was last year so bad? Hedge funds certainly did better than the broader market, but whatever happened to the notion that these investments were supposed to be "absolute return vehicles?"

Nadia Papagiannis, hedge fund analyst at Morningstar put it most succinctly: "It's a fallacy. No such strategy makes money in every single market. Theoretically, it's possible... if you can hedge out all market risk in your portfolio and always have positive alpha, then you can have an absolute return strategy," she says. "It's a good theory, but it doesn't work in practice. I've never seen a manager who always profits from stock picking and market timing. And a lot of funds that say their strategy is absolute return aren't [portraying it accurately] because a lot of strategies work well in some environments and not in others. To say that's absolute return is lying," Papagiannis says.

This issue was the subject of a January research report, "Why My 'Absolute Return' Hedge Fund Lost Money 'Absolutely' in 2008" by Gregory Dowling of the Fund Evaluation Group, a consultancy catering to institutional clients.

[Note: Also read 7 questions for Greg Dowling.]

He pointed out that hedge funds did their job of returning absolutely in the bear market of March 2000 to March 2003. They protected capital and managed to profit as well. And investors expected them to do it again in the next downturn.

But the funds didn't deliver on that expectation, and his report explained what went wrong, cataloguing the firestorm of problems hedge funds encountered last year: an uncertain regulatory environment, deleveraging and an over reliance on the investment banking system. "Given the higher fees and lower transparency, many investors are questioning the hedge fund model and its place within a portfolio," he wrote.

Nonetheless, he concluded that the hedge funds that survived the shakeout were positioned to do well in the future. Summing up what has become a widely held opinion in the industry, he wrote that fewer hedge funds, and less trading by investment banks, means less money chasing the same trades. And that means more profit for the survivors. Moreover, since most of the funds got rid of their extra leverage and appear to have kept it off, they won't run the risks they used to.

Indeed, Dowling agreed with alternatives experts at Merrill Lynch, Wells Fargo, UBS and Raymond James, writing that hedge funds provide value despite their hefty price tags.

Now, heading into the fourth quarter, his colleague Susan Mahan Fasig, director of alternative investments at Fund Evaluation Group, reiterates that early assessment. "It's a great time to be in strategies like long/short equity because things are starting to turn on fundamentals, rather than broad market factors like liquidity risk," she says. "And because the volatility in the market is good for anybody running a hedge fund, exposure to volatility gives you the opportunity for return." She notes that volatility doesn't usually come into play with long-only equity strategies, like those used by the vast majority of equity mutual funds. Fasig also notes that there is opportunity for hedge funds that take advantage of mispricing. The markets are littered with "displaced securities," stocks dumped during the meltdown at fire sale prices by banks and hedge funds racing to lower their leverage or meet redemption requests.

THE ADVOCATES

Experts in the wirehouses take to heart the numbers that show recent hedge fund inflows. David Bailin, president of alternative investment asset management at Merrill Lynch Wealth Management says, "We think the bottom of the hedge fund market has been reached," noting that net redemptions had stopped by mid-May. He says that Merrill's research backs up the notion that many of the funds are seeing cash inflows.

He also says that hedge funds are more institutional than many critics have charged. Last year, commentators projected that about one-third of hedge funds would go out of business. He countered that by saying of the top 100 managers, the actual casualties are only about 5% and he believes fewer than 10% will close by the end of 2010.

Further, he vigorously defends hedge funds' performance in last year's meltdown. "It's a misnomer that they weren't good." He did a back-of-the-envelope calculation and concluded that once leverage is taken out of the equation, hedge funds had a "pre-leverage loss" of only 6.1%, compared with a plunge of 36% for the S&P 500.

And what about the idea of absolute returns? "I think that's an education misnomer," Bailin says. "If I had to criticize our industry, it's that we allowed that phrase to be discussed. Hedge funds are a risk-taking enterprise like any other risk-taking strategy, and the idea that we would not suffer losses in a year like 2008 or in a normal bad year is a mistake. As an industry we need to change that perception of absolute return. That's not the purpose of investing in hedge funds. The purpose is diversification and obtaining sources of profit and risk from different sources in the market."

The Fund Evaluation Group agrees, saying in the January report: "What will change is the very way hedge funds market themselves and the use of terms such as 'absolute' returns. Hedge funds are not magic, but merely unconstrained active management."

Regardless of how hedge funds sold themselves, alternatives experts say that it's the job of advisors to make sure clients understand that there's really no such thing as absolute return all the time. Overcoming the myth surrounding hedge fund managers' market-defying skill comes back to a fundamental part of the advisor's job-regardless of the type of investment. "It's all about setting realistic expectations for the client," says Tim Froehlich, director of Alternative Investments at Wells Fargo Advisors. "What 2008 did was show you that what could happen, would happen," he says.

Froehlich's overall recommendation to clients-using a diversified portfolio of hedge fund strategies-has not changed since the crisis. He says what's new isn't really new at all: a strong reiteration of the importance of setting client expectations early.

Education in the beginning is critical, says Chris Butler, a vice president in Raymond James' alternative assets group. "We work with advisors and clients on what we expect of a fund." That includes fees and liquidity, or the lack thereof, whether redemptions are only allowed quarterly, or even annually. "It's critical that the client understands how the manager is creating value, and the risk that goes along with creating that value," he adds.

Others have noticed the same educational need. September saw the launch of website getalts.com, from investment management firm Rydex/SGI, to help teach investors about alternatives and how they can help a portfolio.

There is one piece of information Butler says clients are asking for now, often before the advisor can bring it up: the due diligence on the managers. In the wake of the collapse of the $65 billion Ponzi scheme run by disgraced financier Bernard Madoff, clients are realizing the importance of having someone vet a manager, and working with an advisor in assessing a particular strategy or manager.

The other form of due diligence is a fund-of-funds, in which a manager creates a portfolio of hedge fund managers. They relatively well last year, Froehlich says. The criticism that they're too expensive-adding an extra layer of fees, usually 1% to 1.5% atop the hedge funds' already high costs-is misguided, he says. "The funds- of-funds proved their worth last year by exiting some of the funds you saw in the paper [for poor performance]. They justified their fees with their expertise."

THE NAYSAYERS

Even in the good days, high fees were a big problem with hedge funds. But those may decline now thanks to pressure from investors disgruntled at the losses from last year, says Fasig of Fund Evaluation Group.

But it may be too little too late to sway others. Morningstar's Papagiannis says that for advisors, the best bet is to use mutual funds that follow the same strategies as hedge funds, minus the high performance fees. Plus, because mutual funds are more closely regulated, they can't use the same amount of leverage or hold as many illiquid assets, making their portfolios less risky. She acknowledges that hedge funds are good diversifiers, especially those using strategies with low correlations to stock and bond markets. But even some of those strategies, including arbitrage and market neutral, can be replicated by mutual funds. Some mutual funds she likes include The Arbitrage Fund, which is up 6.4% through the end of July, and shed just 0.63% last year. That compares to the merger arbitrage hedge fund category, which fell 4.34% last year.

She also likes the Highbridge Statistical Market Neutral Fund, which rose 9.79% last year, compared with a loss of 4.67% for its hedge fund peer group, Morningstar's equity arbitrage hedge fund category. (She said that not many mutual funds use this strategy, so there are not enough funds to have an appropriate peer group comparison.)

Although she generally disapproves of funds-of-funds because of the extra layer of fees, she does like a new entry to the mutual fund-of-funds arena: Aston/Lake Partners LASSO Alternative. The portfolio of alternative hedge-like mutual funds opened as a mutual fund recently, but has an institutional track record dating to 1998. The expense ratio is high for mutual funds, 2.58%, but that covers all the underlying funds, and the fund does not carry performance fees. Since it opened in May until the end of July, it gained 6.4%. Over the same time period, Morningstar's fund-of-funds category gained 7.5%.

But not everyone thinks mutual funds automatically win the argument on price alone. Bailin of Merrill notes that the track records of some of the hedge fund imitators are short. "It'll be interesting to see how those strategies do in 2009 and 2010 versus the top half of hedge funds." He adds that hedge fund managers' storied compensation puts them more in line with investors' interests than their cheaper mutual fund counterparts. "Hedge funds pay a manager when they make profits and pay them to avoid sustained losses, but that doesn't mean the returns they generate will always be positive."

Still, those losses mean at least one good thing for beleaguered investors who still have money invested with a hedge fund. Managers won't be pocketing the 20% performance fees for some time. The fees are charged once the manager has hit a certain benchmark-albeit a sometimes fairly low bar, such as Treasuries. But the practice is not allowed after losses until the manager has made back an investor's money from its so-called "high-water mark."

Papagiannis calculated that in the maximum drawdown from peak to trough, investors lost 25.2% between the beginning of November 2007 and the end of February 2009. Between March and July, the hedge funds in Morningstar's database gained 14%, so one might think investors only have 11% to go to get back to square one. But really they have 17% to go to break even.

Funds-of-funds have an even bigger hurdle to make investors whole again. They lost 24.7% in the same period, and between March and July climbed 9%, leaving a gain of 21.7% to go before investors get back to their original investment. That's before the funds can charge a performance fee again.

Still, critics say some of the shuttering hedge funds with an even worse sin than failure: gamesmanship.

They suggest that some of the fund managers are simply closing down temporarily so they do not have to spend months, if not years, working to regain investors' money without being able to charge that 20% performance fee. If they open a new fund later, they can charge 20% performance fees again as soon as that first benchmark is surpassed.

Dominick Vetrano, a certified financial planner and a certified public accountant with Clune & Associates in Chicago, says, "They closed down because they can get rid of the high-water mark. Then wait a while-a year or two until memory fades-hide for a bit, then come back out and say, 'We have a new strategy.' I'll say I have a proprietary model nobody understands, and I could be doing the same thing. The market goes up, and I get carried up with the rest of the market and I make 20%. It's a beautiful thing. They say they don't get paid unless they're making you money, and that's true-unless they close the fund and start over. Nobody thinks about that."

Vetrano has heard many sales pitches from hedge funds to his clients, who have an average net worth of $3 million to $4 million, and generally declines. He'll occasionally recommend a managed futures strategy—one he notes has been around for 40 years—for diversification and low correlation to other assets. But only to substantially wealthy clients who will not need the liquidity. In any case, his clientele has almost no appetite for hedge funds these days. "Since the crash and Madoff, people only want things that are public. Anything fairly convoluted, people back away—even private structured notes. Anything illiquid is really hard to present to anybody now. Before they would entertain it," he says. "I don't see that at all now."

The big change in his clients from before the crash is they've lost their snobbery, Vetrano says. Many wanted entire portfolios of hedge fund managers—up to 70% in alternatives, "because anything else they saw as stupid, for the masses," he says. "They wanted to be better than that. It was like going to a nightclub or a special restaurant that was invitation only. Did they understand it? No, they thought it was a privileged investment, and that they'd get better performance. Not that zero correlation stuff that you hear from advisors, or adding alpha. None of that stuff was thought of."

If the fund flows are indicative, they're thinking hard about it now.

They'd better be thinking hard about it, because take from it from someone who has conducted many due diligence exercises and invested with some of the best hedge funds in the world, these 'absolute return' funds are no panacea. And in many cases, they are pure con artists peddling snake oil.

I am glad the SEC is finally moving to beef up reporting from U.S. hedge funds, but I fear that this won't be enough. As I stated before, I prefer liquid hedge fund strategies in managed accounts, which allows investors to pull the plug if they feel a manager is severely underperforming.

But I warn all of you, liquid risk strategies are highly correlated, so don't be fooled into thinking that just because you have liquidity and transparency, you are not at risk of a severe downturn. In these markets, things can go awfully wrong very quickly. Always be prepared for the unexpected.

Monday, September 28, 2009

Banker-Bashing or Plain Old Common Sense?


David Stringer of the Associated press reports that U.K. to scrap annual bonuses for bankers:

British Treasury chief Alistair Darling said Monday that automatic annual bonuses for banking executives will be outlawed in an attempt to curb excessive risk taking in the country's huge financial sector.

Mr. Darling told the governing Labour Party's annual conference that new legislation to scrap the payments will be put to Parliament within weeks.

Leaders of the G20 rich and developing countries agreed last week to limit executive bonuses, but didn't set specific caps. Mr. Darling said bankers in Britain will in future be offered bonuses for their performance over several years, rather than over 12 months.

“We won't allow greed and recklessness to ever again endanger the whole global economy and the lives of millions of people,” Mr. Darling said.

He told the rally that new laws would include a claw-back provision and help to “end the reckless culture that puts short term profits over long term success.”

“It will mean an immediate end to automatic bank bonuses year after year, it will mean an end to immediate payouts for top management,” Mr. Darling said.

The plans, to be included in a new Business and Financial Services Bill, will be proposed formally in the Queen's Speech in December, the annual announcement of the government's legislative program.

Mr. Darling told the rally that Britain's economy has not yet recovered from the financial crisis but predicted the U.K. is likely to come out of recession by the end of the year.

“Germany, France and Japan are showing signs of growth. There are many independent forecasters now believing too that the U.K. is coming out of recession,” he said. “I think it is too early to say so with total confidence.”

Prime Minister Gordon Brown's Labour Party trails badly in opinion polls ahead of a national election that must be called by next June.

Mr. Brown said Sunday that his party could recover if the economy rallies and the public give him credit for averting a worse financial crisis.

“When the history of this period is written, this country and this party will be proud. Proud that the people who led the way in stopping recession turning into global depression were our government and our Prime Minister Gordon Brown,” Mr. Darling told delegates.

In recent weeks Mr. Brown has acknowledged that the government will need to cut public spending to reduce mounting government debts – but insists his Labour Party would protect key services.

Mr. Darling said the main opposition Conservative Party – which is widely tipped to win Britain's next election – would put the country's economic recovery at risk by making fast and sweeping cuts to spending.

“If we followed the Tory route now, recovery would be put at risk, prospects for growth damaged, borrowing would in the long run be greater. We cannot and must not let that happen,” Mr. Darling said.

Bloomberg reports that according to some analysts, Darling’s Bonus Call Is ‘Banker-Bashing’ Politics:
Chancellor of the Exchequer Alistair Darling’s call for greater regulation of British bankers’ bonuses amounts to “banker-bashing” and “pandering” to appease popular sentiment, according to London-based analysts and head-hunters.

Darling announced an end to “automatic” bonuses and pledged legislation to punish banks’ risky pay policies through higher capital requirements in a speech to the governing Labour party’s annual party conference today. Two months ago, Prime Minister Gordon Brown announced plans to hold back half of all bonuses for up to five years.

“This is a government on the cusp of losing the next election, and if banker-bashing is going to be popular they’ll do it,” said Simon Maughan, a banking analyst at MF Global Securities in London. “This is a classic case of knee-jerk political reaction to a crisis.”

Britain’s government is looking for ways to limit banker pay and acknowledge public anger as it attacks the practices it blames for causing the worst recession since World War II. With an election due by June at the latest, Labour’s percentage support is the same as the Liberal Democrats, Britain’s third- biggest party, and 15 points behind the Conservative opposition, a ComRes Ltd. poll today shows.

Darling will meet directors of Britain’s four biggest banks this week, asking them to change the way they compensate staff, his office said. That follows a Group of 20 agreement in Pittsburgh Sept. 26 to ensure banks restrain pay. Banks were told to avoid “multi-year guaranteed bonuses” and that a “significant portion of variable compensation” must be deferred, paid in stock, tied to performance and subjected to possible clawbacks.

‘Reckless Culture’

“Let me assure the country and warn the banks that there will be no return to the business as usual,” Darling told Labour party delegates in Brighton, southeastern England. “We will introduce legislation to end the reckless culture that puts short-term profits over long-term success.”

Any legislation to limit bankers’ bonuses needs to be mirrored by G-20 governments, or banks’ top performers may move abroad, according to Shaun Springer, chief executive officer of Square Mile Services Ltd., a London-based remuneration-advisory firm that provides services to 15 of the largest financial institutions in the City of London.

“There needs to be joined-up thinking and not just pandering to satisfy delegates at the Labour party conference,” Springer said. “We need to be thinking about the City’s financial evolution over the next decade, not Labour’s political convolutions over the coming months.”

‘Revolving Door’

“If these proposals are introduced I see a revolving door with people jumping to get out,” Howard Wheeldon, senior strategist at BGC Partners LP in London, said of Darling’s plans. “Do these guys not understand that this is a hugely competitive market and whatever we do to tighten the remuneration will only be to the benefit of our competition? Do they want any national income?”

Royal Bank of Scotland Group Plc, Britain’s biggest government-owned bank, declined to comment on Darling’s speech. Barclays Plc, Lloyds Banking Group Plc and HSBC Holdings Plc were unable to offer immediate comment.

Should Britain get ready for a mass exodus of bankers who are pissed at these new measures to curb their bonuses? Oh please, where are they going to go? Wall Street? They're next in the line of fire.

Bankers have had it good for far too many years, but politicians are ruthless and when it comes to votes, they'll screw the bankers in a second, even if they're feeding them. Is this really banker-bashing and shameless pandering to the masses or is it about time that governments start curbing reckless greed driven by the myopic focus on short-term profits?

Sure, Mr. Darling won't be the "darling" of London's financial elite, but his measures are hardly punitive. In particular, what is wrong with tying bonuses to the long-term health of a bank and paying bonuses over years, so they can be clawed back if not warranted by long-term performance?

After the financial calamity of 2008, that's the least they can do in terms of regulating banks. The next step is to get the same type of regulations to govern the bonuses at Canadian public pension funds, making sure that bonuses are based on risk-adjusted returns and subject to clawbacks if long-term performance falls short of expectations.

***UPDATE: A Banker's Comment***

A banker shared these thoughts with me:

Actually, bankers are leaving, and top graduates are going elsewhere! We have seen a surprisingly large number of mid level managing directors leaving the profession to do something else. Nothing wrong with that, in fact it may be healthy, but bankers have options, they may choose a less stressful life in other sectors, and they are making those choices. One friend recently commented, its cheaper than a divorce! Several I know have gone to academia; there is an aging "Professor" problem in most OECD universities. People have options; sure they will not make gazillions. But
they will not have to work 100 hours a week.

Are bankers finally getting the meaning of enough?

Sunday, September 27, 2009

Does Asset Allocation Still Work?


Richard Bookstaber, author of A Demon of Our Own Design, recently wrote an excellent piece in Seeking Alpha, Why I'm Skeptical About Asset Allocation:

I appeared last Friday on a the PBS program WealthTrack, where the topic was asset allocation, in particular, as host Consuelo Mack put it, how to build an all weather portfolio. I was the skeptic of the group. I don’t think there is some magic asset allocation that protects you from the buffetings of financial storms without it also trimming your sails during fair weather. Here is an encapsulation of my views from the program.

Asset allocation and risk appetite

One of the participants, asset allocation guru David Darst of Morgan Stanley (MS), proposed various portfolios to protect against a 100-year flood, 30 to 70-year flood, a 25-year flood, etc. Those portfolios boiled down to putting less in risky assets and more in bonds; the more severe the flood you anticipate, the less risk you take. Of course, that will do the trick. If by asset allocation you mean determining where to set your risk tolerance dial, we’re all on board.

Asset allocation is like clapping with one hand

But the discussion of risk tolerance highlights that we can only go so far with asset allocation if we only look at assets. What matters is assets versus liabilities, because the liabilities determine our risk tolerance and, related to that, our demand for liquidity. It is impossible to formulate an ideal asset allocation strategy without knowing the liability stream those assets are intended to meet. There is no one-size-fits-all for asset allocation. This reminds me of an FAJ article I did back in the 1980s with pension actuary Jeremy Gold entitled “In Search of the Liability Asset”.

Diversification works well, except when it really matters

We all know the argument from Finance 101: If you hold 16 uncorrelated assets, your risk will drop by a factor of four. Well good luck with that.

During a crisis, when diversification really matters, correlations aren't near zero (as if they ever are). All that people care about is risk and liquidity. All assets that are highly risky drop, all assets that are less liquid drop. No one cares about the subtlety of earnings streams. It is like high energy physics. When the heat gets turned up high enough, matter is just matter, the distinctions between the elements is blurred away.


This is not to say that one should not try to diversify, but rather that one should not think diversification will work magic. It is a given that a portfolio should not be limited to U.S. Treasuries and S&P 500 stocks, because while it should not be oversold, diversification does have some benefit. And, on the other side, unless someone is still living in the 1970’s, it borders on the intellectually dishonest to trumpet a diversified portfolio by using the S&P 500 as the bogey.


A college kid can construct a portfolio that will beat the S&P 500 on a risk-adjusted basis, because there are so many more markets available now. A better approach is to look at a given asset allocation versus its nearby well-diversified neighbors, and try to understand why one is better than the other.


Commodities do not form an asset class

This sounds heretical given what we have seen oil and gold do recently, but a lot of the reason that has happened is precisely because people are treating them as an asset class when they are not.


Commodities are not assets. They are factors of production. They do not generate returns, they have no claim on production. They have supply that flows out at a nearly fixed rate short term, and they comprise very small markets compared to the financial markets.

If pension funds all decided to put two percent of their capital into commodities, two things would happen. First, that two percent would be a rounding error in their returns, no matter how commodities behaved. Second, they would swamp the supply of the commodities for economic purposes – i.e. for their true role as factors of production. I agree with Michael Masters’ view that oil prices were pushed up by this sort of financial activity. I might quibble with one chart or another, I might not couch it in the loaded terms of speculation.
But the subsequent behavior of the market demonstrated that he was right and Goldman and others who took the opposing view were wrong.

Inflation-Linked Bonds

Which brings me to inflation-linked bonds.
At the close of the program we all were asked for one investment recommendation. In one form or another we all focused on the same one: inflation-linked bonds. But I would not carve them out as a distinct asset class any more than I would commodities -- though unlike commodities, at least I think they are an asset. They are one of many assets that load on the inflation factor.

If you have a long-term view, equities are also decent inflation hedge. After all, over time prices adjust, and so do earnings.
And, as with commodities, the supply of inflation-linked bonds is low; there is a liquidity premium to pay.

I think what has elevated inflation-linked bonds from the category of “asset” to that of “asset class” is memories of the 1970s, a heyday for inflation-linked bonds. If you could have held them during the stagflation period, you would have looked golden; they would have given you a Sharpe Ratio of over 1.0 while many other assets was flat-lining. If I were building a simulation to beat the market on an historical basis, I would add in inflation linked bonds just for the pop they would give in that decade.
You can read at the transcript of that WealthTrack episode and watch it on YouTube below. I happen to believe that diversification is still important, but loses its power as huge inflows are going into all sorts of public and alternative asset classes.

Importantly, institutional fund managers have to start thinking how huge inflows into all asset classes are influencing the correlations between them, especially during a financial crisis when these correlations typically break down.

As the nature of markets evolve, you need to understand how collective inflows are influencing the trends in each asset class and changing the relationship between them. Rebalancing is crucial, but so is understanding what is going on in each asset class and how developments in one asset class will impact other asset classes.


Friday, September 25, 2009

Who Is Eyeing Clean Energy?


Reuters reports that Barclays pension fund eyes clean energy:
The 15 billion pound ($24 billion) defined-benefit pension scheme of UK banking group Barclays Plc is poised to make a foray into clean energy investments, its chief investment officer said.

Tony Broccardo said the pension scheme was considering alternative energy investments, including via private equity firms which finance green energy projects.

"Clean technology is an area that could be a big allocation for us in the future," Broccardo told Reuters.

Broccardo, appointed last year as the fund's first chief investment officer, said the fund will seek exposure to alternative energy as part of its "opportunistic" investment program.

Last year, the strategy prompted allocations to corporate credit in the United States and Europe, which increased its overall risk profile but netted 20 percent returns.

Broccardo said the fund had about 500 million pounds annually to investing opportunistically. Combined with emerging markets and technology, he said the pension scheme could allocate over 10 percent in clean technology.

The scheme is also poised to increase its investments in active management. "We have had good experience with hedge funds and more active management. Skilled managers will do quite well," he said.

Good for Barclays. At least some pension funds are thinking carefully about the big themes that will shape the future of energy. Clean energy is definitely one of them.

And it's not just Barclays. After being relentlessly negative on the solar industry since the summer of 2008, investment bank HSBC is starting to warm up to the sector again:

The upshot: The worst of the solar sector’s woes may be behind us. That doesn’t mean the good times are here yet—but it does open the door to selective investments in companies that can weather the three years or so of storms that still lie ahead, the bank says in a new report.

The thesis of “Global Solar Power: Solar Eclipsed?” is straightforward: The supply glut that has plagued the sector all year will persist until 2012. That will keep pushing prices down—bad news for corporate profits, good news for the sector as a whole as it becomes more competitive with traditional sources of power generation.

HSBC’s winners include Yingli Green Power, Sharp, Solar World, and REC. The bank doesn’t care as much for Suntech Power and LDK, among many others.

[Note: I like them all, including LDK, Suntech and Trina Solar.]

What’s really interesting about HSBC’s new report is how solar power stacks up today against other ways of generating electricity—it doesn’t. That is, all the other power-generation technologies are in roughly the same neighborhood, even wind power—but not solar.

For instance, HSBC estimates costs per megawatt for different options: Combined-cycle gas, 43 euros; regular coal, 62 euros; onshore wind, 58 euros; nuclear power, 48 euros; geothermal, 43 euros. Photovoltaic solar power costs 290 euros per megawatt; concentrated solar power 181 euros.

Or put another way: What price would oil or gas have to be for each technology to be break-even without subsidies, using combined-cycle gas turbines as the low-cost yardstick?

Geothermal is the cheapest: It is competitive with natural gas at $5.16 per million BTUs or oil at $57 a barrel. Nuclear power breaks even at $6.26 and $69.

Traditional, onshore wind power breaks even with gas at $8.33 or oil at $92. Offshore wind still needs a push: It requires gas at $17.14 or oil at $189.

In contrast, solar thermal needs to see natural gas at $35.66 or oil at $393. And good old photovoltaic solar, like the kind on rooftops? Natural gas needs to be at $59.61 or oil at $657 a barrel.

Quick reality check: Gas today is at $3.93 and oil is at $66.

That’s not to say there’s no hope for solar power. There’s always the government.

Thanks to price supports, HSBC expects solar power to reach retail “grid parity” in some places—California and New York—as soon as next year. That means solar power will generate electricity that’s competitive with what you pay on your bill every month. It will take another five years or so for solar to reach wholesale grid parity—when it becomes a no-brainer investment for big utilities.

There is a clean energy revolution going on and it's just in its infancy. Those who can't see it are either blind or hopelessly ignorant. If pension funds are smart, they will start thinking about investing opportunistically in this sector now.

***UPDATE: Supply Glut Putting the Heat on Solar Stocks?***

Just so I am not accused of pumping solar stocks, read this Barron's article, Supply Glut Will Put the Heat on Solar Stocks. I agree with some comments (I am not as bullish on FSLR relative to other solar stocks), but respectfully disagree with other comments made in the article. Looking ahead, I see PV supply chain revenues rebounding as demand picks up and credit concerns ease.

Also, Solar Feeds reports that VC Investment in Green Technologies Roaring Back.

Thursday, September 24, 2009

The Last Hedge Fund Hurrah?


Bloomberg reports that hedge-fund assets increased by $21.4 billion in August:
Hedge-fund assets increased by $21.4 billion in August as managers completed their best year- to-date return in almost 10 years, driven by rising stock markets amid signs of economic recovery, Eurekahedge Pte said.

Assets grew for a fourth straight month, adding about $100 billion, the largest sustained growth period since the end of 2007, the Singapore-based research firm said in a report posted on its Web site. Net inflows into the industry totaled $12.6 billion in August, while gains through performance were $8.8 billion, bringing total assets under management to $1.38 trillion, the firm said.

A rebound in global stock markets has helped hedge funds record their best first eight months since 2000, after managers posted their worst year on record in 2008. The Eurekahedge Hedge Fund Index, tracking more than 2,000 funds, gained 1.3 percent in August, as the MSCI World Index of 23 developed nations advanced 3.9 percent in the month.

“We believe the worst of the crisis has now passed and markets are slowly returning to more normal levels of functionality and performance,” said Spencer Young, chairman of HFA Holdings Ltd., an Australian hedge-fund manager with A$6.16 billion ($5.4 billion) in assets, in its annual report released today. “We have also seen early signs that the redemption levels we witnessed at the height of the crisis have diminished and we are cautiously optimistic that overall fund flows will stabilize.”

Europe, Relative Value

With the gain in August, the global benchmark is up 13.4 percent so far this year, the best eight-month gain since 2000, Eurekahedge said. Gains during August were supported by economic data such as the reduction in the unemployment rate in the U.S. and return to positive gross domestic product growth rate for some developed countries, Eurekahedge said.

Assets of funds investing in Europe rose 1.8 percent from July to $318.9 billion, the biggest percentage increase among five geographical mandates, the report showed. Manager allocations to Latin America had the smallest increase in assets, gaining just 0.9 percent.

All regions reported inflows, led by Asia excluding Japan, which added $1.4 billion, or 1.5 percent of assets. A sell-off in Chinese equity markets hurt hedge-fund performance in the region and led to a 0.1 percent performance-related drop in assets. China’s Shanghai Composite Index tumbled 22 percent in August, its biggest slide since October 2008, pushing the benchmark into a so-called bear market.

New Funds

By strategy, relative value funds had the biggest percentage gain, rising 3.7 percent, while long-short equity funds reported the biggest absolute gain, with inflows of $4.1 billion and performance-related increases of $2.1 billion.

Recovery in the capital markets has prompted managers to start funds, Eurekahedge said. About 300 funds have started this year through August, while the rate of fund closures continued to slow, with 200 of them shutting since the end of the first quarter, compared with about 600 closures through fourth quarter in 2008 and first quarter this year, the firm said.

Eurekahedge forecasts hedge-fund assets to reach $1.5 trillion by the end of this year.

“Hedge funds have benefited from the recovery in global markets and that’s the biggest reason behind the comeback,” said Hideki Hashiguchi, chairman of the Japan chapter of the Alternative Investment Management Association in Tokyo. “We’re starting to see some of the fund-of-funds investors consider to allocate money back into alternative investments, so it seems like the industry slowly but surely is emerging out of the worst conditions.”

Hedge funds are mostly private pools of capital whose managers participate substantially in the profits from their speculation on whether asset prices will rise or fall.

All those assets flowing in explains why hedge funds still aren't reducing their fees:

After posting poor returns and in some cases preventing investors from withdrawing cash, hedge funds had been expected to make it up to investors by softening some of their hard conditions or lowering fees. It appears not.

Research compiled by France's Olympia Capital Management, a fund-of-hedge-funds firm that manages pools of individual hedge funds, found that only a handful of 2,659 funds it analyzed shortened the time between one redemption date to the next, or reduced the initial lockup period they place on investors' capital.

The funds' fees also remained steady, said Guido Bolliger, chief investment officer at Olympia Capital Management, "contrary to expectations."

"Industry analysts expected the level of fees to decrease in order to reflect both the strong decrease in the demand for hedge funds and their disappointing performance," Mr. Bolliger said. But "we have not seen any significant changes in the liquidity terms and the fees taken by hedge funds during the first half of 2009," he said.

In the 12 months to May, the research found that fewer than 1% of fund managers had adjusted their liquidity terms, which include their redemption frequency or notice periods investors must give to exit. A similar proportion hadn't changed any lockup periods they imposed on investors.

That is mainly because performance has been so much better this year. After an average 19% loss in 2008, hedge funds posted a 14% gain in the first eight months of 2009, according to Hedge Fund Research. Funds that survived 2008 also are typically larger and performed better than those that failed, giving investors less power to renegotiate fees or redemption terms.

Funds also may be holding back on offering features that can become a double-edge sword in a crisis. Investors like buying funds that give them the option to redeem at frequent intervals. But it can also make them the first port of call for investors that can't get their money out elsewhere, even when a fund is posting strong returns.

Alex Allen, chief investment officer of London-based Eddington Capital Management, which like Olympia Capital puts together and manages portfolios of hedge funds, said his firm lost between 30% and 40% of its assets from investor redemptions between December 2008 and April of this year. This is despite that Eddington's two main funds of funds had returns of 25% and a 1% loss -- much better than the average 21% loss on Hedge Fund Research's Fund of Funds Composite Index.

After some modest inflows since then, Eddington manages about $155 million, down from a peak of $280 million. "We were a victim of our own success because we didn't gate the fund and investors used it as a cash machine," Eddington Chairman Andrew Popper said last week.

Dozens, if not hundreds, of hedge funds slammed down "gates" last year to prevent investors from pulling money. On top of liquidity terms that can range from one month to three years, hedge funds nearly always have a right in their contracts with investors to put a gate down on part or all of their capital.

It's amazing how a year after the worst financial crisis in post-war history, when hedge funds were closing the gates of hedge hell, things have not changed on Wall Street.

German Chancellor Angela Merkel urged Group of 20 leaders on Thursday to agree concrete new regulations for financial markets at a summit this week, but we shall see if anything comes out of this summit.

Moreover, Paul Volcker, the former Federal Reserve chairman, expressed more doubts over the White House’s plan for financial regulatory reform on Thursday and backed new taxes on banks.

One interesting Bloomberg article that did catch my attention today reported that the IRS told its auditors in Manhattan to develop cases against offshore hedge funds and foreign companies it said are trying to avoid taxes on income from loans they make in the U.S:

The agency, in a Sept. 22 directive, urged the Manhattan field director of the IRS financial services section to pursue a transaction the agency says seeks to improperly take advantage of an otherwise legal tax break. The agency also urged the official to be watchful for similar techniques.

“We understand that foreign corporations and non-resident aliens may have used other strategies to originate loans in the United States, giving rise” to tax obligations, Steven Musher, the top lawyer in the IRS’s international department, wrote in a memo to Kathy Robbins, the Manhattan field director.

“We encourage you to develop these cases and we stand ready to assist you in the legal analysis,” Musher wrote.

It is unusual for IRS lawyers to recommend audit targets to field investigators, said Robert Willens, founder of Robert Willens LLC, which advises investors on accounting and tax rules.

The IRS is “obviously incensed about this and intends to pursue the strategy quite vigorously,” Willens said in an interview.

Hedge Fund Risks

The IRS memo signals new tax risks for hedge funds and foreign investors making and refinancing loans to Americans after the financial system crash, lawyer Roger Lorence, a partner at Sadis & Goldberg LLP in New York, said in an interview.

“Anything that doesn’t involve buying a loan in the secondary market is arguably affected by this IRS action,” said Lorence, who advised clients in a letter today to “consider their structure in light of the IRS’s conclusions.”

“Who knows how far they’ll go,” Lorence said.

How far will they go? It's about time they start cracking down on sophisticated tax avoidance schemes that hedge funds and private equity funds regularly engage in. Joe & Jane Taxpayer are squeezed, scared to death of losing their jobs and health care and we got a financial elite that are using an army of accountants to avoid paying their fair share of taxes.

Michael Moore is right, capitalism has failed and we need a new democracy that addresses the concerns of the restless many, not just those of the privileged few.


Wednesday, September 23, 2009

Private Equity on the Cusp of Golden Age?


A senior private equity manager sent me an article from Andrew Ross Sorkin of the NYT, A Financier Peels Back the Curtain:

“We all had too much money. It was just too easy.”

That’s the unvarnished appraisal of the private equity business by Guy Hands, perhaps best known for his unfortunate $4.73 billion purchase of the record company EMI in March 2007, the peak of the buyout boom — a bet that will almost certainly lose his investors and his firm, Terra Firma, a fortune.

That ill-timed acquisition aside, Mr. Hands’s surprisingly candid assessment of the private equity industry is worth sharing. He was in the midst of the industry’s growth to dizzying heights during the debt-fueled boom, and he is now having to deal with the aftermath of its shopping spree. Like others, he is desperately trying to keep businesses afloat and pay off the equivalent of huge monthly mortgage payments to the banks that financed them.

Mr. Hands, a large man with unruly hair who is a name-brand financier in his hometown, London, was in New York last week to meet with investors and speak at a conference. A longtime investor who started his career at Goldman Sachs, he made his reputation investing for Nomura. His net worth is estimated at more than $400 million.

Over afternoon tea at the Jumeirah Essex House hotel by Central Park, Mr. Hands, who now lives on the island of Guernsey to escape British taxes, offered the most frank assessment of the private equity world — including his mistakes — I had ever heard from anyone still gainfully employed in the business.

He had prepared remarks for a conference that morning, but didn’t get to air many of them. Some of his most provocative thoughts were in his notes, which he shared with me. Most strikingly, he grabbed the third rail of the private equity world: the fee structure that gave the firms 2 percent of assets under management, plus 20 percent of profits.

The problem, he said, was that the funds had grown so big that the 2 percent became just as important as the 20 percent.

“Clearly a large number of P.E. firms were totally overpaid at the peak of the market,” he said. “The fees were an entirely unwarranted windfall, as the managers did not use the excess fees to invest in resources to grow the skill base of their funds.”

He estimated that the private equity firms’ “net earnings will decline a minimum of 80 percent from the peak in 2007.”

Success had less to do with performance or risk management, he said, and more to do with bulking up. “It is time for investors to see through the elaborate marketing machines created by the industry,” he said.

Between sips of his mint tea, he said that during the boom, investors had thrown so much money at so many private equity firms — some of which formed consortiums to buy businesses from one another — that they were “really investing in the same thing so their capital was competing against itself, driving up prices.”

He also argued that private equity firms formed consortiums not to spread risk, but because, ultimately, it was easier than going “through the pain of gaining internal consensus to do something contrarian.” The big firms would counter that consortiums allowed them to buy bigger companies and to spread the risk.

With banks still holding back on loans, some on Wall Street have suggested that the private equity industry is dead. Others argue that the biggest firms — the Blackstone Group, Fortress Investments, Kohlberg Kravis Roberts & Company, which is planning to go public — will survive, albeit in a different form. Last year, Stephen A. Schwarzman, the co-founder of Blackstone, said, “The people rooting for the collapse of private equity are going to be disappointed.”

Mr. Hands is not rooting for the industry’s demise, but he is predicting it will wither. The firms still have funds big enough to last them at least a decade, as they provide steady fees. “Right now, the big firms have a tower of fees,” he said. “But the tower starts to collapse over time.”

As the funds dry up, Mr. Hands expects the firms will struggle to raise enough new money to support the hundreds of employees they now employ. His prediction has a precedent — that’s what happened to venture capital after the late 1990s. The industry shrank sharply after it became clear that too much money was chasing too few deals.

But the pattern may play out in slower motion for private equity. “Neither the banks nor P.E. want to come clean about mistakes,” he wrote in his notes. “Hence companies will live as zombies unable to grow their businesses or make long-term commitments. Meanwhile banks will try to suck out as much money as they can in fees and postpone recognizing the full extent of the losses of their underwriting decisions.”

In the end, he said, “Many P.E. firms are hoping that daylight doesn’t shine on the corpses of their companies, so they are reluctant to restructure too quickly.”

Of course, it’s possible that some firms will make terrific bets now, in the depressed economy, and will come out even stronger when things improve.

Mr. Hands is quite open that he made an awful mistake with EMI, which desperately needs to be restructured or sold (most likely to Warner Music, eventually).

His timing was off, he says, but not by much. If, by chance, he had waited several weeks, the deal probably wouldn’t have happened. The securitization market was about to seize up, which would have pushed him into a higher interest rate, making it impossible to sell some of the business to co-investors.

“If the EMI auction started two weeks later, it wouldn’t have occurred,” he said. “We wouldn’t have bought it. We’d have 90 percent of our funds still to invest and we’d look like geniuses.”

The good news for Mr. Hands is that most analysts, and even his own investors, give him high marks for operating the business very well, squeezing out every last efficiency.

The bad news is that he has been unable to invest in the company’s future and any additional cash goes only to one place: Citigroup, which provided the financing for the deal.

The bank has become Mr. Hands’s de facto boss now that there is more debt on the books than equity. “Negotiations with one’s bankers, when the debt is so large in relation to the earnings, are always difficult,” he said.
I can't say that I am shocked with Mr. Hands's comments because I saw this coming back in 2005. A bunch of large private equity firms with slick marketing presentations gathering obscene amounts, collecting 2% management fee and 20% performance fee as they leveraged their way from one deal to the next. A big fat financial orgy that came to a grinding halt after the 2008 credit crisis.

The problem is that over the last several years, public pension funds were funding this nonsense and now that it's curtains for private markets and the end of the great pension con job, the chicken has come home to roost.

And the nonsense continues as public pension funds continue to plow billions into private equity, betting that the worst is behind us. Maybe the worst is behind us, but I wouldn't want to make any outsize bets in illiquid asset classes.

In the environment we're heading into, I prefer liquid asset classes over illiquid ones and I certainly would pick and choose my private equity and real estate funds more carefully instead of writing big cheques to every large buyout fund. I'd make sure that my private equity managers are not glorified financial engineers who came from an investment banking background, but guys and gals with solid hands on experience restructuring companies from the bottom-up.

Is the PE tower collapsing? It depends on who you listen to. Reuters reports that private equity may be on cusp of "golden age":
The near collapse of the global financial system, which wiped out trillions in corporate value and personal savings, may be giving way to a new "golden age" for private equity investment, Silver Lake Co-CEO Glenn Hutchins said in an interview on Tuesday.

Private equity firms suffered badly when debt markets seized up as a result of the crisis and banks did not want to lend increasingly scarce capital. Only just recently have credit markets started to unfreeze.

"The financial markets may be on the cusp of a new 'golden age' for private equity," Hutchins, who is also a co-founder of the firm, told Reuters on the sidelines of the International Economic Alliance Symposium.

Hutchins, the co-founder of the $13 billion private investment firm, cautioned that while there has been a significant stock market rally, the economy is showing stable, though not robust, growth.

"This recent stock market rally is a little troubling because it seems to me not to be supported by underlying economic fundamentals," Hutchins said.

"But that aside, we have gotten down to levels that are pretty attractive and the banks seem to be recovering enough to provide modest levels of financing, which is all we need. We feel pretty optimistic," he added.

The major concern, he said, is how long will investors have to be prepared to withstand low levels of economic activity.

'ATTRACTIVE' RISK PREMIUMS

But for the moment, Hutchins said, investors are once again finding risk premiums at attractive levels versus the low premiums before the asset bubble burst in December 2008.

"Now that the sort of panic of '08 is over and capital markets seem to be returning to some degree of normality ... companies will be able to access debt and equity markets like they have in the past. And that is no surprise," Hutchins said.

But he added that investors needed to be mindful that valuations in 2007 should not be defined as normal. They were an "overshoot in another way," he said.

The average investment grade corporate bond now yields 232 basis points over U.S. Treasuries, down from the all-time high of 656 basis points on December 5, 2008. By comparison, in May 2007, before the credit crisis started, spreads narrowed to 92 basis points, according to the Merrill Lynch indexes.

"Now risk premiums are at attractive levels. Investors are being paid to take risk again. That means when you look back on this, when you get back to economic recovery, this will have been a good time to invest," Hutchins said.

Silver Lake makes only a few acquisitions a year and is more inclined to use financing for working capital rather than purchases, Hutchins said.

"If you need financial engineering to enter a deal and multiple expansion to exit a deal, then your business is fundamentally challenged," Hutchins said.

The firm, along with other investors, agreed to a deal earlier this month to pay $1.9 billion to buy a 65 percent stake in online telephony unit Skype from Internet auction and services company eBay Inc (EBAY.O).

Ebay agreed to sell the stake in Skype for $1.9 billion to a consortium including Netscape founder Marc Andreessen's Andreessen Horowitz, venture firm Index Ventures, Silver Lake, and the Canada Pension Plan Investment Board.

Asked what he thought about the Skype sale and lawsuits filed by Skype's founders, Hutchins responded: "No comment."

I am not as worried about guys like Glenn Hutchins and David Bonderman of Texas Pacific Group who has $30 billion to invest:

One of the world's largest private equity funds TPG [TPG.UL] currently has about $30 billion in uninvested capital and is looking for opportunities, its founding partner said on Friday.

"We have about $60 billion of capital, half of it is uninvested and we are looking for opportunities," David Bonderman told Sochi Investment Forum.

Bonderman said the fund saw growth capacity in Russia's consumer sector and was "cautiously optimistic" about Russia.

Mr. Bonderman should go back to read his 2004 interview with The Harbus:

Harbus: Where do you see the private equity sector going in the next 5 to 10 years in terms of players in the industry and the overall potential for attaining the level of returns that private equity funds have achieved historically?

DB: I think the right way to look at private equity is as an illiquid equity investment which ought to be competing in the investors' minds with the public markets. As a result, the private equity firms should deliver returns significantly higher than what the public markets do.

You can argue about whether that return should be 500 basis points or 1,000 basis points higher, but somewhere in that range at least. And if they can't, they probably shouldn't be in business because, given the liquidity penalties and so forth, that's what private equity ought to deliver.

What you think of the private equity sector depends on what the markets are likely to be doing going forward. We've obviously had a roaring market in 2003, but if you believe that over the long-term public markets should be yielding 10%-11% in real terms, then the private equity firms should be yielding 16%-25%, or they shouldn't be in business. As the market comes to realize that, what is going to happen - and you've seen some of that already - is that the players who are successful and continue to be successful will not have a lot of trouble attracting capital.

The people who can't do that will fall by the wayside. You had one or two big firms already lose their way in that regard. At the end of the day, you will see a collection of larger firms, and you'll see some midsize firms and you'll see some niche firms. But over time, you probably will have less than the 85 or so firms at the moment who have $1 billion dollars in capital or more. Probably some of those guys will go away over time.

...

Harbus: What do you think makes a good private equity investor?

DB: Being a good private equity investor is more complicated than it seems. I would say that there are a few characteristics that are important. If you look at the skill set that you need to ultimately be a successful private equity investor, at least at the senior level, you have to be, in this business, a good investor. You have to be able to help companies perform and you have to have judgment around exiting investments. If you look at the skill sets there, they include some things you can teach and some that you can't.

One of them, of course, is being a person who has good judgment about businesses. A second is someone who's pretty analytical and understands how to deal with numbers. A third one is personality, because in the private equity business, there's no deal unless you can persuade somebody to sell you their company. And as you say, there are many competitive situations here. So if many of us are all out there competing, and people like you and they don't like me, they're probably going to be interested in selling their company to you, and not me. So, you have to have a mix of those talents.

In addition, a very important characteristic is having a nose for value. That's why some of the very best private equity people, in my experience, are people who start out as stock pickers - people who really understood value, how to take a company's financials apart and couple that with good judgment about businesses, macro trends, and where things are going.

It's a complicated skill set, and probably no one is perfect at all of them.

The more you start out with the right kind of personality, the right kind of smarts and the better the training you get, the more successful you're likely to be.

Harbus: Mr. Bonderman, you've obviously had a very successful career in private equity. What do you enjoy most about your job? What has been the most challenging aspect of your career path?

DB: Let me answer those in different ways. For me, one of the highlights of being in the private equity world is that you need to learn a lot and very quickly about different businesses. So it's always a continuing learning experience where you can apply what you know, of course, by way of judgment and by way of numerical analysis. You're always investing in new businesses, which is a learning experience in itself. I think that is a wonderful thing and I think it makes for intellectual challenge and for continued personal growth. That, for me, is the highlight of this job.

You have a challenge every day in figuring out what's happening in the markets, where your next deal is coming from and so forth. So there is always a continuing challenge - but this is a financial services business, it's not brain surgery. The challenges are all about getting it right, but in the scheme of things, there is plenty of latitude to get it wrong.

Given the uncertain economic landscape, there is plenty of latitude to get it wrong, but guys like David Bonderman didn't get to where they are by being stupid with their money. The management fees that TPG charges its investors can attract some pretty smart people to help them uncover value. They'll need all the brains and brawn they've got to face the challenges that lie ahead.

***UPDATE: Comment from an informed reader***

Please read this comment carefully:

PE has been a good idea for hundreds of years, but best executed by family offices with long term time horizons and fewer “agency” problems. The current mega LP led/investment banker enabled business model is dysfunctional, and I fear some limited partners will harden their approaches at the expense of the general partners (rather than seeing themselves as the root of the problem), with the usual unintended consequences of poorly thought through alignment of interests creating more dysfunction going forward.

I think the golden age references imply that current tough markets are transient, and opportunistic, distress style deals will work out well. In my view, most GP’s are poorly equipped for distress investing, and those who on the whole are strange, mean people who aren’t really cut out to be fiduciaries.

Given my personal extreme bearish view on broader economic fronts, I can’t see a golden age emerging. I see this as a tough business that will get tougher.

My solution, as always, is to contain PE activities within portfolios to a relatively minor scale.

Tuesday, September 22, 2009

Rating Public Pension Funds?


Last week Tara Perkins of the Globe and Mail reported that rating agencies are at the crossroads:

Just like the investment portfolios of most Canadians, Walter Schroeder is a shrunken version of his former self in the wake of the financial crisis.

The 67-year-old founder of credit rating agency DBRS Ltd. has lost a noticeable amount of weight, something that acquaintances point to when speaking of the stress he and his team have endured over the past couple of years.

More than three decades after conceiving a brazen business plan for a Canadian credit rating agency during a family road trip in his Volkswagen Beetle, Mr. Schroeder succeeded in building DBRS into the country's pre-eminent rating agency.

But a year after Lehman Brothers imploded, DBRS, along with other credit raters, is battling the fallout of having given high ratings to a number of securities that cratered. Now, the agencies are under fire from investors, regulators and politicians who are introducing new rules for the sector.

For Mr. Schroeder, “this is easily the worst” economic cycle in recent history. “I've seen them all, from '72, '82, '92, to 2002,” he said.

In the years leading up to Lehman, credit raters became a backbone of the financial system. Their ratings affect everything from the interest rates companies pay to raise money, to the amount of capital banks must hold, to pension funds' investment decisions.

In the aftermath of Lehman, the rating agencies are fighting some of the proposed reforms and also searching for ways to maintain profits. The recession has bitten into their revenues, and some proposed regulations could leave teeth marks deep enough to cause permanent scars.

The outcome of this evolution will not only change the ratings business, but the way that many investors make choices about where to park their money.

Long before Lehman failed, the credit crisis reared its head in Canada and quickly turned the spotlight on DBRS. Canada's homegrown rating agency was the only one to rate $33-billion worth of third-party asset-backed commercial paper, and assigned high ratings to most of it. The ABCP market froze in August, 2007, when investors suddenly panicked about potential exposure to subprime mortgages. That became the biggest financial headache this country would face as a direct result of the crisis. Other rating agencies say they refused to rate the paper because of possible risks it posed.

The ABCP crisis left thousands of Canadians unable to tap into portions of their savings. In the finger-pointing that ensued, the country's banking regulator questioned why investors would buy a product that only one agency had weighed in on. DBRS, like all of the main players in the third-party ABCP market, was eventually protected from a flurry of lawsuits by way of a special indemnity clause that was written into the plan to restructure the market.

DBRS is a private company and doesn't disclose financial results, but it is one of the biggest players in a sector with estimated sales of more than $5-billion (U.S.) a year. Larger rivals Standard & Poors Corp. and Moody's Investors Service Inc. each saw revenues from their ratings businesses fall by more than 9 per cent in the latest quarter, but their sales still amounted to hundreds of millions of dollars apiece.

Globally, the big three rating agencies – S&P, Moody's and Fitch Ratings – have borne the brunt of the criticism, and their businesses could change dramatically as policy makers figure out ways to serve investors better.

Whether agencies should be legally liable for their ratings is one of dozens of questions regulators are considering as they debate reforms. Until now, U.S. courts have struck down major lawsuits against the agencies on the basis of free speech.

Imposing more liability on agencies could motivate them to give out low ratings, Fitch's chief executive officer Stephen Joynt told the U.S. House of Representatives in May.

“A Fitch rating is our opinion about the future financial capacity of a company or other issuer to pay its debt,” he said. “It is not a statement of fact or a professional judgment. It is not a recommendation to buy a security, it is not investment advice, it is not an advertisement or an offer to buy or sell a security.”

Beyond liability, one of the most talked-about proposals is changing the way agencies earn money.

Since the 1970s, they have been charging companies and other issuers of debt fees for ratings. For instance, S&P, which publishes a general fee schedule, charges corporations, such as banks, a minimum of $70,000 or up to 4.25 basis points per transaction. (A basis point is 1/100th of a percentage point.)

Critics charge that it's a conflict of interest for agencies to be taking fees from companies they rate.

“A good way to do it, and a fair way to do it, would be to have investors who use their services – research and ratings – pay for it,” says Paul Rivett, a spokesman for Fairfax Financial Holdings Ltd. “If [the agency is] not good and the analysis is not sound, no one's going to pay.”

The industry argues that people who use ratings also have a vested interest in them. “Potential conflicts exist regardless of who pays. The key is how well the rating agencies manage the potential conflicts,” Moody's CEO Raymond McDaniel said in hearings at the U.S. House of Representatives.

Ironically, many officials in the ratings business argue the market's reliance on ratings goes beyond what they were intended for. As S&P states in a subscriber contract: “Any user of the information contained in any of the services should not rely on any credit rating or other opinion contained therein in making any investment decision.”

Ratings look at a company's or other borrower's ability to repay debt. While they serve an important purpose, “investors benefit from having multiple perspectives, can't rely on single sources, and must do their own due diligence,” says Don Guloien, chief executive officer of Manulife Financial Corp., whose previous job was running the company's massive investment portfolio.

Charles Dallara, managing director of the Washington-based Institute of International Finance, says “investors perhaps do bear their own share of responsibility for undo reliance on ratings, but that does not absolve the rating agencies from their inadequate management of the rating process on these structured products.”

For his part, Mr. Rivett believes that switching to a user-pay model would spur competition in the ratings business.

The ratings business, dominated by the big three rating agencies, is the most concentrated business in the world, Mr. Schroeder claims.

DBRS is one of 10 agencies the U.S. Securities and Exchange Commission deems to be a Nationally Recognized Statistical Rating Organization (NRSRO). It's a designation that once applied only to the big three, but the SEC has been trying to foster competition. (More than 50 other competitors have not applied for the designation.)

It might have been trying too hard. In August, its auditor-general released a report criticizing it for not doing enough due diligence before approving some agencies.

The report also noted that increased competition could actually reduce the quality of ratings by spurring “forum shopping,” where a company seeks a rating from multiple agencies and hires the one that provides the highest.

Meanwhile, the head of the SEC wants a requirement that all agencies be registered, something that the G20 favours and the Obama administration has proposed. The European Union has already adopted a law requiring registration.

In Canada, the Canadian Securities Administrators (CSA) has recommended that the business be regulated. Securities regulators should have the authority to review, and require changes to, the practices and procedures of rating agencies, it suggests. The CSA made the recommendation last fall and is still looking at the issue while watching to see what other jurisdictions do so that it can develop regulations that are consistent.

More regulations are likely to increase costs, if not reduce revenue, for agencies that have already laid off staff as a result of the crisis.

For DBRS, the timing of the crisis was particularly bad. It finally had its name emblazoned in lights on top of a tower in Toronto's financial district. It was making inroads in the United States, and had opened offices in Europe.

It closed its three European offices last year, laying off 43 people in London, Paris and Frankfurt, and some staff in North America. Its worldwide headcount is down to about 175, from 280 before the crisis.

“We felt that European rating assignments could be handled by our New York and Toronto-based analytical teams, and decided that three local offices were not necessary, given the credit crunch,” says Huston Loke, co-president of DBRS's Canadian business. One of the changes that European regulators are now looking for is ensuring that agencies have an on-the-ground presence. With markets stabilizing, DBRS is considering opening a European office in the future, Mr. Loke says.

Meanwhile, Mr. Schroeder moved from president to chairman in December, initiating a series of management changes that left his son David, 38, CEO.

Mr. Loke and Peter Bethlenfalvy were promoted to co-heads of the Canadian business. They acknowledge that they have had a lot of tough conversations with debt issuers and users of their ratings, and say that they're learning from those.

“We've evolved,” Mr. Bethlenfalvy says. DBRS wants to move beyond ratings to become more of a credit information provider, by issuing newsletters, research and “thought pieces.”

It has new products. One is something it calls an impact assessment, where DBRS tells an issuer what the rating impact will be following a major strategic deal. For example, when an oil patch company considered splitting into separate oil and natural gas companies, DBRS told it with certainty what the ratings would be on each business following the split.

It sounds eerily similar to the so-called reverse engineering of ratings that agencies have come under fire for – helping issuers put together structured products in such a way that they receive top ratings – but Mr. Bethlenfalvy said impact assessments are different because “we only rate capital structures and businesses as presented, and do not structure or give any advice.”

Another is called transparency rating meetings, where DBRS hosts a session for clients who want to better understand how the agency's methodologies work, and the drivers that affect the client's rating.

“Over the long term, we want to do much more – provide information, transparency, and help with understanding,” Mr. Loke says.

Mr. Schroeder still says foreign markets are key. “I think Canada is probably a very stable market,” he says. “I think the growth is going to be outside of Canada for us.”

The company's reorganization saw Dan Curry recruited to head the U.S. business. He has dedicated much of his time to the agency's relationship with regulators.

“We were complaining to the Fed and anyone else who would listen that they seemed to have a bias towards relying on the three large U.S.-based rating agencies,” says Mr. Curry, who was previously a managing director at Moody's.

Ironically, he saw it as a big breakthrough when DBRS began receiving calls to testify at hearings about the problems in the industry. “We captured some mind share, so when they think about industry issues they're interested in our input as well.”

A major coup was the Fed's decision in May to include DBRS on the list of agencies whose ratings will be recognized on commercial mortgage-backed securities (CMBS) that are eligible under the U.S. government's program designed to boost credit and the economy by trying to revive part of the securitization market.

Originally the Fed was going to limit participation to the big three agencies, and DBRS worked to convince them to include a fourth, Mr. Curry says. The Fed said in May that CMBS had to have at least two triple-A ratings to be eligible for the program, and it would recognize those from the big three as well as DBRS and another agency called Realpoint.

Warren Buffett's decision to sell some of Berkshire Hathway Inc.'s shares in Moody's Corp. this summer was read as a negative sign for future profits in the industry.

But “it's still a reasonably good business,” Mr. Schroeder says. He suspects that new oversight will scare away some entrepreneurs who might otherwise have started an agency.

“With regulation and everything happening on control and transparency, it's going to get tougher and tougher for more competition to develop in this market, simply because it's going to get much more complex,” he says. The technology and software required for modeling, accounting, auditing and surveillance is increasing significantly.

“When we started out, our biggest capital expenditure was just a shade over $1,000.”

Yesterday, the Investment Executive reported that according to DBRS, Canadian public pension funds hard hit by downturn are still solid:
Public pension plans and asset managers have been rocked by poor returns, but their credit ratings remain strong, DBRS Ltd. said Monday.

Pension plans rated by DBRS include the Caisse de dépôt et placement du Québec, Canada Pension Plan Investment Board, Ontario Teachers’ Pension Plan Board, OMERS Administration Corp. and Public Sector Pension Investment Board.

According to new research from the credit rating agency, while the public pension funds and asset managers it rates “have been adversely affected by the challenging economic environment that prevailed in 2008 and into 2009”, they remain solid credits. DBRS points to several factors that support their high credit ratings, including low leverage, superior liquidity positions and strong sponsorship, along with large asset bases.

DBRS notes that the funds and mangers it rates were certainly hurt by the financial market turmoil, reporting returns of -15% to -25% in the last fiscal year. “The poor investment performance had the effect of significantly shrinking their asset base and eroding their funding position, suggesting that the risk level in certain portfolios may have been higher than originally measured. This situation also generated considerable attention among investors trying to assess the potential impact of the losses on the credit profiles of these organizations,” it says.

Moreover, the rating agency allows that the downturn has reduced the financial flexibility of these operations, and that it will likely take several years to make up for the poor performance. However, it maintains that they retain “considerable resilience” and that these factors keep them highly rated. “DBRS believes that these credits have the necessary flexibility to weather the downturn, provided leverage is kept under control and no attempt is made to recover the recent losses through increased risk-taking,” says Eric Beauchemin, managing director at DBRS.

Let's set aside the potential conflicts of interest of having DBRS rate Canadian public pension funds who bought ABCP paper based on their ratings (Caisse, PSP Investments, and Ontario Teachers).

I agree with DBRS, it will take several years for these funds to make up for the poor performance, but I question the assumption of "low leverage and superior liquidity positions". There is plenty of leverage and low liquidity in private equity, real estate and infrastructure holdings and to a lesser extent, hedge fund holdings.

More importantly, how can DBRS or any rating agency rate these public pension funds without conducting thorough independent performance and operational audits? To do that, they need full transparency on the benchmarks governing internal and external investments. That information is not readily available, especially for private markets.

Finally, I am not sure that leverage will remain "under control" or that no attempts will be made to "recover recent losses through increased risk-taking". There too, I agree with DBRS, but I fear that the pension parrots will crank it up once again, especially if they're underperforming their peers.

It's not just rating agencies that are at the crossroads, but pension funds are at the crossroads too. We need a governance overhaul that introduces more transparency and a compensation system that rewards risk-adjusted returns. The status quo at rating agencies and pension funds is totally unacceptable.

***UPDATE: Moody's accused of issuing inflated ratings***

Based on news from the WSJ, Reuters reports that Moody's accused of issuing inflated ratings:
A former analyst with Moody's Corp has accused the credit ratings agency of issuing inflated ratings, and has taken his concerns to U.S. congressional investigators, the Wall Street Journal reported on Wednesday.

In a letter dated July, obtained by the paper, Eric Kolchinsky accused Moody's Investor Service of issuing a high rating to a complicated debt security in January, in spite of it being aware it was planning to downgrade assets backing the securities.

"Moody's issued an opinion which was known to be wrong," Kolchinsky wrote, along with detailing other instances of inflated ratings issuance, according to the paper.

The paper said a Moody's spokesman declined to comment on the January rating under scrutiny, but had said Kolchinsky refused to cooperate with an investigation into the issues he raised, and was suspended with pay.

Kolchinsky is scheduled to testify on ratings firm reform before the House Committee on Oversight and Government Reform on Thursday, the paper said.

Moody's was not available to comment.

Inflated ratings only serve to distort the true financial health of a company or pension fund. The model governing rating agencies and pension funds needs to be revisited.