Tuesday, January 31, 2012

Canada’s Subprime Crisis?

Andrew Mayeda of Bloomberg reports, Canada’s Subprime Crisis Seen With U.S.-Styled Loans:

Canadian lenders are loosening standards, offering mortgages similar to U.S. subprime loans that pose an “emerging risk” to financial institutions, according to the country’s banking regulator.

Banks and other lenders are becoming “increasingly liberal” with mortgages and home-equity credit lines that don’t require individuals to prove their income, according to 152 pages of documents obtained by Bloomberg News under freedom of information law from the Office of the Superintendent of Financial Institutions. The mortgages, typically granted to the self-employed and recent immigrants, “have some similarities to non-prime loans in the U.S. retail lending market,” the documents show.

“It just speaks to the general easing in lending standards, which has contributed to a booming housing market,” said David Madani, an economist in Toronto with Capital Economics, which estimates that Canadian housing prices may fall 25 percent over the next few years. “The problem is sort of baked in now, so I’m not sure there’s a way to prevent a weakening of the housing market.”

Canada’s housing market has surged since the 2009 recession as near-record low mortgage rates fueled prices and home purchases, unlike the U.S., where sales and values have fallen since 2007. Bank of Canada Governor Mark Carney has said record consumer debts are the greatest domestic threat to the country’s financial institutions, even as the central bank has held the benchmark rate at 1 percent since September 2010.

Most Vulnerable

While there are differences with U.S. mortgage practices, the Canadian housing market is displaying classic signs of a bubble, with a run-up in prices, high ownership rates and overbuilding, said Madani of Capital Economics.

“The biggest concern is taking extreme levels of debt for those who are most vulnerable,” Carney told reporters Jan. 18. The bank estimates the proportion of Canadian households “highly vulnerable” to an economic shock - those with a debt service ratio of 40 percent or more - remains above the average of the past decade. Canadians’ debt reached a record 153 percent of disposable income in the third quarter, according to Statistics Canada data.

Most mortgages in Canada are funded through deposits, followed by mortgage-backed securities and bonds guaranteed by Canada Mortgage and Housing Corp., a federal agency known as CMHC.

CMHC had an outstanding balance as of Sept. 30 of C$132 billion ($132 billion) in mortgage-backed securities and C$202 billion in Canada Mortgage Bonds. The agency’s financing arm issued C$41.3 billion in debt last year, up from C$6.5 billion in 2001.

Covered Bond Sales

Banks are also cutting their funding costs by selling covered bonds, a form of corporate bond backed by assets such as home loans. Bank of Montreal and Bank of Nova Scotia (BNS) sold $4.5 billion of the securities this month, according to data compiled by Bloomberg, after a record $25 billion of sales in 2011.

Relative yields for Canadian covered bonds average 91 basis points, or 0.91 percentage point, more than government benchmarks compared with 102 at the end of last year, according to Bank of America Merrill Lynch index data. That compares with a premium of 306 basis points for covered bonds issued by euro- region lenders.

Canada’s banking system has been rated the soundest in the world for four straight years by the World Economic Forum, and none of the country’s lenders needed a bailout, unlike U.S. banks, which suffered losses on securities backed by sub-prime mortgages.

No Documentation

U.S. nonprime mortgages - which include both subprime and “alt-A mortgages” - accounted for slightly more than a third of originations at the peak of the market in 2006, according to Inside Mortgage Finance, a Bethesda, Maryland-based company that tracks residential mortgages. Loans that required little or no documentation of income accounted for 46 percent of all U.S. subprime mortgages that year, according to a Credit Suisse Group AG report at the time.

While there is no common definition of subprime mortgages in Canada, the proportion of such loans has probably fallen from about 5 percent of the market since the financial crisis, said Benjamin Tal, deputy chief economist at CIBC World Markets in Toronto.

“If you look at the overall story and marginal borrowers, it’s a very small segment of the market,” said Tal.

Mortgage terms are also typically shorter in Canada than the U.S., and lenders can pursue defaulting borrowers for full reimbursement even after foreclosure. As well, mortgage interest isn’t tax deductible in Canada, unlike the U.S.

Stress Testing

OSFI head Julie Dickson said in a Sept. 26 speech the agency is “very focused” on mortgages and home-equity lines of credit, which allow individuals to borrow against the equity in their homes.

In a Nov. 2 letter to Canadian financial institutions, the agency encouraged them to follow mortgage underwriting principles recommended by the Financial Stability Board, including limits on the ratio of loans to property values and regular stress testing of mortgage portfolios. OSFI regulates Canada’s biggest banks, as well as smaller loan providers and credit unions.

Home buyers usually qualify for “non-income-qualified” mortgages because they make a large down payment, according to the August 2011 analysis by OSFI. Lenders typically waive the requirement that buyers prove their income, OSFI says, which identified such loans on a list of issues to be considered by its “emerging-risk committee.”

Slackening Standards

Home-equity credit lines without income verification have become “an increasingly popular option,” OSFI says in the analysis, adding that they “pose greater risk” than mortgages because the credit lines are offered at floating interest rates.

Slackening lending standards were one of the early warning signs of the subprime crisis in the U.S., said Joshua Rosner, managing director at research firm Graham Fisher & Co. in New York. “U.S. history should be a guide to the irrationality of that practice,” he said by phone, referring to granting mortgages to borrowers without verifying their income.

By definition, such mortgages should be considered “nonprime,” added Rosner, who warned of the risks of a U.S. housing crash as early as 2001.

“As part of OSFI’s regular supervisory process, OSFI identifies areas that may require an increased level of monitoring,” OSFI spokesman Brock Kruger said in an e-mail, adding that regulators in many other countries have stepped up monitoring and oversight of residential mortgages and home- equity lines of credit.

Credit Standards

OSFI hasn’t imposed new requirements on banks in this area, Kruger added. “When OSFI identifies areas for heightened supervision, we work to ensure that we understand the issues and pressures driving that area before making decisions.”

OSFI officials assessed Canadian banks’ potential losses from defaults on home-equity lines of credit last year, the documents show. The results were blacked out under legal provisions that allow the government to withhold commercially sensitive information.

Bank of Montreal, the country’s fourth-biggest lender, has “prudent credit criteria, and we regularly review our credit qualifications,” spokesman Paul Gammal said in an e-mail. Other banks declined to comment on their mortgage lending standards, referring questions to the Canadian Bankers Association, an industry group.

Managing Risks

Canadian banks “carefully manage risk in their mortgage portfolios,” said Rachel Swiednicki, a spokeswoman for the Canadian Bankers Association. Mortgages in arrears were 0.39 percent of the total outstanding home loans in September, she said, calling the figure “extremely low.” In the U.S., the rate was 3.5 percent in the third quarter, down from 5.02 percent in the first quarter of 2010, according to the Mortgage Bankers Association. In the first quarter of 2007, the U.S. arrears rate stood at 0.98 percent.

Bank of Montreal (BMO) recently cut its interest rate on five- year fixed-rate mortgages to a record low of 2.99 percent, prompting other banks to reduce their rates.

Falling borrowing costs are driving home sales, which increased 9.5 percent to C$166 billion ($166 billion) last year, the Canadian Real Estate Association said this month. Home prices rose 7.2 percent. Toronto-Dominion Bank (TD) estimated in a Dec. 22 report the average Canadian home is overvalued by about 10 percent, and the heads of Bank of Montreal and Royal Bank of Canada warned that condominium markets in Toronto and Vancouver are at risk of correction. By contrast, the median price of previously owned homes in the U.S. plunged about 30 percent from a 2006 peak.

Arrears Rates

Non-income-qualified mortgages aren’t necessarily riskier than conventional loans, said Jim Murphy, head of the Canadian Association of Accredited Mortgage Professionals, which represents mortgage brokers, lenders and insurers.

“There’s no data out there that I’m aware of that says these sorts of mortgage products have a higher arrears rate or a higher default rate,” Murphy said by telephone.

Finance Minister Jim Flaherty has tightened mortgage lending rules three times since October 2008, most recently last January, when he limited the period over which mortgages can be amortized to 30 years, capped the amount people can borrow by refinancing their mortgages, and eliminated government insurance on home-equity lines of credit that are not amortized. Flaherty said Jan. 17 he’s prepared to intervene again if necessary, though the government has no plans to take immediate action.

Mortgage Insurance

Mortgage insurance plays a role in protecting Canadian banks from losses. Federal regulated lenders must insure mortgages to borrowers who make a downpayment of less than 20 percent of the loan, a requirement that doesn’t exist in the U.S. Most mortgage insurance in Canada is underwritten by the CMHC. The OSFI documents refer to both insured and uninsured mortgages.

While CMHC validates the income of all borrowers whose mortgages it insures, the agency “may accept non-traditional means of income validation” from newly self-employed borrowers with an “acceptable” credit history, spokesman Charles Sauriol said by e-mail

CMHC’s policies “help ensure that newcomers and others without a Canadian credit history have access to CMHC mortgage loan insurance products through the utilization of alternatives to validate a borrower’s credit history,” he added.

Reuters just ran an insight piece on how the growth of household debt in Canada to levels approaching those seen in the United States before the 2008-2009 crash seems to be keeping a lot of people awake - from central bankers to economists, lenders, real estate agents and the indebted consumers.

All this confirms my worst fears, namely, Canada's housing market is a disaster waiting to happen. When the great Canadian housing bubble bursts, watch out below, it will take years to repair. And that's when we'll find out just how solid Canada's mortgage monster really is.

When you see BMO's Sherry Cooper coming out telling us that the housing bubble is really a balloon, you know the top is in. "Stick a fork in it Jerry, it's cooked!" (any Seinfeld fans out there?) Just like CMHC's risk models are cooked and grossly underestimate the real risks that lurk if this so-called 'balloon' pops, leaving many people stuck paying off mortgages that are worth more than the actual value of their houses (underwater mortgages).

It's going to get ugly folks, just remember the few of us have who have been warning you all along. Whenever you hear some economist telling you that "Canada's fundamentals are strong" and that "we can never suffer the same fate as the U.S.", start running for cover.

Below, Bank of Canada Governor Mark Carney talks about the potential impact of the so-called Volcker rule on the trading of government bonds, the European Central Bank's efforts to ease the region's debt crisis and bank capital regulations. He speaks with Bloomberg's Erik Schatzker on the sidelines of the World Economic Forum's annual meeting in Davos, Switzerland.

Record High Pension Assets Hit by Liabilities?

Towers Watson just came out with a report, Global pension fund assets hit record high in 2011:

Global institutional pension fund assets in the 13 major markets grew by 4% during 2011 to reach a new high of US$28 trillion, up from US$26 trillion in 2010 according to Towers Watson’s Global Pension Assets Study released today. The growth is the continuation of a trend which started in 2009 when assets grew 17%, and in sharp contrast to a 21% fall during 2008 which took assets back to 2006 levels. Global pension fund assets have now grown at over 6% on average per annum (in USD) since 2001, when they were valued at US$15 trillion.

The study reveals that, despite the growth in assets, pension fund balance sheets1 weakened globally during 2011, with the ratio of global assets to liabilities well down from its peak achieved in 1999. According to the study, pension assets now amount to 72% of global GDP, which while lower than in 2010 (76%) is substantially higher than the 61% recorded in 2008.

Carl Hess, global head of investment at Towers Watson, said: “In case investors needed any reminding, the last six months of 2011 have driven home the need to have investment strategies that are flexible and adaptable and which contain a broader view of risk. This approach makes greater allowance for extreme events, which are occurring more frequently, while accommodating the softer elements of risk, such as credit and liquidity. The past few years have focused attention on the multi-faceted nature of risk within our increasingly precarious financial systems. At the same time risk management processes have evolved somewhat to factor in more qualitative measures. However, there is still some way to go before the appropriate measurement and management of risk is firmly embedded in the governance structures of most pension funds.

Other highlights from the report include:

Global asset data for the P13 in 2011

  • The ten-year average growth rate of global pension assets (in local currency) is over 6%.
  • The US, Japan and the UK remain the largest pension markets in the world, accounting for 59%, 12% and 9% respectively of total pension fund assets globally.
  • All markets, except Japan, saw growth in pension assets in 2011 (measured in local currency), and all markets in the study, except Japan, have positive ten-year compound annual growth rate (CAGR) figures.
  • In terms of ten-year CAGR figures (in local currency terms), Brazil has the highest growth of 14% followed by South Africa (13%), Hong Kong (10%) and Australia (9%). The lowest are Japan
    (-1%), France (1%), Switzerland (4%) and Ireland (4%).
  • Ten-year figures show the UK has grown its pension assets the most as a proportion of GDP (by 30% to be 101% of GDP ), followed by the Netherlands (up 23% to 133% of GDP), Australia (up 17% to 89% of GDP), Hong Kong (up 15% to 34% of GDP) and the US (by 12% to 107% of GDP). During this time Japan's ratio of pension assets to GDP has fallen by 1% to 55% of GDP.

Asset Allocation for the P7

  • Bond allocations for the P7 markets have decreased by 3% in aggregate during the past 16 years (40% to 37%). Allocations to equities have fallen by 8% (to 41%) during the same period, although much of this fall (7%) occurred in 2011.
  • Equity allocations in the UK have fallen from 67% in 2001 to 45% in 2011 (falling 10% in 2011 alone); similarly in the US allocations have fallen from 65% to 44% during the same period. Australia maintains the highest allocation to equities at 50%, while Japan has the highest allocation to bonds of 59%.
  • Allocations to other (alternative) assets, especially real estate and to a lesser extent hedge funds, private equity and commodities, for the P7 markets have grown from 5% to 20% since 1995.
  • In the past decade most countries have increased their exposure to alternative assets with the US increasing them the most (from 5% to 25%), followed by Switzerland (9% to 28%), Netherlands (1% to 14%), Australia (14% to 24%) and Canada (10% to 20%).

Carl Hess said: “The volatility in markets and the heightened risk awareness associated with possible sovereign defaults continues to make asset allocation incredibly challenging as companies and trustees balance such priorities as long-term de-risking, short-term market opportunities, rebalancing or maintaining a strategic asset allocation mix. These are already complex decisions - which are increasingly being delegated to specialists such as fiduciary managers - without adding numerous competing considerations, such as contributions from already stretched sponsors, contingent funding arrangements, hedging strategies and pension insurance buy-ins and buy-outs, not to mention changes to benefits structures including fund closures.”

Defined Benefit (DB) and Defined Contribution (DC) for the P7

  • During the ten-year period from 2001 to 2011, the CAGR of DC assets was 8% against a rate of 5% for DB assets.
  • DC assets now comprise 43% of global pension assets compared with 41% in 2005 and 38% in 2001.
  • Australia has the highest proportion of DC to DB pension assets, 81% : 19%.
  • The markets that have a larger proportion of DC assets than DB assets are the US, Australia and Switzerland while Japan and Canada are close to 100% DB. The Netherlands, historically only DB, is now showing signs of a shift towards DC, having grown these assets by 6% in the past five years to reach 7% of total assets.

Carl Hess said: “If institutions are finding it tough to invest, the growing number of individuals making their own investment through DC vehicles are facing a real challenge to preserve wealth, let alone augmenting their contributions via net-of-fee returns. Getting the default investment option right continues to be a priority for companies and trustees, while various governments battle the rising demographic tide by auto-enrolling or otherwise encouraging their citizens into sustainable vehicles for cost-effective retirement saving . At the same time companies and trustees are trying to balance the affordability of their plans with employee demands for suitable alternatives to retail savings vehicles.”

Public vs. private sector pensions in 2011

  • 65% of pension assets of the P7 group are held by the private sector and 35% by the public sector.
  • In the UK and Australia the private sector holds more than 80% of pension assets with 88% and 85% of total assets respectively.
  • Canada and Japan are the only two countries where the public sector hold more pension assets that the private sector, holding 61% and 71% of total assets respectively.

Notes to editors

  • The P13 refers to the 13 largest pension markets included in the study which are Australia, Canada, Brazil, France, Germany, Hong Kong, Ireland, Japan, Netherlands, South Africa, Switzerland, the UK and the US. The P13 accounts for more than 85% of global pension assets.
  • The P7 refers to the 7 largest pension markets (over 95% of total assets in the study) and excludes Brazil, Germany, France, Ireland, Hong Kong and South Africa.
  • All figures are rounded and 2011 figures are estimates.
  • All dates refer to the calendar end of that year.

1Measured by asset values over liability values using sovereign bond yields to discount liabilities.

aiCIO also reports, Record High Pension Assets Hit by Rising Liabilities:

Global pension assets hit a record high at the end of last year, but burgeoning liabilities meant funding ratios were in a worse state than 12 months earlier, a survey has shown.

Assets held in defined benefit and contribution schemes at the end of 2011 hit $27.5 trillion, according to investment consulting firm Towers Watson.

This figure showed a 3.9% increase in the asset level over the 12 months, but this was much lower than the 10.9% rise over 2010. All figures were stated in US dollar terms.

However, lower interest rates and changes to other accounting measures around the world’s major economies meant liabilities also hit record highs compared to a benchmark date at the end of 1998, Towers Watson said.

Using this measure, liabilities were 107.3% of their 1998 totals, whereas assets had only grown 54% from this point.

This shift meant global pension fund balance sheets worsened in 2011, losing 4.3% in the asset-liability indicator, despite the growth in assets.

Chris Ford, Head of Investment in Europe, Middle East and Africa at Towers Watson, said: "In case investors needed any reminding, the last six months of 2011 have driven home the need to have investment strategies that are flexible and adaptable and which contain a broader view of risk. This approach makes greater allowance for extreme events, which are occurring more frequently, while accommodating the softer elements of risk, such as credit and liquidity.”

Across the 13 countries counted in the survey, which have the largest pension fund assets worldwide, the allocation to fixed-income investments rose, and the percentage held in equities fell over the year, indicating investors were moving away from risky assets.

The largest shift towards bonds was seen in the United Kingdom, where 15 percentage points worth of assets were moved into fixed-income investments since 2006. A seven percentage point shift to alternative assets made up the rest of a 19 percentage point reduction of equity holdings.

Japan and the Netherlands - both relatively risk-averse investing nations – moved the next largest amount of assets into fixed income. They moved 13 and 14 percentage points of assets into bonds and other related securities over the five years to the end of 2011, cutting equity exposure by over 10 percentage points.

Investors in the United States, which holds 80% of pension assets within its borders, withdrew 16 percentage points from equities over the last five years, preferring split these assets between alternatives and fixed-income securities.

Ford said: "The volatility in markets and the heightened risk awareness associated with possible sovereign defaults continues to make asset allocation incredibly challenging as companies and trustees balance such priorities as long-term de-risking, short-term market opportunities, rebalancing or maintaining a strategic asset allocation mix.”

The largest surge in assets came from some developing economies, Towers Watson said. Brazil and South Africa saw pension assets climb by over 16% in 2011. Australia, which offers mainly defined contribution schemes, saw assets rise by 17% over the same period, in US dollar terms.

Over the past decade, however, Brazil has seen the largest asset growth with an upsurge of 14.3%. South Africa and Hong Kong followed slightly behind with 12.5% and 10.3% respectively.

You can read the Towers Watson Global Pension Assets Study 2012 by clicking here. When it comes to pensions, its all about matching assets to liabilities. And with the growth rate of liabilities outpacing that of assets, it's not surprising that global pension plans are in the hole. But keep in mind that underfunded pensions can get back to healthier status if they take the necessary measures to restore funding.

Unfortunately, here is where things get tricky. If we are heading toward a long-term debt deflationary cycle, then pensions are better off de-risking and shifting more assets into bonds, even at historic low interest rates, and focus more on generating alpha internally or through external managers.

However, if we are on the precipice of major inflation, then pensions should reduce their allocation to bonds, pile into risk assets, including inflation-sensitive assets, and allow the rise in bond yields to 'fix' their funded status gradually over time.

I can make the case for both deflation and stagflation. I am more worried about deflation because we just entered a period of massive deleveraging/austerity which will mute growth in the developed world. Having said this, bankers and policymakers will do whatever it takes to fight debt deflation, injecting trillions into the global financial system. All that liquidity will find its way somewhere and will eventually stoke inflationary expectations, but in a low growth environment (stagflation).

Add to this all the trillions invested in hedge funds and you get a great environment for traders to keep trading and profiting from the volatility in markets. This, in a nutshell, is what I foresee for the decade ahead. This will prove to be an extremely challenging environment for pensions and all long-term investors.

Below, Fredrik Nerbrand, global head of asset allocation at HSBC Holdings Plc, talks about investment strategy, adding risk, and the potential impact of higher oil prices on the global economy. He speaks with Owen Thomas on Bloomberg Television's "On the Move."

Monday, January 30, 2012

Greek-German Wrangling Just Pointless Fury?

James G. Neuger and Jonathan Stearns of Bloomberg report, EU Nears Confrontation Over Greek Rescue:

European governments moved toward a confrontation over a second rescue package for Greece, just as a dimming fiscal outlook in Portugal opened a new front in the debt crisis.

Euro leaders left a Brussels summit late yesterday with no accord over how to plug Greece’s widening budget hole and German Chancellor Angela Merkel voicing frustration with the Athens government’s failure to carry out an economic makeover.

“Greece’s debt sustainability is especially bad,” Merkel told reporters. “You have to find a way through more action by the Greek government, more contributions by private creditors, for example, in order to close this gap.”

Bargaining with Greece over a debt writedown and its economic management overshadowed efforts to point the way out of the financial crisis. EU chiefs agreed to speed the setup of a full-time 500 billion-euro ($654 billion) rescue fund and signed off on a German-inspired deficit-control treaty.

The summit was the 16th in the two years since the Greek debt emergency provoked a Europe-wide drama, leading to unprecedented aid packages for Greece, Ireland and Portugal and shattering European faith that the common currency was indestructible.

After the gathering of European leaders, EU President Herman Van Rompuy convened a smaller group, including Greek Prime Minister Lucas Papademos and European Central Bank Executive Board member Joerg Asmussen, to weigh the next steps on Greece.

‘On Track’

Van Rompuy spoke of the need “to put the current program back on track” and said finance ministers will try to hammer out the follow-up plan -- in the works since July -- by the end of the week. Greece is counting on aid to meet a 14.5 billion- euro bond payment on March 20 to escape default.

Merkel’s comments indicated that governments are loath to boost an October offer of 130 billion euros of loans in a second package, forcing investors to absorb net-present-value losses on Greek bonds that go beyond the 69 percent now on the table.

Speaking to reporters at 1:30 a.m. today, Papademos said “some difficulties” beset the debt-swap talks and hinted that donor governments may have to put up more money.

“The timeline is tight, but we are absolutely focused on the target of bringing the negotiations to a successful conclusion by the end of the week,” Papademos said.

Greek Feuds

In turn, Greece’s feuding political parties face pressure to deliver more savings and to verify in writing that the austerity program will be carried out, no matter who wins elections to replace Papademos’s interim Cabinet.

Germany’s proposal for an EU-appointed overseer of Greece’s budget prompted consternation in Athens and led to a rejection by other European governments that warned against stigmatizing Greece.

“Greece is a sovereign nation and must enact the promises it’s made,” said French President Nicolas Sarkozy. “Surveillance of Greece’s progress is normal, but there was never any question of putting Greece under guardianship.”

Investors were seized by fresh doubts about the economic health of Portugal. Concern that the EU would break a promise not to restructure Portugal’s debt pushed 10-year yields up by 2.17 percentage points to 17.39 percent yesterday as two-year yields surged to 21 percent, both euro-era records.

‘Sustainable’ Portugal

Portugal’s debt has been judged “perfectly sustainable” by the EU and International Monetary Fund, Prime Minister Pedro Passos Coelho said. Asked if there is a risk of writedowns on Portuguese bonds, he said: “No, there is not.”

The Greek standoff and Portugal’s tottering market punctured the start-of-year crisis respite that had been nourished by 489 billion euros in three-year loans infused by the ECB into the banking system.

ECB loans enabled most bond markets to withstand the impact of credit rating downgrades by Standard & Poor’s. Ten-year yields in Italy, with debt estimated at 120.5 percent of gross domestic product in 2011, last week dipped below 6 percent for the first time since Dec. 6.

While Italian yields went back up to 6.09 percent yesterday, the government stockpiled cash for the year’s biggest bond redemption by selling 7.5 billion euros of debt, close to its maximum target.

Leaders completed the fiscal-discipline treaty, which speeds sanctions on high-deficit states and requires euro countries to anchor balanced-budget rules in national law. Eight countries outside the euro backed the pact, which was shunned by Britain and the Czech Republic.

French Elections

One potential hiccup emerged when Sarkozy said that ratification in France will likely be delayed until after elections in April and May that polls show he will lose.

The front-runner, Socialist Francois Hollande, has vowed to renegotiate the treaty, saying it is biased toward austerity and would put an additional squeeze on the economy.

With an eye toward Ireland, Germany pushed through provisions that only countries ratifying the fiscal compact will be eligible for aid from the permanent bailout fund, the European Stability Mechanism, now set to go into operation on July 1, a year ahead of schedule.

The permanent fund requires governments to put collective action clauses into new bond issues as of January 2013, five months later than previously planned. The clauses are common in U.S. and U.K. law, enabling a debt restructuring to go ahead by a vote of a supermajority of bondholders, denying a veto right to solitary investors.

Bond Clauses

“Collective action clauses shall be included, as of 1 January 2013, in all new euro area government securities, with maturity above one year, in a way which ensures that their legal impact is identical,” according to a final text of the statutes obtained by Bloomberg News.

While the clauses would leave the door open for future restructurings, the fund’s statutes deem write-offs “exceptional” and subject to IMF standards, the text says. It tones down language on “private sector involvement” -- code for forcing bondholders to take losses on governments that fall too deeply into debt.

Leaders sidestepped mounting pressure to raise the ceiling on rescue lending from 500 billion euros once the permanent fund goes on line, sticking with plans to handle that question at the next summit on March 1-2.

Luxembourg Prime Minister Jean-Claude Juncker, Europe’s longest-serving leader and the head of the panel of euro finance ministers, summed up two years of crisis-fighting: “If I wasn’t optimistic you could have reported about my suicide months ago.”

I know exactly how Juncker feels and while I understand Germany's frustration with Greece, and the response from Athens, I agree with what Yannis Varoufakis wrote in his latest comment, it's all pointless fury:

So, some German politicians put on paper that which they have been thinking of a while: Greece has become an unbearable burden and, if they are to resign themselves to continue putting their money in that particular black hole, they might as well have a say in the way it is managed on the ground. Predictably, the leaking of this document gave Greek politicians, and the hapless Finance Minister in particular, a great opportunity to flex muscles, to recite their fury regarding Germany’s trampling on Greece’s national sovereignty, etc.

Poppycock, I say! On both sides. On the Greek side, what on earth did we expect? Once a country accepts the logic of massive loans on condition of austerity that deepen the country’s insolvency, thus demanding more loans, the moment will come when the international lenders will insist upon direct executive powers. In corporate language, this is known as receivership. Greek politicians that put their signatures on the dotted line of the various ‘bailout’ agreements are stretching credulity when protesting the loss of national sovereignty. The horses bolted months ago.

As for the German politicians, I am afraid that the judgment of history will not be kinder. They willfully piled gigantic new loans on an insolvent nation, on condition of austerity that shrinks the national income from which these loans (plus the preexisting ones) would have to be paid. And then, when Greece’s social economy shrivelled and died, they became incensed that the ‘reforms’ did not work, that the tax revenues shrank, that there are no buyers for the Greek state’s assets. My message to them is: you imposed an erroneous policy on Greece, and the rest of Europe’s periphery, and now you must bear the consequences.

For months now, through the pages of this blog (and elsewhere), I have been arguing that the tragedy of the Greek ‘bailouts’, indeed of the overall strategy for dealing with the euro crisis, has been a comedy of errors. Is it not time that our politicians (Greek and German) owned up to their serial idiocy? Has the time not come to stop the blaming game and the posturing?

On a final note, I have a message for Germany’s politicians: As a private Greek citizen, I understand your fatigue with all things Greek. But if you are so sure that your blueprint for stabilising Greece is so good (and that the problem is its implementation by the Greek authorities), I would welcome you to come to Athens to take over its implementation. But on one condition:

If you succeed in making austerity work in the middle of a debt-deflationary cycle, I am happy for you to name your price. E.g. if within a year or so Greek GDP starts growing again and unemployment diminishes to below 10%, you can have our electricity grid (that Siemens has always coveted), our water companies, any assets that you name in advance. But, if you fail, then you must pay a price: e.g. pay in full Greece’s outstanding loans to the troika.

So, how about it? Are you game?

As a Greek-Canadian who knows Greece and Greeks all too well, I think Germany needs to take a step back here. Importantly, Germany cannot change 60 years of corruption, public sector bureaucracy and huge tax evasion in 60 days by ramming more austerity down the throats of Greeks, most of whom had nothing to do with this crisis. It will backfire in a spectacular fashion.

Yes, we all know Greece hasn't done enough in terms of structural reforms. They have way too many public sector workers with way too much power, all threatening the government that if they go though with troika's demands, it will cost them the elections. That's the reality in Greece.

What else? Tax evasion is endemic and happens at all levels of Greek society. Business people, doctors, lawyers, accountants, pharmacists, and tax collectors -- the worst offenders -- are among the people found guilty of tax evasion. These tax evaders are getting away with murder. So are many others that are not part of this official list.

Publishing a list of shame is stupid! Go after these people and throw them in jail! And don't forget to go after ex-ministers -- many of whom 'discovered' new fortunes after serving in government.

I can write books on what is ailing the Greek economy but one thing is for sure, hard working Greeks are tired of being made to look like lazy asses by Germany and other Northern European countries who are frustrated by the slow progress of Greek structural reforms.

At the end of the day, you cannot reconcile austerity with growth. Germany has to listen to Soros and get on with a more permanent solution to the European debt crisis. We can have 100 EU summits, but it all boils down to what Soros is advocating, which is why he took Germany to task at the World Economic Forum.

I know many Germans will fight tooth and nail against fiscal union and eurobonds, but such reactions will only ensure a prolonged and nasty debt-deflationary spiral in Europe and likely bring the rest of the global economy down with it. This is something we can ill-afford, especially after the 2008 financial crisis.

Below, Max Keiser debates with another panelist on Press TV on what he thinks about the Greek debacle and who is to blame. Don't agree with everything Max says, but he is colorful, animated, and knows how to cut to the chase to expose the fraud and corruption in our global financial system. [Note to Max: Jamie Dimon is an American of Greek descent.]

"Eaten Alive" by Hedge Fund Fees?

A follow-up to my earlier comment on Bain or blessing discussing private equity. This time I'll focus on hedge funds. David Mildenberg of Bloomberg reports, Texas School Fund Weighs In-House Managers to Curb Fees:
Texas's Permanent School Fund may hire in-house money managers to oversee its $25 billion in assets because returns are being “eaten alive” by hedge-fund fees, according to Chief Investment Officer Holland Timmins.

Returns were less than 1 percent for the 44 months through November on assets managed by the five companies that bundle multiple hedge funds into single investment vehicles, Timmins said Jan. 25 at a State Education Board meeting. After fees, the return was negative, he said.

“The sector that should have enhanced our funding for schools actually detracted from it,” Timmins said. “We had a positive return in the asset class, modestly, but it got eaten alive by the fees.”

Hedge-fund expenses have reached about $72.7 million since 2008, according to a document Timmins distributed among board members. The reserve backs school-district debt and distributes $1 billion annually to support public education in the second- biggest U.S. state by population. The board voted 13-0 today to draw up a detailed plan for making the change, said Tom Ratliff, a member of the board’s investment committee.

Driven by Competition

“Big-brand hedge funds have been able to maintain their fee levels, but other funds have had to react to the marketplace and make adjustments,” said Brian Bruce, a former finance instructor at Southern Methodist University who previously worked for PanAgora Asset Management Inc. in Boston. “But that’s been more driven by competition rather than people saying these fees are too high.”

The Standard & Poor’s 500 Index of equities gained 2.3 percent including reinvested dividends from March 31, 2008, through November 30, 2011. The reserve’s hedge funds had a gain of 0.75 percent through that month, according to Timmins.

Timmins proposed hiring one of the current investment managers to advise on allocating assets to hedge funds, while one or more of the poorly performing companies would be dropped. The adviser would be picked from among the five firms, according to Patricia Hardy, the head of the board’s finance committee.

Picking the adviser from among the current providers would save time, as they are familiar to the board and know the reserve’s investment goals, board members said.

Fee Estimate

About 68 percent of the reserve’s costs, or about $34 million a year, is tied to absolute-return and private-equity investments that hold just 16 percent of its assets, Timmins said at a July meeting. Absolute-return fees are projected to be $114.7 million from 2012 to 2016 under the current system, excluding private-equity investment costs, he said.

The fund had $2.42 billion in hedge-fund assets as of Aug. 31, 2010, according to its annual report.

The proposed arrangement would deliver the same strategic advice provided by outside companies at a lower cost, said Ratliff. “They will still be making plenty of money,” he said of the hedge fund companies.

The Legislature last year added $18 million annually to the fund for new employees to manage assets and cut costs, Ratliff said. The board hasn’t acted in deference to Texas Education Agency Commissioner Robert Scott, who is hiring a deputy commissioner to focus on the fund, he said.

Five Companies

The five companies that oversee the reserve’s hedge-fund investments are K2 Advisors LLC, Grosvenor Capital Management Holdings LLP, Mesirow Advanced Strategies Inc., Blackstone Alternative Asset Management and GAM Holding AG (GAM), according to documents distributed in July. The fund dismissed Goldman Sachs Group Inc. (GS) last year, citing performance issues.

Timmins didn’t say how many new employees would be hired if his proposal is set in motion. In July, he estimated about 30 would be added.

Christine Anderson, a Blackstone Group LP (BX) spokeswoman, and William Douglass III, a K2 co-founder, didn’t immediately respond to telephone calls seeking comment on the proposal. Bill Blase, a spokesman for GAM, declined to comment. Officials of Mesirow and Grosvenor didn’t immediately respond to telephone calls or e-mails.

I think this fund and a lot of other pension funds are waking up to the reality that they're getting "eaten alive" by hedge fund and private equity fees. They're also probably asking themselves where are the customers' yachts?

Does it make sense to hire in-house managers? HELL YES!!! Why pay $72 million in fees for mediocre results from funds that can't even deliver beta? At a fraction of the cost, you can hire some excellent portfolio managers who know how deliver alpha. Just make sure you pay these people properly, especially US pension funds which are notoriously cheap on compensation.

I have an even better idea for Mr. Timmins, contact me (LKolivakis@gmail.com) and I will give you all sorts of ideas on rethinking your hedge fund strategy, including seeding some excellent Canadian hedge fund managers in commodity relative value strategies, global macro, CTA and L/S Equity. All liquid, all alpha, no egos, no bullshit, just the way I like it. And these are all great managers who deliver results and can be used as an extension of your investment team.

I am tired of seeing pension funds waste millions in fees to under-performing hedge funds or worse still, fund of funds. For Pete's sake, stop wasting your money on hedge fund hype. The entire industry has grown way out of proportion and just like private equity, most hedge fund managers are mediocre. In fact, as a group, hedge fund performance is ‘shockingly bad':

We often hear that hedge funds are run by the best and the brightest. Their strategies tend to give them ultimate flexibility and of course the highest fees. And most marketing materials claim they can offer investors absolute returns, with lower levels of risk than the market.

Unfortunately for many investors this is simply not the case. I don't want to overgeneralise because there are many excellent hedge funds with great records but as a group they really have not delivered the goods. In fact their performance has been shockingly bad. Here are the findings of some of my research:

1) In Simon Lack's recently released book titled The Hedge Fund Mirage: Illusion of Big Money and Why It's Too Good to Be True, Lack mentions that hedge funds lost enough money in 2008 to cancel out the entirety of the profits they made in the prior ten years. Many will point out that mutual funds have underperformed as well but I would suggest many people are less upset paying 0.75 percent to 1.75 percent in fees than paying two percent plus 20 percent of returns to have the privilege of losing money.

According to Lack, “If all the money that's ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good.” In analysing funds from 1998 through 2010, Lack adjusted the HFRX Index (an index that tracks hedge funds) by factors such as the “survivor bias” (only surviving hedge funds report returns), and found that fees were $324 billion while real investor's profits equate to a loss of $308 billion.

2) In another study published by the Journal of Financial Economics in 2011 titled “Higher risks, lower returns: What hedge fund investors really earn” researchers compared actual investor returns in hedge funds versus buy-and-hold strategies using dollar-weighted returns (which is just a fancy way of estimating how the actual money people had invested in the strategy performed).

Their “main finding is that annualised dollar-weighted returns are on the magnitude of 3 percent to 7 percent lower than corresponding buy-and-hold fund returns.”

In fact they suggest “the real alpha of hedge fund investors is close to zero” and that in absolute terms the “dollar-weighted returns are reliably lower than the returns on the S&P 500 index, and are only marginally higher than risk-free rates as of the end of 2008.”

3) On the whole Funds of Hedge Funds (FoHFs) have also not been very effective in adding much value according to the 2011 study titled “Assessing the Performance of Funds of Hedge Funds”. The authors suggest that “the vast majority of FoHFs do not exhibit alpha.

Furthermore, “only a small fraction of FoHFs deliver alpha per se, i.e. above the one already delivered by the universe of single-manager hedge funds. This means that the additional layer of fees that FoHFs charge eats away any manager added value”. The key here is fees. Jack Bogle, the founder of Vanguard, once said: “Performance comes and goes, but costs roll on forever”.

4) Speaking of Vanguard, a white paper written in 2010 called “Alternative Investments Versus Indexing: An Evaluation of Hedge Fund Performance” concluded that they were unable to “find merit in the argument that hedge funds provide diversification as an alternative asset class. The average returns for hedge funds have been highly correlated with those of long-only indexes. While it is true that hedge funds have been capable of insulating their investors from the worst declines in the broad stocks market, they missed the upturn in the broad market as well.” They also addressed why they felt investors have flocked to this segment and suggest it's simply “irrational exuberance”, the hope while others might have failed, they could consistently pick winners.

5) A Global Asset Allocation note by the research firm BCA titled “Do Hedge Funds Diversify Risk?” on November 30, 2011 suggests that diversification benefits of hedge funds are overstated. Their increasing correlation with the market and each other shows no sign of abating. Style selection is becoming less important.

They also conclude that “As an industry, hedge funds have not met their original objective. Positive returns have not been generated in both bull and bear markets.”

It may be that 2012 is the year hedge funds return to strong performance and outperform. If not, it's likely we will see widespread redemptions from the industry when the opportunity arises. In my opinion the comparison between alternatives and traditional asset allocation is very simple.

Traditional balanced asset allocation has provided diversification, superior performance, liquidity and much cheaper fees, yet investors continue to shun the traditional approach. (See Chart 1/Source: Bloomberg/Anchor Investment).

In 2000 the hedge fund industry was quite small with some $200 billion in assets. It subsequently climbed to around $2 trillion under management by early 2008. In the last two years portfolio allocations to alternatives has jumped from 7 to 17 percent (BCA Research/Scorpio Partnership).

Alternatives have underperformed, tend to be much more correlated to other asset classes than advertised, have limited liquidity, and charge much higher fees, so why do investors continue to pile into such investment vehicles? It is concerning to see an increasing allocation to what one many consider to be an inferior and more expensive product compared to a superior less expensive product.

This is all stuff I know because I invested in hedge funds and can tell you from experience, most hedge funds and funds of funds are full of shit, all hype to gather assets. They couldn't pay me to invest in them (some have tried).

And yes there are excellent hedge funds. In a punishing year, the biggest one thrived. But be careful, don't get too impressed by press coverage on Bridgewater's excellent returns and keep asking them very tough questions (like what is up with cameras following your employees' every move?!? Radical transparency? Sounds more like a paranoid police state!).

I get nervous when I see hedge funds all over the media. I prefer the guys who keep their heads down and deliver alpha. I am very impressed with Ken Griffin and Citadel whose flagships recently cleared their high-water marks, allowing them to start collecting performance fees after getting clobbered in 2008. Coming back strongly from a significant loss tells me a lot about a hedge fund.

Bottom line: If you're forking over huge fees, make sure you're paying for true alpha which you can't replicate internally and don't be a sucker, falling prey to hedge fund hype. I can rip apart any hedge fund and private equity fund (have done it plenty of times). And above and beyond doling out fees, make sure you get knowledge transfer and use your external managers as an extension of your investment staff. Never underestimate the importance of knowledge transfer.

Below, Troy Gayeski, senior portfolio manager at SkyBridge Capital LLC, discusses liquidity conditions for hedge funds and high-yield bonds, and efforts by the U.S. government to boost the housing market. He speaks with Scarlet Fu and Stephanie Ruhle on Bloomberg Television's "InsideTrack."

Future of Pension Profits: Bain or Blessing?

The Economist reports, Bain or blessing?:

If Steve Scharzman thought it was valid in 2010 to compare Barack Obama’s “war” against business to Hitler’s invasion of Poland, what can he be thinking now? Private-equity executives must be hoping the boss of Blackstone will keep his opinions to himself. More bad publicity is the last thing the industry needs. Other Republican presidential candidates are competing to see who can say the most damning thing about Mitt Romney’s career at Bain Capital. Newt Gingrich’s supporters have even made a sort of horror movie about what happens when private-equity firms like Bain Capital get their hands on otherwise healthy companies.

The buy-out bit of the industry, which buys mature companies, fixes them up and sells them on, is the one on trial (few have a bad word for venture capital, which invests in start-ups). It is charged with destroying the jobs of ordinary people while enriching the likes of Mr Romney.

But private equity isn’t employment’s grim reaper. Buy-out firms usually set their sights on companies that they can improve, which means they may buy weaker or more bloated ones in the first place. A recent NBER working paper looked at employment after 3,200 leveraged buy-outs in America. It found that private-equity ownership resulted in both more rapid job destruction and faster job creation than other forms of ownership. Two years after a buy-out, employment declines by 3% on average; if acquisitions, divestitures and new sites are included the losses are only 1% of initial employment. Other research has found that wages do not rise as quickly at private-equity-owned firms, probably because buy-out firms try to control costs after a takeover. But wages also don’t plummet, which may be why unions that used to oppose buy-outs have moderated their criticisms.

In any case, it is not the mission of buy-out firms to create jobs. Their mandate is to produce higher risk-adjusted returns, and this is where private-equity firms should be judged more harshly. The industry has long boasted about its earth-shattering performance. Investors, and public-pension funds in particular, have piled into the asset class. But the bulk of investors’ capital has gone into funds that were raised when asset prices were at peak levels (see chart 1). Although fears of a bloodbath among bubble-era buy-outs have not yet been realised, returns for most of these funds are going to be middling at best.

Nor is there conclusive evidence that private equity consistently outperforms public companies, although certain high-performing firms undoubtedly do. A recent attempt to analyse private-equity performance, by Robert Harris of the University of Virginia’s Darden School, Tim Jenkinson of Oxford University’s Saïd Business School and Steven Kaplan of the University of Chicago’s Booth School of Business, concludes that it is “very likely” that private equity outperforms the S&P 500 (after fees). But the outcome looks different depending on which database is used. These vary wildly (see chart 2), and none has returns for all funds. The study emphasises a new data set, which could make things look rosier because the worst-performing funds may not be sufficiently represented.

The bigger issue

There is also a question about how private-equity firms calculate their returns. The internal rate of return (IRR) is the usual measure. But according to a 2010 study by Peter Morris, a former banker, entitled “Private Equity, Public Loss?”, it is rare for two firms to calculate IRR in the same way. This can complicate any attempt to compare funds. IRRs can also overstate the actual returns investors realised, according to Ludovic Phalippou at Amsterdam Business School, since the measure implies that the return was achieved on all the investor’s cash, even if some of it was given back early and reinvested at a lower rate.

The S&P 500 may not even be a fair benchmark for private-equity firms, says Mr Phalippou, since most buy-out firms purchase midsized companies, which have performed better than the big firms included in the S&P 500. An index of mid-cap stocks could offer a more accurate comparison, but also a higher hurdle for private-equity firms to jump.

Why would investors put money with private-equity managers who aren’t that good? It could be that investors herd mindlessly into asset classes. But some of it may also reflect the way the industry manipulates data. “Every private-equity firm you talk to is first-quartile,” quips Gordon Fyfe, the boss of PSP Investments, a C$58 billion ($58 billion) Canadian pension fund.

Oliver Gottschalg of HEC School of Management in Paris looked at 500 funds, and 66% of them could claim to be in the top quartile depending on what “vintage year” they said their fund was. The vintage year is supposed to be when the fund has its final “close” and stops fund-raising. But some firms may decide to use the year they started raising the fund or had their first “soft” close (when a fund is no longer officially open to new money), if it allows them a more favourable benchmark.

If investors can work out a way to place their money with funds that are actually in the top quartile, it is probably worth the fees and the extra risk of investing in this illiquid, leveraged asset class. But that is a big if. David Swensen, the man who runs Yale’s $19.4 billion endowment and a noted proponent of alternative investments, has written that “in the absence of truly superior fund-selection skills (or extraordinary luck), investors should stay far, far away from private-equity investments.”

Abuzz about fees

Buy-out executives have always claimed their interests are perfectly aligned with those of their investors, since they can only eat if their investors do. But that has changed as private-equity firms have morphed from small outfits into behemoths managing billions of dollars. Private-equity firms usually charge a 2% annual fee to manage investors’ capital and then take 20% of the profits. Big firms can now support themselves just from management fees. A study by Andrew Metrick at Yale School of Management and Ayako Yasuda at the University of California, Davis finds that private-equity firms now get around two-thirds of their revenues from fixed fees, regardless of performance.

If all that wasn’t bad enough for investors, the prospects for future returns look dim. Higher debt has accounted for as much as 50% of private equity’s returns in the past, according to a 2011 study co-written by Viral Acharya of New York University’s Stern School of Business. But banks are not lending as much as they did five years ago, increasing the amount of equity that firms are having to stump up (see chart 3). That will cap returns. “Employees are going to make less money, and firms are going to make less money. Returns are going to be much more mundane,” is the gloomy prediction of the boss of one of the largest private-equity firms.

Prices have also remained painfully high. Last year the average purchase-price multiple for firms bought by private equity was 8.4 times earnings before interest, tax, depreciation and amortisation, higher than it was in 2006. That’s because the industry is sitting on $370 billion in unused funds, or “dry powder”, that firms need to spend soon or risk giving back to investors, which means there is fierce competition for deals. Many transactions are between private-equity firms, which does little good to investors who have placed money with both the seller and the buyer.

With the option of financial engineering basically gone, private-equity firms have no choice but to improve the businesses they buy. Every private-equity firm boasts about its “operational” skills but sceptics question whether private-equity executives are that good at running companies. A senior adviser at a big buy-out firm and former boss of a company that was bought by private equity says he disagrees that buy-out executives are good managers of businesses: “They’re even less in touch with the real world than public-company managers. They’re a group of very clever, very analytical people paid lots of money whose general feel for the businesses is pretty poor.” Their edge, he says, comes from having a fixed investment term, which helps focus managers’ minds.

With the landscape bleaker than it was, many private-equity firms are reinventing themselves. Most buy-out firms now prefer the fluffy title of “alternative asset manager”. They have started to do more “growth equity” deals, taking minority stakes in companies and using less debt. This has been their strategy in emerging markets like China, where control and highly leveraged deals are not as welcome, but now the approach is also increasingly being used in the West. Big American firms like KKR, Carlyle and Blackstone have all expanded or started other units focused on things like property, hedge funds and distressed debt.

Many private-equity firms will quietly fade away, although Boston Consulting Group’s infamous prediction in 2008 that 20-40% of the 100 largest buy-out firms would go extinct has not yet come true. That is probably because private-equity firms take a long time to die. There are 827 buy-out firms globally, according to Preqin, a research firm. They will not all be able to raise another fund. European private-equity firms are particularly vulnerable because they have not diversified as much as their American competitors.

But Mr Romney’s candidacy will ensure that American firms feel more political heat. Executives’ special tax treatment, under which their profits are taxed as capital gains rather than income, will almost certainly go. The limelight has not yet scared off the 236 buy-out funds that are in the market trying to raise another $172 billion. But it is not as much fun as it was. “Back in 2005 fund-raising was like having a velvet carpet with a rope,” says one buy-out boss. “You had a bouncer and only let the prettiest people in. Now it’s buy one, get one free, and free entrance before 11.”

I've already commented on private equity's public subsidy, as well as its changing landscape, but the article above is excellent and should be read by every single institutional investor.

And Gordon Fyfe, President and CEO of PSP Investments, is right when he says all private equity funds claim to be top quartile but the reality is very few funds consistently deliver top quartile performance. Moreover, even the best funds have flopped in the past (TPG), so each fund and follow-on fund must be evaluated carefully. David Swensen isn't kidding when he says most investors should stay away from private equity.

But institutional investors are piling into private equity and hedge funds, getting raked on fees. Smart pension funds prefer going direct in private equity. Below, listen to Jim Leech, President and CEO at the Ontario Teachers' Pension Plan discuss private equity with CNBC's David Faber and Andrew Ross Sorkin.

Good interviews except I caution investors, take things Jim Leech says with a grain of salt. First, Teachers' has been successful in private equity because Claude Lamoureux, the former CEO, got in that asset class early, way before everyone else. Second, past performance in private equity is not indicative of future performance. Third, while Teachers' does do a lot of direct investments, it's mostly co-investments, not "head-to-head" competition with PE funds which Jim claims. Fourth, just like other pension funds, Teachers' does not report the returns of the fund investments separately from those of their direct investments, so we can't really gauge how good their direct team is relative to PE funds.

If they really are "just as good as PE funds", they too would be charging 2 & 20, becoming stinking rich. Not that Teachers' doesn't pay them well. Their senior managers were the first to profit from bogus benchmarks in private equity and made a killing in the process, a point which irritated Claude Lamoureux when I pointed it out to parliamentarians at pension hearings in Ottawa (truth always stings, especially when it comes to pension compensation).

Having said this, I like what Jim Leech says about staying put in terms of private equity allocation, stating they are "comfortable where they are" (roughly 11%). And he's right, if you can hire the right people and pay them properly, direct investing and co-investing are the way to go because you cut outrageous fees and develop talent internally. Also, listen carefully to his comments on using a realistic discount rate in valuating liabilities and on compensation at Wall Street "creeping up".