Category: pension funds

How Will Japan’s Largest Pension Fund Find Room To Maneuver?

The WSJ is out with a short piece about new rumblings coming from Japan’s $1.43T public pension fund, Japan’s Public Pension Weighs New Investments. If I may be so bold as to impersonate the Japan deflation-blogger Mish for a moment, let’s take a look at a few of the dynamics at play as reported by the WSJ. I’ll provide some commentary along the way:

Japan’s public pension fund—the world’s largest with assets totaling 123 trillion yen ($1.43 trillion)—is weighing the controversial idea of investing in emerging-market economies as a way to gain higher returns as it faces a tsunami of payout obligations over the next several years.

The conservative Government Pension Investment Fund, which alone is larger than India’s economy, has a staggering 67.5% of its assets tied up in low-yielding domestic bonds. The fund plans to sell off a record four trillion yen in assets by the end of March 2011 to free up funds for payouts to Japan’s rapidly aging population. By the year 2055, 40% of Japan’s population is expected to be over the age of 65.

There’s a lot to discuss but before I do I want to clarify an error I believe the journalists who wrote this piece made.

The comparison between the size of the GPIF and the size of India’s “economy” is not a meaningful one because the GPIF is a “stock” while the aspect of India’s economy being referred to, GDP, is a “flow”. At $1.235T (2009 estimate, Wiki), India’s GDP is supposed to measure the total monetary value of output of all goods and services for a particular period of time, in this case one year. Meanwhile, GPIF’s asset base is a static measurement of current asset valuation. I’ll avoid the bath tub analogy and instead refer to public company financial accounting: GPIF’s asset size is like examining an entry on the asset side of a company’s balance sheet; India’s economic “size” is like examining an income statement for the revenue or earnings generated in the period in question.

One other minor quibble– the “2055” statistic is completely irrelevant to telling this story because the GPIF is not going to last that long, at least not in its present form and at its current levels of funding.

With the fur out of the way, let’s dig into the flesh of the matter. First things first: the GPIF is another Ponzi-finance scheme, much like the US Social Security Administration system. I think Takahiro Mitani, president of the GPIF, explained the predicament all Ponzi-finance schemes eventually find themselves in best in this recent WSJ interview:

Mr. Mitani: Baby boomers are now 60 years old or older, and have started receiving pension. In the meantime, the number of people who pay a pension premium is smaller. What’s more, pension premium is determined by wage, which has been on decline. So, pension special account overseen by the health ministry is having a tough time.… More outlay than income in the pension system means that they need to tap into the reserve we have. [emphasis added]

Long-term, the GPIF and SSA will always be running up against a potential demographic problem like this, where the amount promised to past generations of present retirees is greater than the amount being contributed by present workers. Therefore, there will come a time in every Ponzi-pension fund’s life during which the managers of the fund will be forced to go out on the risk curve in a search for yield. And as luck would have it — or rather, as generations of inflationary central planning schemes would have it — the very time these demographic trends reach an apex, so, too, do long-running financial trends on which the fund’s internal rate of return projections have been built. In other words, the perfect financial storm, a “liquidity event” of colossal proportions, metaphorically and literally-speaking.

Unfortunately for Mr. Mitani and his loyal horde of investment management professionals (you did know that scams like the GPIF also serve as lucrative government-sponsored subsidies to investment banks like BlackRock, Morgan Stanley and State Street, Mitsubishi UFJ Financial Group and Mizhuo Financial Group, didn’t you?) there’s more than just wind and noise coming out of those storm clouds in the form of macro demographic and economic trends, though they are all related in a way. Another problem facing the GPIF is political and is tied up in the composition of the GPIF’s portfolio:

The GPIF holds the lion’s share of its assets in low-yielding Japanese government bonds. (The yield on the 10-year JGB is currently a paltry 1.07%.) Roughly 67.5% of its assets are parked in domestic bonds, including government and corporate bonds; the rest are spread among Japanese stocks, overseas shares and foreign bonds.

The GPIF is a Ponzi, wrapped in a Ponzi, inside an enigma. If you take a look at the investment results for the first quarter of fiscal 2010[PDF] provided by the GPIF, you’ll see that the “domestic bonds” portion is split roughly 76% into “market investments” (JGBs of varying maturities) and the remaining 24% into “FILP bonds”.

FILP bonds, issued by the Japanese Ministry of Finance’s Fiscal Investment Loan Program, are similar to agency debt and municipal/public works bonds floated by US state and federal government agencies (think FRE/FNM, FHLB, New York MTA bonds, DOT/highway bonds, public school and university bonds, etc.). According to the Japanese MoF’s own online resource page, which I encourage you to click and skim-read in its entirety for yourself, FILP bonds can be issued to fund nearly anything the Japanese government might deem worthy of funding, including “housing construction, small and medium-sized businesses, roads, railways and subways, airports, water and sewerage [sic], education, medical care and social welfare, agriculture, forestry and fisheries, industry and technological development, regional development” and let’s not forget “international cooperation.”

Like I said, nearly anything. And with Japan’s bubble-fueled reputation for being a corrupt, greasy-handed place to get business done, you can bet that at least one of almost everything in Japan’s economy (and other countries’ economies!) has been funded exactly this way. The FILP is like a giant government-sponsored slush fund for amakudari, Japan’s version of the “golden parachute” for its fascistic, entitled union bosses-cum-career public servants[PDF].

Back to the Ponzi within a Ponzi. One reason that Japan’s central government has been able to issue so much debt ($10.55T and rising as of the end of June) without blowing yields sky-high is due to the phenomenon of captive finance, an ugly cousin of vendor financing, of which government managed pension funds like GPIF are a facilitator. It works like this: the Japanese government issues debt, the Japanese worker is forced to contribute to a government pension fund such as GPIF, and the GPIF buys the Japanese government’s debt because it’s “safe”. Hopefully you can see it now. The Japanese government must keep rolling over debt into new debt just to stay afloat which is purchased by the GPIF, while the GPIF must keep milking workers to pay off the retirees. Ponzi within a Ponzi.

Something’s gotta give. But there’s the rub– it can’t. According to the WSJ article, 67.5% of GPIF’s funds are committed to JGBs and FILP bonds (the allocation as of the Q1 investment results[PDF] linked to above was 68.14%) with the remaining portion divided up approximately 9% international stocks, 8% international bonds and 11% domestic stocks. It can’t easily touch that 67.5% allocation without experiencing stern consternation from Japanese politicians who see their Ponzi-scheme unravelling before their very eyes.

That means the search for yield will have to come from elsewhere in the portfolio, and anywhere else it might come from means potential pain for the supplier. Think the Nikkei can’t go lower? Think the US Treasury has enough problems? Think the S&P 500 has been beat up enough already? Think again. Meanwhile, wherever the GPIF potentially re-places the funds could see a nice little second-wind. Good-bye SPY, hello EWZ!

I’m being facetious but hopefully my point is clear. Of course, where government is concerned, “can’t” doesn’t always mean “won’t”:

Regarding its four-trillion-yen selloff this year, Mr. Mitani said: “We won’t only target [selling] domestic bonds. It could be [Japanese] stocks or foreign-currency-denominated securities or stocks,” depending on market conditions.

At the end of the day, Japanese politicians can kick and scream but the GPIF has to meet its liquidity needs and one way to do that is to suck it up and kick some JGBs and FILPs out the door. Again, this is a problem and it will be chronic until it is terminal. Pay attention those of you long JGBs.

John Vail, chief global strategist at Nikko Asset Management, echoed that sentiment. “They need to take on more risk. As a long-term investment, equities will nearly always outperform JGBs,” he said “Global equities are a wise investment for the GPIF—especially with equities being so inexpensive.”

Mr. Mitani said he is aware of such opinions, but his mandate is to invest in “safe” assets with a long-term view. “In 2008 after the collapse of Lehman, while we posted a negative result we were relatively better than overseas pension funds thanks to our conservative, cautious stance. We posted only single-digit [percentage] loss while others posted double-digit loss,” he says.

In the U.S., the California Public Employees’ Retirement System, known as Calpers, is the nation’s largest with assets of $200 billion. Calpers reported a 23% slump in the year ended June 30, 2009, marking its worst year ever. Some of the biggest hits were from private or alternative investments such as real estate. Calpers has since begun pulling back on such exposure. In comparison, the GPIF reported only a 7.6% slump in the fiscal year ended March 31, 2009.

That list bit about comparative slumps should clue you in as to where the GPIF is going to want to go to first when it comes to meeting liquidity needs. Why sell volatile equity securities and potentially lock-in another loss when you can sell some ultra low-yield JGBs and FILPs, perhaps even turning that ROI-frown, upside-down in the process?

A special thanks, by the way, to John Vail of Nikko Asset Management, for providing some much-needed “useful idiot” stock-jobber equity permabull nonsense encouraging the GPIF to go out on the risk curve a bit more. Over the long-term, equities will “nearly-always” outperform JGBs… except for the past 30 years (image pulled from Mish):

Dang, looks like the long-term can be very long, indeed.

Meanwhile, Mr. Mitani seems fairly confident that the Ponzi-scheme will be kept up a bit longer:

Mr. Mitani expects the 10-year JGB yield to mostly stay below 1.5% for the next two to three years, though it may break above that point temporarily. He added that he isn’t too concerned about the risk that JGB prices will plunge due to fears about increasing JGB supply, creating a Greek-style fiscal crisis.

“If financial firms keep receiving ample funds from [the Bank of Japan], if companies remain reluctant to borrow, and if individuals keep savings at banks, there’s no choice but to purchase government bonds,” Mr. Mitani said.

Maybe. Hayman Capital Advisors’ Kyle Bass doesn’t seem to think so. Either way, it’s not a popularity contest. Just keep in mind that that’s a lot of “Ifs”. The other thing to remember is that the GPIF may be the biggest fund facing this kind of problem, but it is far from being the only one, in Japan and around the world. As discussed above with the Ponzi within the Ponzi, there are a lot of moving pieces in these deadly contraptions and this type of intertwined financial structure has been rigged, Rube Goldberg-style (you’re going to have to click the link and watch the 2min vid to the end to see just how ironic a choice it was given the subject matter at hand), across the world’s pension and financial systems as well as governments.

I know not when it will end, but I do know this– when these things end, they don’t end well.

Pension plan chickens outsource services to big bank foxes

The LA Times wrote this in late October but I thought it was pertinent based on recent fireworks at Citigroup. Past outsourcing trends were relegated to more mundane services yet it seems a firm in London is willing to hire the responsible people at Citigroup, with the Fed’s blessing, for all money management services regarding their existing pension plan.

Citigroup Inc. got the green light from the Federal Reserve for an unusual deal to take over the $400-million retirement plan of a British newspaper company. In exchange for getting its hands on all that cash, Citigroup will run the pension plan — investing the money, paying the benefits and taking on the liability previously borne by Thomson Regional Newspapers.

Do you think the supporters of this decision may want to reconsider?

Advocates say such changes would be a win-win for retirees and employers, retaining all the protections of current law, while putting plans in the hands of sophisticated financial stewards. Plus, large banks are less likely to go out of business or face severe financial strains than smaller employers.

My comments: Why would the Fed approve of such a move, especially when Citigroup can’t even reveal their true assets and liabilities to existing shareholders? And why are pensions handing the car keys to a gang that deserves a starring role in Grand Theft Auto?

Private equity boom over, yet funds still raise money

Yesterday’s Bloomberg article, “Buyout Funds Face Elusive Returns as Debt Costs Rise,” covered the declining state of the private equity market.

Not unlike real estate speculators of 2 years ago, it looks like private equity funds are holding over-priced merchandise financed by cheap credit during the boom:

Buyout firms relied on cheap debt in the past two years to finance the biggest deals of all time, often paying premiums of more than 30 percent for companies. Now, as the subprime mortgage meltdown rattles credit markets, firms will have to sell their companies to buyers who no longer have access to low-cost loans. That will cut the sale prices of the companies and slash the buyout funds’ returns, billionaire financier Wilbur Ross says.

“When it comes time to resell these investments, we’ll likely be in a very different rate environment,” says Ross, whose New York-based WL Ross & Co. focuses on distressed assets such as auto parts makers. “The implications for returns could be substantial.”

And quite a boom it was:

In 2005, buyout firms began to show a swagger rarely seen in the industry’s 30-year history. In the first half of this year, mega deals for TXU Corp., First Data Corp. and Equity Office Properties Trust — all topping $20 billion — were part of a record $616 billion in announced purchases. That’s just shy of 2006’s all-time-high total of $701.5 billion, data compiled by Bloomberg show.

Cheap credit fueled the frenzy. The extra interest that investors demanded to own high-yield, high-risk debt rather than U.S. Treasuries fell to 2.41 percentage points in June, the lowest on record. The rates enabled buyout firms, which use credit to finance about two-thirds of a company’s purchase price, to ratchet up their bids.

Premiums for U.S. companies, or the percentage offered above the target’s stock price, soared to 39 percent in June compared with 23 percent a year earlier, Bloomberg data show. Gavin MacDonald, Morgan Stanley’s head of European mergers and acquisitions, said in April that a $100 billion leveraged buyout was possible.

The boom hit a brick wall in August:

By July, the appetite for deals, especially record-breaking ones, had evaporated. Investors, surprised by their level of exposure to the subprime debacle, saw greater risk in the approximately $330 billion of loans and bonds that banks had slated to fund LBOs. Investors balked at credit terms that allowed companies to pay off debt by issuing more bonds. Lenders had to rework or cancel at least 45 loan and bond offerings since the beginning of July, including debt to pay for Cerberus Capital Management LP’s acquisition of Auburn Hills, Michigan-based automaker Chrysler LLC.

Buyout firms and sellers are also renegotiating deals in order to get financing and keep them alive. On Aug. 26, Home Depot Inc., the world’s biggest home-improvement retailer, agreed to sell its construction supply unit to Bain Capital LLC, Clayton Dubilier & Rice and Carlyle Group for $8.5 billion. That’s 18 percent less than the price negotiated in June, Home Depot said in a statement today.

Many other deals aren’t getting done. The value of announced buyouts dropped to $18 billion from Aug. 1 to 26. That compares with $87.4 billion last month and $131.1 billion in June, Bloomberg data show.

Yet hope springs eternal:

The severity of the drop depends on whether the U.S. economy flags further, says Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College’s Tuck School of Business in Hanover, New Hampshire. Growth will slow to a pace of 2.6 percent in the second half of the year, according to a Bloomberg News survey of economists taken from Aug. 1 to 8.

Blaydon says that sluggish expansion, which crimps companies’ ability to pay back debt, may push down annual returns to as low as 10 percent in the next three years. “The question is how harsh it’s going to be,” says Blaydon, who examined returns during the economic slump in 2001 to produce his forecast.

Still, investors won’t flee private equity funds as long as they outperform the Standard & Poor’s 500 Index by several percentage points, says Warren Hellman, who co-founded Hellman & Friedman in 1984. The private equity investments by the California Public Employees’ Retirement System in 2001 returned 17 percent through the end of 2006, according to its Web site. The S&P 500 returned about 15 percent over that same period.

“Returns are relative,” Hellman says.

And money continues to pour in from investors longing for the outsized gains of the past:

Investors in Blackstone Group LP, whose shares fell 23 percent to $23.80 on Aug. 27 from its initial public offering in June, haven’t lost all of their faith in private equity. In August, the firm said it had raised $21.7 billion to establish the world’s biggest buyout fund.

My comments:

  1. This is nothing like the 2001-2002 speed bump for private equity. a) There was no mega-boom that preceded that downturn, save the tech bubble. b) Value-oriented stocks that buyout firms seek were actually depressed in 2000 because people unloaded their Old Economy furniture to own more tech. c) The 2002 “recession” was one of the mildest in history. d) The conditions – cheap valuations and ultra-cheap credit of 2001-2002 lit the fuse for the buyout boom of 2005-2007.
  2. With all the leverage the private equity shops employ, outperforming the S&P 500 by 2% during the greatest buyout boom in history is hardly impressive.
  3. Returns aren’t going to 10%; they’re going negative.
  4. Pension funds were snookered into “diversifying” into this new “alternative investments” asset class. What they’re stuck with is overpriced merchandise, levered to the gills, assembled by grossly overpaid managers, going into a brutal recession.
  5. Without the light of liquid public markets for these holdings, it will be interesting to see how long bagholders – er, shareholders – are left in the dark over pricing.

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