From a new SIEPR report on the grotesque pension underfunding problems at California's major plans, a chart comparing the stated and adjusted shortfalls at CalPERS, et al.

Source: Going For Broke: Reforming California’s Public Employee Pension Systems

Gotta love when a firm that advises others on investments gets sucked into the very top of a bubble, and loses $8 billion of its own money.  Article can be read here

An interesting article, drawing a parallel between the government's behavior toward the financial industry during the Great Depression, and today.

Press Release

Kapolei, Hawaii:  Six months ago, Island Pacific Academy was like many start-up independent schools. Even though it had enrolled 650 students PK-11 in four years of existence, it struggled to meet the debt service on a $20 million bond issue amidst rising costs and the stagnant enrollment of the current recession.  Today, the School has cash reserves and completed the purchase of its property. The debt remains, but the debt service is more manageable, given the school’s comparatively low tuition and enrollment.  How did they do it?

"Bond math 101", says Nick Prassas, financial advisor to the School.  “Two years ago, the School sold a bond issue at par, at a low fixed interest rate.  When the credit crisis hit, interest rates spiked higher.  Higher interest rates, lower bond prices.  The School was able to negotiate the repurchase of its bond issue from bond holders at a substantial discount.”

Of course, the School still needed a source of funds to buy back their discounted bonds.  That source:  federal stimulus dollars from the United States Department of Agriculture.

"We were at the right place at the right time," says Stuart Hirstein, Associate Headmaster and Chief Operating Officer.   “The USDA, which provides rural community facilities financing, became one of the conduits for disbursing federal stimulus funds. The agency, having guaranteed a loan for the School several years ago, was already familiar with our financial profile.  We made our request just as stimulus funds were being allocated.”

The USDA funds came in the form of a direct loan, and a loan guarantee.   The direct loan carries an interest rate of 4.5%, repayable over forty years, instead of the customary thirty.

"It sounds straightforward, now that we've closed the transaction," says Dan White, Headmaster of the School. "The USDA program is designed to support new community initiatives.  Fortunately, IPA had received a five-year grant from the Hawaii Community Foundation in their Schools of the Future program. The Schools of the Future process will, in fact, transform our school and represent a genuinely new initiative. Putting the deal together, though, required long hours and hard work by several knowledgeable people.”

The notion of a school capitalizing on the USDA stimulus program to buy back their own bonds at a discount, just one year after selling them, is novel.

“Obviously the recession provided fertile ground for thinking outside the norms of independent school finance,” added Prassas. “Everything we hear, though, about independent schools in the post-recession world would suggest that the old norms are not likely to return.”

“The schools of the future—15 to 20 years down the road—might well look very different than today.  Why wouldn’t school financing evolve in a similar fashion?” asked White.“We still need to make enrollment targets,” continued White. “The debt service is still a huge chunk each month.  We continue to be frugal; we have to be. But we have a huge asset—our land—that we did not have before, and there is great security for the school in that fact.”

A few years ago, a relative asked me to manage his money.  I have a rule against managing family money, for obvious reasons, but this relative was rather insistent.   His current advisor was retiring, and intended to hand off his account to an advisor new to the business (someone who, incidentally, had been a Big-O Tire salesman a year earlier).   

 I directed my relative to my website, and suggested that he read past Commentaries, so that he could make sure he was comfortable with my style and approach to the markets.  He felt that was unnecessary, since he was sure I would do a great job, and besides, the whole point of an advisor was never having to think about such stuff.  I explained that a little discussion now would head off potential misunderstandings in the future, and that I would not accept his account until he at least read a few of my Commentaries.

He wouldn’t do it.  He subsequently went with the tire salesman.

Lest my relative appear particularly foolish (a fact I’m not arguing against, either), this nature of interaction is not uncommon.  In the nine years I have run money professionally, in an industry overrun with consultants, experts and armchair quarterbacks, I’m not sure I have ever met a sophisticated investor, even among other professional managers.  Since I assume every adult approaches life with some degree of wariness, it is fascinating that Madoff targeted the financially sophisticated – advisors, hedge funds, and institutions.  It is said that fear and greed (and I might add, laziness) are stronger than long-term resolve, and it is almost reassuring that human nature never changes.  If I were a lesser man, I might be smirking right now.

Of course, now the pendulum has swung hard, and I’m reading articles on how you can’t trust anyone.  Resume isn’t enough.  Experience and references are not enough. Bill Miller, a lengendary manager, had his first losing year.  His prior eighteen years of outperformance has now been dismissed as just a lucky streak.

This is pretty dumb as well.  The biggest (financial) losers I know are people who never trust anyone, who see a con at every turn.  Ultimately, life must be lived in good faith, that the rules will ultimately apply.

 But the question remains:  how did Madoff get away with it?  By giving the customers what they want.  And on a certain level, it was a brilliant bit of marketing.

 The hardest part of managing other people’s money is often… the other people.  Investment returns are, by their nature, lumpy.  They do not come regularly, and safely, like interest payments from a bank account.  But it is axiomatic that most clients are long-term investors – as long as they make money every quarter.  In a bull market, there are comments that an index fund would have been just as good, and a lot cheaper; in a bear market, well, the manager should have been more conservative.  And it is not only the smaller investor; the larger sophisticated investor is often worse.  Consultants evaluate money managers on both returns and volatility:  smooth returns are good; volatile (real world) returns are bad.  Hedge funds generally report every month; however, some clients expect weekly updates, and Jim Cramer wrote that he once had investors calling several times a day.

 This is why many successful investment partnerships and hedge funds do not accept outside money.  They can no longer bear the headaches.

 But if a money manager is looking for outside money, we in the industry all know that a track record of smooth, consistent returns will bring clients beating down the door.  In fact, it has been expressly stated that the holy grail of performance is a steady one percent per month – which is exactly what Madoff delivered.  The clients knew better, without a doubt.  But they preferred to believe the lie.

 The case does bring forth two useful points worth noting:

1. Many of Madoff’s investors had no idea they were Madoff investors.  That’s because their money managers are not money managers.  They are salesman on commission, who charge a fee simply to place the money entirely with someone else.  In fact, the majority of money managers are actually just middlemen (the industry term is “asset gathers”).  This is not necessarily wrong, or bad.  But many “advisors” are vague in this disclosure, lest they lose stature in the eyes of their clients.  And you will be charged twice, and may not know exactly where your money is.
2. Custodians versus advisors.  This one really stumps me.  Any legitimate advisor uses a third-party fiduciary.  For example, I use T.D. Ameritrade.  I can make trades, and request withdrawal of my fee every quarter.  Otherwise, I cannot touch the money.  A client wishing a withdrawal must contact Ameritrade directly.  Ameritrade issues its own quarterly statements.  It protects the client and the advisor.  Any other arrangement, by definition, screams of potential fraud.  It just isn’t done.

We've apparently learned nothing from the residential mortgage disaster, since we're about to repeat the identical mistake in the auto industry.

Obama's Car Puzzle

by Holman W. Jenkins, Jr.

Wall Street Journal

You have in GM's Volt a perfect car of the Age of Obama — or at least the Honeymoon of Obama, before the reality principle kicks in.

Even as GM teeters toward bankruptcy and wheedles for billions in public aid, its forthcoming plug-in hybrid continues to absorb a big chunk of the company's product development budget. This is a car that, by GM's own admission, won't make money. It's a car that can't possibly provide a buyer with value commensurate with the resources and labor needed to build it. It's a car that will be unsalable without multiple handouts from government.

AP

The first subsidy has already been written into law, with a $7,500 tax handout for every buyer. Another subsidy is in the works, in the form of a mileage rating of 100 mpg — allowing GM to make and sell that many more low-mileage SUVs under the cockamamie "fleet average" mileage rules.

Even so, the Volt will still lose money for GM, which expects to price the car at up to $40,000.

We're talking about a headache of a car that will have to be recharged for six hours to give 40 miles of gasoline-free driving. What if you park on the street or in a public garage? Tough luck. The Volt also will have a small gas engine onboard to recharge the battery for trips of more than 40 miles. Don't believe press blather that it will get 50 mpg in this mode. Submarines and locomotives have operated on the same principle for a century. If it were so efficient in cars, they'd clog the roads by now. (That GM allows the 50 mpg myth to persist in the press, and even abets it, only testifies to the company's desperation.)

Hardly mentioned is the fact that gasoline goes bad after a few months. If the Volt is used as intended, for daily trips of 40 miles or less, the car's tank will have to be drained periodically and the gas disposed of.

The media have been terrible in explaining how the homegrown car companies landed in their present fix, when other U.S. manufacturers (Boeing, GE, Caterpillar) manage to survive and thrive in global competition. Critics beat up Detroit for building SUVs and pickups (which earn profits) and scrimping on fuel-sippers (which don't). They call for management's head (fine — but irrelevant).

These pre-mortems miss the point. Critics might more justifiably flay the Big Three for failing long ago to seek a showdown with the UAW to break its labor monopoly. In truth, though, politicians have repeatedly intervened to prevent the crisis that would finally settle matters.

The Carter administration rushed in with loan guarantees to keep Chrysler out of bankruptcy. The Reagan administration imposed quotas on Japanese imports to prop up GM. Both parties colluded in the fuel-economy loophole that allowed the passenger "truck" boom that kept Detroit's head above water during the '90s.

Barack Obama and Nancy Pelosi now want to bail out Detroit once more, while mandating that the Big Three build "green" cars. If consumers really wanted green cars, no mandate would be necessary. Washington here is just marching Detroit deeper into an unsustainable business model, requiring ever more interventions in the future.

The Detroit Three will not bounce back until they're free to buy labor in a competitive marketplace as their rivals do. In the meantime, private money, even in bankruptcy, almost certainly will not be available to refloat GM and colleagues. Nationalization, with or without a Chapter 11 filing, is probably inevitable — but still won't make them competitive.

History seldom affords such perfect analogies: In 1968, the Penn Central merger (a proxy for GM-Chrysler) was touted as a fix for a sagging rail business. In two years, the company was in bankruptcy. When a judge couldn't find new lenders, Washington absorbed them into government-owned Conrail, but the death spiral continued. Finally, Congress passed the deregulatory Staggers Act, which overnight gave the rail industry back its future. Conrail was triumphantly reprivatized in 1987.

We're about to replay this ordeal with the auto industry. Let's at least give ourselves a chance to be successful on the first try.

The simplest step forward would be to get rid of the "two fleet rule," devised by Congress's fuel-mileage managers to keep Detroit making small econoboxes in high-cost UAW factories. Dumping the rule would force the UAW to compete directly inside each company for jobs against cheaper workers abroad.

Even better would be to dump CAFE altogether. If Congress really thinks consumers must be encouraged to use less gas, replace it with an intellectually honest gas tax. Mr. Obama promised to transcend the old stalemates — let him begin with the 30-year-old fraud that our fuel-economy rules represent.

He ran a brilliant campaign, but his programmatic prescriptions amounted to handwaving designed to capture the presidency rather than tell voters what really to expect. This may have been a virtue in campaigning but it becomes a handicap in governing. The public now has no idea what to expect — except miracles, reconciling all opposites, turning all hard choices into gauzy win-wins. Thanks to Detroit, his honeymoon is about to end before it begins.

  I had planned to write a piece on the limits of diversification, at a time when the underpinnings of almost every asset class is based on the twenty-five year bull market in interest rates.  However, the following article from The Economist is well-presented.

All bets are off

Oct 30th 2008
From The Economist print edition

Spreading the risk has spread the losses

Illustration by S. Kambayashi

THERE is such a thing as a free lunch. That, at least, is what pension funds have been told in recent years. Diversify into new asset classes and your portfolio can improve the trade-off between risk and return because you will be making uncorrelated bets.

Boy, did pension funds diversify. They bought emerging-market equities, corporate bonds, commodities and property, while giving money to hedge funds and private-equity managers with their complex strategies and high fees.

The idea was to “be like Yale”, the university endowment fund run by David Swensen, a celebrated investor, which started to diversify into hedge funds and private equity in the 1980s. Compared with other institutional investors over the past 20 years, Yale had very little exposure to conventional equities. It also produced remarkably strong returns.

But those who thought Yale had found the key to success have been disappointed. Every one of those diversified bets has turned sour this year. In retrospect, it looks like the strategy had two problems. The first was that all risky assets were boosted by the same factors: low interest rates and healthy global growth. That encouraged investors to use leverage, or borrowed money, to enhance returns. The result was what Jeremy Grantham of GMO, a fund-management group, describes as “the first truly global bubble”. As confidence has unravelled, investors have been forced to sell all those asset classes simultaneously, driving down prices across the board.

The second, and related, problem is that some of the asset classes were quite small. Initially, this illiquidity was attractive since it seemed to offer more alluring returns. And as more investors became involved, their liquidity duly improved. But they still suffer from the “rowing boat” factor. When everyone tries to exit the asset class at once, the vessel capsizes.

Furthermore, some of these asset classes were always likely to be driven by the same factors as stockmarkets. Private-equity funds, for example, give investors exposure to the same kinds of risks as quoted companies, only with added leverage.

So was the whole idea of diversification a write-off from the start? The strategy’s defenders say no. They argue that pension funds (and other institutional investors) had made too big a bet on equities in the 1990s. When the bet went wrong with the bursting of the dotcom bubble, funds went into deficit.

They accept that, in a crisis, correlations head towards one; in other words, all asset classes (except government bonds) tend to fall together. But the diversifiers have three counter-arguments. The first is that any correlation less than one is still worth having. Hedge funds may have performed badly this year but their losses have been far lower than those of equity markets.

Second, there is a difference between short-term correlations and long-term ones. If you take a five- or ten-year view, it still looks as if property, commodities and the rest offer some diversification benefits. They did so during the equity bear market of 2000-02, for example.

Third, consultants like Colin Robertson of Hewitt Associates argue that diversification does work when it is applied in a sophisticated way. There is no point in diversifying if the investment does not offer a genuinely different source of return (much of private equity falls into this category) or if the asset is already overvalued.

Yet even allowing for this, diversification has surely not offered the benefits most pension funds expected. Indeed, it may have had perverse results. In the old days, with equities trading at below-average valuations, funds would now be on a buying spree. They could afford to ignore the short-term risks because of the long-term nature of their liabilities. Pension funds thus acted as an automatic stabiliser for the market.

This time round, that does not seem to be happening. One reason may be accounting changes which make pension-fund managers more focused on the short term. Another, however, may be the strategic drive to diversification. The Wall Street Journal has reported that CalPERS, America’s largest public-pension fund, has been selling shares to meet commitments to put more money into private-equity firms.

The final problem with diversification has been the cost. Investing in quoted shares via an index fund is very cheap—a fraction of a percentage point. But diversified asset classes cost more to trade and involve higher management fees, expenses that eat into pension-fund returns.

So perhaps diversification has been a free lunch after all. Not for the pension funds, but for the fund managers.

In light of the recent stock market turmoil, investors are turning to bonds as a safe haven.  Financial planners, playing to the fear, recommend that an individual's bond allocation should approximate their age; i.e a forty year old should have about 40% of their assets in bonds.

This is interesting, because most money managers consider long treasuries to be the last remaining bubble.  Interest rates have fallen so low in anticipation of a recession, that any hint of inflation, or the market's demand for higher yields in the face of default risk, will send rates skyward.  Not everyone understands that as interest rates rise, bond prices fall.  And not everyone knows that the Federal Reserve has no control over long rates.  On the contrary; recent central bank policy will eventually guarantee vastly higher long rates.  So unless you are prepared to hold your bond to maturity (and honestly, who plans to hold a 4% bond for thirty years?), the probability of loss is virtually assured.

 The little homilies like "bonds for safety", "buy and hold", etc., were developed over the past twenty five years.  If such tactics were used during the inflation-ridden seventies, a period in which we seem to be repeating, you would have been crushed.

The current issue of Forbes reports that the stock of Horsehead Holding Company, a zinc producer in Pennsylvania, is currently selling at less than net working capital.  Pretty cheap.