naked capitalism

Submitted by Leo Kolivakis, publisher of Pension Pulse.

David Leonhardt and Geraldine Fabrikant of the NYT report that the Rise of the Super-Rich Hits a Sobering Wall:

The rich, as a group, are no longer getting richer. Over the last two years, they have become poorer. And many may not return to their old levels of wealth and income anytime soon.

Perhaps the broadest question is what a hit to the wealthy would mean for the middle class and the poor. The best-known data on the rich comes from an analysis of Internal Revenue Service returns by Thomas Piketty and Emmanuel Saez, two economists. Their work shows that in the late 1970s, the cutoff to qualify for the highest-earning one ten-thousandth of households was roughly $2 million, in inflation-adjusted, pretax terms. By 2007, it had jumped to $11.5 million.

The gains for the merely affluent were also big, if not quite huge. The cutoff to be in the top 1 percent doubled since the late 1970s, to roughly $400,000.

By contrast, pay at the median — which was about $50,000 in 2007 — rose less than 20 percent, Census data shows. Near the bottom of the income distribution, the increase was about 12 percent.

Some economists say they believe that the contrasting trends are unrelated. If anything, these economists say, any problems the wealthy have will trickle down…Other economists say the recent explosion of incomes at the top did hurt everyone else, by concentrating economic and political power among a relatively small group….

Mr. Saez, a professor at the University of California, Berkeley, said he believed that the rich had become poorer. Asked to speculate where the cutoff for the top one ten-thousandth of households was now, he said from $6 million to $8 million.

For the number to return to $11 million quickly, he said, would probably require a large financial bubble…..

“We are coming from an abnormal period where a tremendous amount of wealth was created largely by selling assets back and forth,” said Mohamed A. El-Erian, chief executive of Pimco, one of the country’s largest bond traders, and the former manager of Harvard’s endowment.

Some of this wealth was based on real economic gains, like those from the computer revolution. But much of it was not, Mr. El-Erian said. “You had wealth creation that could not be tied to the underlying economy,” he added, “and the benefits were very skewed: they went to the assets of the rich. It was financial engineering.”….

The possibility that the stock market will quickly recover from its collapse, as it did earlier this decade, is perhaps the biggest uncertainty about the financial condition of the wealthy. Since March, the Standard & Poor’s 500-stock index has risen 49 percent.

Yet Wall Street still has a long way to go before reaching its previous peaks. The S.& P. 500 remains 35 percent below its 2007 high. Aggregate compensation for the financial sector fell 14 percent from 2007 to 2008, according to the Securities Industry and Financial Markets Association — far less than profits or revenue fell, but a decline nonetheless…..

Beyond the stock market, government policy may have the biggest effect on top incomes. Mr. Katz, the Harvard economist, argues that without policy changes, top incomes may indeed approach their old highs in the coming years. Historically, government policy, like the New Deal, has had more lasting effects on the rich than financial busts, he said.

One looming policy issue today is what steps Congress and the administration will take to re-regulate financial markets. A second issue is taxes.

In the three decades after World War II, when the incomes of the rich grew more slowly than those of the middle class, the top marginal rate ranged from 70 to 91 percent. Mr. Piketty, one of the economists who analyzed the I.R.S. data, argues that these high rates did not affect merely post-tax income. They also helped hold down the pretax incomes of the wealthy, he says, by giving them less incentive to make many millions of dollars……

Yet there is also a reason to think that the incomes of the wealthy could potentially have a bigger impact on others than in the past: as a share of the economy, they are vastly larger than they once were.

In 2007, the top one ten-thousandth of households took home 6 percent of the nation’s income, up from 0.9 percent in 1977. It was the highest such level since at least 1913, the first year for which the I.R.S. has data.

The top 1 percent of earners took home 23.5 percent of income, up from 9 percent three decades earlier.

One issue that has perplexed economists on both sides of the political spectrum is how to deal with inequalities in wealth. I am not convinced that the rich are not getting richer, but I will concede that the deflation scenario will wipe out many fortunes.

The fact is that the poor are hurting much more than the wealthy in a downturn. The affluent should be paying more in taxes and they should count themselves lucky and remember Pete Peterson’s wise words on the meaning of enough.

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Bloomberg reports pension plans’ private equity cash depleted as profits shrink:

U.S. pension funds contributed to the record $1.2 trillion that private-equity firms raised this decade. Three of the biggest investors, state pensions in California, Oregon and Washington, plunked down at least $53.8 billion. So far, they only have dwindling paper profits and a lot less cash to show the millions of policemen, teachers and other civil servants in their retirement plans.

The California Public Employees’ Retirement System, the Washington State Investment Board and the Oregon Public Employees’ Retirement Fund — among the few pension managers to disclose details of their investments — had recouped just $22.1 billion in cash by the end of 2008 from buyout funds started since 2000, according to data compiled by Bloomberg. That amounts to a shortfall of 59 percent. In total, they haven’t reaped a paper gain from funds formed in the past seven years.

The wisdom of those investment decisions hangs on the remaining value private-equity firms assign to companies they snapped up in 2006 and 2007, during the peak of the buyout boom. For the California, Oregon and Washington plans, that figure totaled $15.8 billion at the beginning of the year.

While some investors say they’re confident the private- equity industry’s traditional practice of taking over companies will pay off, others have been shaken by a credit contraction that froze deal-making, eroded the value of the assets on private-equity firms’ books and prevented them from cashing out in public share sales.

‘Can’t Eat IRRs’

Now pension managers on both ends of the spectrum are looking skeptically at the so-called internal rate of return buyout firms calculate to gauge their results.

“I work for over 400,000 employees, and they can’t eat IRRs,” said Gary Bruebaker, the chief investment officer of the Washington State Investment Board. “At the end of the day, I care about how much do I give you, and how much money do I get back.”

Private-equity firms pool money from so-called limited partners — pension funds, endowments, wealthy families and sovereign wealth funds — and use that cash, along with money borrowed from banks, for corporate takeovers. The buyout managers aim to boost profits through cost cuts, acquisitions or added lines of business, then reap a return for themselves and their investors in a public stock offering or a sale to another buyer.

The buyout firms also levy fees, typically 2 percent of the assets they oversee annually and 20 percent of profits from successful investments. That’s helped make the titans of the industry into billionaires.

Avago IPO

Stephen Schwarzman, the 62-year-old co-founder and chairman of Blackstone Group LP, the biggest private-equity firm, ranked 261st on the 2009 Forbes list of the world’s richest people, with an estimated net worth of $2.5 billion. KKR & Co. LP co- founder Henry Kravis, 65, topped that with $3 billion, while Carlyle Group co-founder David Rubenstein, 60, weighed in at $1.4 billion.

Buyout managers, and some pension funds, downplay their cash returns so far this decade and counsel patience, saying that investments often look worse in the years immediately after they’re made. Blackstone’s Schwarzman told backers on an Aug. 6 conference call he expected his New York-based firm to take some of its companies public in 2010. KKR, also in New York, sold shares in Avago Technologies Ltd. through an IPO earlier this month, raising $648 million.

Harvard’s Sales

Pension funds also say that over time, private-equity returns compare favorably to the Standard & Poor’s 500 Index, which declined 28 percent from the beginning of 2000 through the end of last year. Bruebaker says his Washington fund had an 8.2 percent average annual gain from its buyout investments in the past 10 years, compared with a 3.9 percent drop in the S&P.

While investors can sell publicly traded stocks as needed, buyout funds keep money tied up for years, said Steven Kaplan, a professor at the University of Chicago’s Booth School of Business.

“With private equity, you’re taking on a liquidity risk, which people did miscalculate,” said Kaplan, who has studied takeover returns.

University endowments and philanthropic foundations hurt by the worst economic crisis since the Great Depression have struggled to sell their stakes in private-equity funds to raise cash. Investors including Harvard University, in Cambridge, Massachusetts, planned to raise more than $100 billion through so-called secondary sales of limited partnership interests, some at discounts of at least 50 percent, people familiar with the effort said last year.

‘Money in the Ground’

Rubenstein, of Washington-based Carlyle, acknowledges that the buyout industry faces tough questions.

“People have a lot of money in the ground and today it’s probably not worth what they had intended, but a turn-around in valuations is now beginning,” Rubenstein said in an interview. “You’ll probably see general partners and limited partners focused more on multiples of equity rather than just IRRs.”

Representatives of Washington, Calpers and Oregon all said they remain committed to private equity, and pointed to the long-term nature of the investments.

“The market is in a trough,” Oregon spokesman James Sinks said. “The picture would’ve looked different at the end of 2007.” Calpers spokesman Clark McKinley noted that Calpers in June raised its target commitment to private equity to 14 percent of assets from 10 percent.

“That’s an affirmation of our confidence in the asset class,” he said.

Schwarzman and Kravis declined to comment for this article.

‘A Snapshot’

“We are hopefully toward the end of the absolute worst recession of our lifetimes,” said Washington’s Bruebaker. “If you take a snapshot right now, things might not look good. These are 10- to 12-year investments and we believe they’ll be much better than what we see today.”

Bruebaker’s fund and the Oregon Public Employees’ Retirement Fund warmed to buyouts during the 1980s, and Calpers joined in 1990. Today, among U.S. pension plans, Calpers is the largest investor in private-equity funds, while Washington and Oregon are the third- and fourth-biggest, respectively, according to San Francisco-based consulting firm Probitas Partners Inc.

The three state funds, which serve more than 2 million people, collectively more than doubled their buyout commitments in 2005, to $8 billion from $3.1 billion. They ramped up even more the next year, when commitments climbed to $18.7 billion, the data show.

Chrysler, TXU

All told, private-equity firms raked in $1.2 trillion from 2000 through 2008, according to London-based researcher Preqin Ltd. The influx of money, coupled with cheap debt-funding from Wall Street banks eager to collect fees, fueled record-setting takeovers. Nine of the 10 biggest deals were announced from 2005 to mid-2007 as buyout firms acquired the likes of hotel operator Hilton Hotels Corp. and power producer TXU Corp.

The buyouts ground to a halt after the subprime-mortgage market collapsed in late-2007, extinguishing investor demand for high-yield, high-risk debt. The dollar value of deals has dwindled to $42.2 billion so far this year from $212.2 billion in 2008, according to data compiled by Bloomberg.

Private-equity firms unable to cash out of investments have spent much of the credit crisis reworking the capital structures of their debt-laden companies. Chrysler LLC, the carmaker that Cerberus Capital Management LP bought in 2007 for $7.4 billion, and doormaker Masonite International Corp., which KKR purchased in 2005 for C$3 billion ($2.4 billion), filed for bankruptcy this year.

Marked-to-Market

At the same time, changes in accounting rules have cast a spotlight on the current value of private-equity investments.

The Financial Accounting Standards Board’s so-called Statement No. 157, which went into effect at the end of 2007, requires investors, including private-equity managers, to gauge the fair value of holdings that aren’t traded. While most buyout firms typically carried their investments at cost, FAS 157 mandates quarterly assessments of current value.

Such marking-to-market means private-equity funds must tell investors how much their stakes are worth at that moment, even if the managers are planning to hang onto them for years.

“Getting carried away by looking at mark-to-market in my personal view can lead you to an incorrect conclusion for the longer term,” Blackstone’s Schwarzman said on the Aug. 6 conference call.

Blackstone spokesman Peter Rose says it’s premature to judge recent investments, such as those made by the $21.7 billion fund the firm set up in 2007.

‘Profound Losses’

Schwarzman, who created Blackstone in 1985 with Peter G. Peterson, has said their unspent capital — about $29 billion — will enable them to buy companies at depressed prices and generate profits as the global economy recovers.

Others see signs that the private-equity business is undergoing a transformation. Carlyle’s Rubenstein predicted that deals in the current environment will be smaller and less reliant on debt. Individual funds already being marketed to investors won’t top $10 billion, and subsequent efforts won’t exceed $5 billion to $6 billion, he said.

“These are major structural changes taking place,” said Dayton Carr, founder of VCFA Group, a New York-based firm that buys interests in private-equity and venture-capital funds. “The basic economy has had huge issues. A lot of the funds will be smaller.”

The upheaval is reflected in the attitudes of pension-fund investors, who are watching and waiting for cash to come in the door.

“When managers are forced to put a hard value on their holdings, we’re seeing some profound losses,” said William Atwood, the executive director of the Illinois State Board of Investment, an $9 billion pension fund. “The rubber hits the road when cash is returned.”

Let me share with you some thoughts on private equity. First of all, many of these large pension funds got carried away from 2005 to mid 2007, shoveling billions into private equity. Why did they do this? They will tell you because private equity offers diversification benefits (it doesn’t, it’s highly correlated to public equities) and true alpha (once you strip away leverage ad liquidity risk, the returns over public equities are not that half as great as they report). The real reason is that pension funds can game their private market benchmarks allowing them to reap big bonuses based on bogus benchmarks.

Second, there are very few private equity funds that are worth investing in. The large pension funds are all trying to get into the latest buyout funds of a handful of general partners. A monkey can write a cheque for $100 or $200 million to get into a “top” buyout fund. Why do they focus on large buyouts instead of venture capital? Because if you need to allocate billions into PE, it doesn’t leave you much choice but to try to get into the biggest and (hopefully) the best U.S. and European buyout funds (to a lesser extent Asian funds). The top VC funds are much smaller, typically capped at $300-500 million, and there are only a handful in the world (Sequoia and Kleiner Perkins Caufield & Byers come to my mind but good luck getting an allocation with them). Importantly, there is evidence of performance persistence in private equity and VC, so if you can’t get into the best funds, you are better off investing in public equities.

Third, in private equity, vintage year diversification matters. When you are tying up your money for up to ten years, you better make sure you are diversifying properly in terms of strategy, geography and vintage year. A lot of big pension funds are going to get creamed from those 2004-2007 vintage years and some of them are very exposed to particular vintage years.

Fourth, mark-to-market and IRRs are a total waste when it comes to PE returns. What ultimately counts in how much money you put in and how much money you get out (cash on cash returns). For reporting purposes, mark-to-market will just exacerbate the swings, underestimating the true value at market troughs and overestimating the true value at market tops. I understand the new accounting rule is needed to ascribe a value at any point in time, but it does not necessarily reflect the value at which the GP will sell the asset.

So what is the current state of private equity? I think everyone should carefully read Coller Capital’s Global Private Equity Barometer – Summer 2009. In note the following points:

• The global downturn has reduced investors’ overall private equity returns. 37% of LPs now report overall net returns of 16% or more from the asset class, compared with a high of 45% of LPs in Summer 2007.
• Three quarters (74%) of private equity investors expect distributions from their portfolios to deteriorate over the next year. This is the most gloomy LPs have been since the
  Barometer began in 2004.
• For the time being at least, investors are almost equally pessimistic about distributions from funds focussed on different regions.
• For the first time in years, a significant number of private equity investors are planning to decrease their target allocation to private equity – 20% of LPs plan a reduced allocation in the coming year. (This compares with just 3-6% planning a decrease in previous Barometers.)
• However, in general, LPs remain strongly committed to the asset class – 80% plan to maintain or increase their target allocation over the next 12 months.
• A large majority (84%) of LPs have declined to re-invest with one or more of their existing GPs over the last 12 months. Just 45% of LPs had refused re-ups in the Summer 2005 Barometer.
• Almost all (92%) North American LPs have declined to re-invest with some of their GPs over the last 12 months, compared with 82% of European and 70% of Asia-Pacific LPs.
• Around half of LPs believe that changes to regulation and/or taxation are likely to damage private equity’s wealth-creating potential in developed markets over the next two years. Just over half (55%) of LPs expect a negative impact in North America and almost half (48%) expect the same in Europe. Fewer investors (just 17%) anticipate a negative impact in Asia-Pacific.

As you can see, private equity is in the doldrums. Is it a bottom for this asset class? That all depends on where public equities are heading. You need robust stock markets, mergers and acquisitions to pick up, the IPO market to open up (so that exits are in place) and last but not least, you need strong bond markets willing and able to finance large buyout deals.

Some large funds are committing more money to private equity over the next year. In early June, the National Post reported that Alberta’s investment fund plans $1-billion spending spree:

Submitted by Leo Kolivakis, publisher of Pension Pulse.

A week ago, MacLean’s magazine published an article, Pressure rises to protect our pensions:

At long last, there is a ray of hope for workers whose employers have filed for bankruptcy. Currently pensioners, the disabled, and employees owed severance pay are treated the same way as banks and other sophisticated creditors: when a company goes under, they have to get in line to fight for a piece of what’s left with everyone else.

But a group of former Nortel employees is looking to change that. They have asked the federal government to make an emergency amendment to the Bankruptcy and Insolvency Act to give preferred status to the claims of pensioners, the disabled and severed employees—essentially putting workers at the front of the line.

In principle, there is already agreement to consider the amendment amongst all the federal political parties. Driven by concern that Nortel pensioners could lose 30 to 40 per cent of their pension income, on June 16 NDP MP Wayne Marston (Hamilton East- Stoney Creek) introduced a motion in the House of Commons to look into putting pension fund claimants ahead of other creditors in the event of bankruptcy proceedings. It was passed with unanimous support.

“I am optimistic that politicians could consider making the emergency change when they come back to the legislature in the fall,” says Diane Urquhart, a financial analyst and adviser to the Nortel Pensioners and Severed Employees. “Our bankruptcy law is way out of date with respect to new developments in the marketplace.”

Still, the amendment protecting pensioners is only the first step. According to lawyer Philip Slayton, disability plan members and severed employees need more protection too. The amount of money remaining for them is “grossly inadequate,” he says.

In fact, says Urquhart, if things don’t change, many disabled Nortel employees and employees owed severance pay will likely lose 90 per cent of the money they’re owed—income that is “otherwise obligatory under employment standards set by provincial laws and common law precedents.”

Diane Urquhart wrote an excellent analysis on the Nortel bankruptcy, Bond Owners Use Credit Default Swaps to Gain, While Pensioners, Disabled and Terminated Employees Told to Share the Pain (click here to download the PDF file).

I urge you to take the time to read Diane’s entire analysis. I quote the following:

The old premise of balance or equal compromise in Canada’s bankruptcy laws between employment related claims and bond claims is as obsolete as the horse and buggy.

The Federal Bankruptcy and Insolvency Act (BIA) is based on the goal of balance or equal compromise amongst employment related claims and bond holder claims, but the metrics used no longer make sense due to the evolution of the credit default swap (CDS) market. Under the BIA, pension, health and long term disability plan deficits and unpaid severance are creditor claims treated the same as bond owners’ claims. If there is inadequate assets for disbursement, under the current BIA, balance or equal compromise means, for example as shown in Figure 1, that for every $1.00 of employment related claims and every $1.00 of face amount of bonds outstanding, the loss ratio of say -$0.60 per $1.00 of claim is the same for the two types of claims.

However, since the credit default swap market was invented in 1997, bond owners are able to insure their loss from possible future bankruptcy, by buying CDS contracts. The CDS hedge contracts are not part of the compromise calculation in the bankruptcy courts. The hedged bond owners, who get assigned a loss of -$0.60 in the bankruptcy court, would have an equal offsetting gain of $0.60 from the cash settlement of their CDS hedge contracts outside of the bankruptcy court. The hedged bond owners actually suffer no loss in the bankruptcy process as shown in Figure 1.

(click figure to enlarge)

Prior to the invention of credit default swaps, there was no vehicle for bond owners to transfer the risk of a credit default or other credit event to third parties. In a CDS, the bond owner “sells” his credit risk to a counterparty who “buys” this risk. The “buyer” of the CDS pays fees in the form of upfront and regular annual payments to the “seller” of the CDS, similar to how you pay premiums for car insurance. In return, the seller agrees to pay the buyer of the CDS a set amount when there is a credit default (technically, a credit event). CDSs are designed to cover many credit risks, including: credit default, corporate debt restructuring and credit rating downgrades. The “seller” of the CDS is effectively acting as an insurance company, just like your car insurance company reimburses you for your car accident damages. But the sellers of CDS are public investors and not large insurance companies.

In fact, many hedged bond owners can make a profit from the bankruptcy process, either because: (1) they have bought more CDS contracts than the amount of bonds they own and as such are “short the bonds”; or, (2) their CDS hedge contracts are settled within days of the bankruptcy protection announcement, when the bond price is usually at its lowest point, so that the CDS hedge gain is greater than the actual bond loss when the liquidation occurs at a higher recovery amount calculated at a later date in the bankruptcy process. (See Figures 5 and 6 below)

(click figures to enlarge)

Canadian pension, health and long term disability plan deficits and unpaid severance have no private sector insurance coverage. Canadians must rely upon the nominal amount of protection under the Ontario Pension Benefit Guaranteed Fund for Ontario residents only, the Canada Pension Plan disability benefit and provincial welfare programs, and the Federal Employment Insurance Fund. The negative situation for Nortel’s Canadian pensioners, long term disabled and terminated employees is made worse by the depletion of the Nortel Canada estate by Nortel’s foreign subsidiaries, such that their loss could be $-0.90 per dollar of claim.

Again, please read the entire report (click here to download the PDF file). At the end of the report, Diane makes a few key recommendations and she lists Nortel’s bondholders. The list includes several prominent hedge funds, investment banks, a few Canadian pension funds (Hospitals of Ontario Pension Plan and the Caisse) and a US pension fund (Florida SBA).

[Side Note: Diane also delivered an excellent presentation to the United Senior Citizens of Ontario a couple of day ago on underfunded pension plans. I especially liked pages 13 to 16.]

Is there a precedent for pensioners to come ahead of bondholders? Not exactly, but if you look at what happened in the GM and Chrysler bankruptcies, where politics trumped the seniority of bondholders, then I think there is a case to pay these pensioners, disabled workers and employees owed severance. The question is whether there is enough political will in Ottawa to press their case.

Finally, the NYT reports that the Securities and Exchange Commission, after months of considering what to do about short-selling, came up with a new idea on Monday that could make it virtually impossible to place an order to sell stock short and be sure it would be executed quickly:

The proposal would require that short sales be made only at a price higher than the current best price being offered by would-be buyers of the stock. It is similar to the so-called tick-test, which was effective on many stock markets before 2007, but would be more restrictive and could be easier to apply given the current structure of markets. There is now no limit on short-selling, so long as the seller can locate shares to borrow.

The article ended by stating:

For some, the issue of short-selling has been tied up with the issue of “naked short-selling,” a practice that involves selling stocks short without borrowing them. It appears that other S.E.C. rules have virtually eliminated such selling, particularly for stocks listed on Nasdaq or major stock exchanges. But it remains an emotional issue, and some believe naked short-selling is still a major problem.

SEC rules have virtually eliminated naked short-selling? Yeah right! If you believe that, I got a couple of igloos to sell you in Southern Crete. The SEC should also crack down on other manipulative short-selling practices using credit-default swaps:

Any action the Commission attempts to take against manipulative short selling will not be completely effective without parallel, reinforcing reforms applied to the derivatives market, particularly with respect to credit default swaps (“CDS”). The responsiveness of equity prices to changes in CDS spreads makes the purchase of CDS a powerful device for bear raids, particularly when used in connection with short sales. Combining a short sale with the purchase of CDS sends a false signal into the marketplace about a company’s credit and, accordingly, causes a drop in the stock price that makes the short position profitable. Such manipulation is dangerously cost-effective, as a relatively small investment in an institution’s CDS is sufficient to spark rumors of default or a ratings downgrade and immediately sink stock prices.

To prevent this and other abuses of the CDS market, we believe that only those who are economically exposed to the underlying credit risk of a company should be allowed to buy CDS protection on the company. The purchase of a “naked” CDS, made by a purchaser with no exposure to the reference company, is more akin to gambling than obtaining insurance, and such instruments are capable of causing serious distortions in the market. A prohibition on naked CDS would allow the appropriate use of these instruments while restraining those using the CDS market in a manipulative and abusive way. As an intermediate step, the Commission should use its ability to regulate short sales to require a waiting period between any purchase of a CDS and short sale involving the same reference company.

In addition, to alert the marketplace to situations when CDS are being used to manipulate share prices in conjunction with short selling, the Commission should require disclosure when an actual or synthetic short position in a company’s equity securities is accompanied by a long position in the company’s CDS.

To recap, CDS are used by bondholders to protect their investments and gain in case of a bankruptcy, placing them ahead of pensioners and other employees with more legitimate claims. Purchases of CDS are also used in connection with short sales, to send a false signal into the marketplace about a company’s credit and, accordingly, cause a drop in the stock price that makes the short position profitable.

Don’t you just love these “free markets”?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

The FT reports that the decline of final salary pension scheme set to accelerate:

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Stocks tumbled on Monday and lots of people are worried that they will retest their March lows. Stop worrying so much! Let me quote the bonddad blog today: “While I am sure there are people in a panic about this, I’m not. The market needs a sell-off right now; we’ve come a long way and it’s time to drive out some weak positions.”

I agree, let the weak hands sell. This market is heading higher. Uri Landesman, who oversees about $2.5 billion as head of global growth for ING Investment Management Americas shared his thoughts on Tech Ticker today:

Landesman now faces a “quandary” of expecting a significant near-term correction but believing major averages will end the year “substantially higher” than where they are currently. His optimism is based on a belief the massive global government stimulus will boost economic growth in the second half and into 2010, and that major averages haven’t fully priced in that rebound.

Landesman believes underinvested or just generally bullish fund managers will become aggressive buyers if and as the S&P 500 falls into the 950-975 area.

Don’t underestimate the psychological effects of performance anxiety. A lot of portfolio managers are underperforming their indexes and they are looking for any dip to pull the trigger and buy stocks.

Interestingly, Bloomberg carried a story today stating that pension funds pare stocks, ignoring economic rebound:

The world’s biggest pension funds lost confidence in stocks as the best long-term investment, cutting holdings or leaving them unchanged during the steepest rally since the 1930s.

Funds overseeing money for California teachers and public workers, Dutch government retirees and South Korean private- sector employees reduced their target weightings for equities this year, data compiled by Bloomberg show. The rest of the 10 largest kept them the same. U.K. pensions have cut stock allocations to the lowest since 1974, according to Citigroup Inc. Managers handling Oxford and Cambridge University professors’ assets have been selling shares as the MSCI World Index posted a five-month, 51 percent rally.

“Given the storm in financial markets that we have seen, the name of the game is risk management,” said Dirk Popielas, head of the Pension Advisory Group at JPMorgan Chase & Co. in Frankfurt. “The majority of pension funds have not finished taking risk off their portfolios. Some have not even started.”

Losses suffered in the worst decade for stocks versus bonds since at least 1900 drove pension funds to pour more money into fixed income, commodities and derivatives just as signs the global recession is easing helped equities rebound from the MSCI World’s biggest annual drop on record.

The average return for U.S. stocks has trailed government bonds by about 8.6 percentage points annually since 1999, after outperforming by 8.2 points last century, based on data compiled by the London Business School and Zurich-based Credit Suisse Group AG.

New Century

Equities appreciated an average 12.91 percent a year from 1900 to 1999, while bonds returned 4.69 percent annually, according to the data from the London Business School and Credit Suisse. Since the start of the new century, bonds gained 6.36 percent, compared with a loss of 2.27 percent for shares.

Stock indexes retreated from Shanghai to London and New York today as foreign direct investment in China fell and Japan’s economy grew less than economists estimated. The MSCI World slid 2.5 percent at 9:35 a.m. in New York, while the Standard & Poor’s 500 Index sank 2.1 percent.

The MSCI World’s 42 percent slump last year decimated equity allocations at pensions. The largest funds oversee a total of about $3 trillion, according to data compiled by Bloomberg, magnifying the impact of their decisions on the performance of stocks worldwide.

Decade of Stagflation

Equity assets in the U.K. fell to 41 percent of holdings at the end of 2008, according to data compiled by New York-based Citigroup. The last time British pension funds held so little in equities was in 1974, after the Middle East oil embargo ushered in a decade of stagnant growth and price increases known as stagflation.

Funds aren’t returning to their previous levels, according to Andy Maguire, a senior partner at Boston-based Boston Consulting Group. The proportion of equities in U.K. pensions exceeded bonds by 1.6 percentage points in the first quarter, the smallest gap since 1962, annual data compiled by Citigroup show.

Equity losses have hit the pension industry just as liabilities increase. The number of people worldwide 65 and older may jump to 1.3 billion by 2040 from 506 million last year. Their proportion of the total population will double to 14 percent in the same period, according to a June report from the U.S. Census Bureau.

‘Right Thing’

“The real issue is they don’t want the volatility they had,” said Louise Kay, head of U.K. institutional business development at Standard Life Investments Ltd. in Edinburgh, which oversaw the equivalent of $34 billion for U.K. pension firms as of December. “Funds normally have to look whether they rebalance or not after one asset class loses value, and this time they are wondering whether this is the right thing to do.”

The FTSE 100 Index of U.K. stocks advanced 6.3 percent this year through last week, the smallest gain among the world’s 20 biggest equity markets, according to data compiled by Bloomberg.

Four of the world’s seven largest pension funds — Sacramento, California-based California State Teachers’ Retirement System and California Public Employees’ Retirement System; Heerlen, Netherlands-based Stichting Pensioenfonds ABP; and South Korea’s National Pension Service — have cut their equity target allocations, data compiled by Bloomberg show.

Calstrs, Calpers

The $119 billion California State Teachers’ Retirement System, which oversees the pensions of 833,000 members, said on July 21 that it had temporarily shifted 5 percent from equities to fixed income, real estate and private equity, and permanently moved 5 percent from stocks to “absolute return” products that target gains even as markets fall.

“The shift out of equities is still in progress,” Calstrs’ spokesman, Ricardo Duran, said in an e-mail on Aug. 12. The value of the fund’s investments slid 25 percent in the fiscal year ended in June.

The $181 billion California Public Employees’ Retirement System, which managed retirement benefits for 1.6 million current and retired public workers as of June 30, lowered its equities target to 49 percent from 56 percent on June 15. Calpers lost 23.4 percent in the fiscal year ended June 30, erasing six years of earnings.

ABP, which oversees the equivalent of $256 billion for more than 2.7 million Dutch government workers and teachers, reduced stock holdings to 29 percent from 32 percent in the first months of this year to reduce risks, according to spokesman Thijs Steger. ABP, the euro region’s biggest pension fund, said the value of investments increased 4.5 percent in the first half.

Rodgers and Hammerstein

The Dutch pension fund is turning to so-called alternative investments to boost returns. It outbid music publishers in April for the works of Richard Rodgers and Oscar Hammerstein II, including “The Sound of Music” and “Oklahoma!” The songs are managed by ABP’s Imagem Music Group, which has rights to more than 200,000 compositions, including Michael Jackson’s “You Are Not Alone.”

South Korea’s National Pension Service cut its 2009 domestic stocks allocation in June for the second time in a year as it predicted a “slow” economic rebound.

The fund posted a 0.2 percent loss on assets in 2008, according to South Korea’s Ministry for Health, Welfare and Family Affairs, even as the country’s benchmark Kospi Index of stocks slid 41 percent. The hedge-fund industry had its worst year on record in 2008, losing 18.3 percent, according to data compiled by Chicago-based Hedge Fund Research Inc.

South Korea’s National Pension, which was set up in 1988 to cover private-sector workers and people who are self-employed, posted returns of more than 5 percent a year between 2003 and 2007.

Norway Oil Fund

Norway’s sovereign wealth fund, which invests the country’s oil money abroad to avoid stoking domestic inflation, has been a buyer of stocks this year even as its target allocation held steady. The fund, which raised its equity weighting to 60 percent in 2007 from 40 percent, said in a presentation on Aug. 14 that its stock holdings stood at 60.3 percent of assets.

The sovereign fund, Europe’s biggest stock owner, said last week the value of its investments rose a record 12.7 percent in the second quarter as the MSCI World posted its biggest gain since 1998, climbing 20 percent in the April-to-June period.

Signs the global economy is rebounding from its first recession since World War II sent the MSCI World up another 10 percent this quarter through last week, while the S&P 500 of U.S. stocks extended its five-month rally to 48 percent.

The U.S. unemployment rate dropped in July for the first time since April 2008, data from the Labor Department showed this month, while the German and French economies unexpectedly grew last quarter, government figures indicated last week.

Valuations, Oxbridge Dons

European pensions reduced their weightings even after the MSCI World fell to 9.4 times the average per-share earnings of its companies in November, the cheapest valuation since at least 1995, according to weekly data compiled by Bloomberg.

“Human emotion comes into the investment-making decision process, and managers are just as prone to it as individuals,” said Neil Hennessy, who oversees $850 million as president of Hennessy Advisors Inc. in Novato, California. His Focus 30 Fund beat 99 percent of rivals in the past five years. “These managers are good, but you can see how they got whipsawed.”

Universities Superannuation Scheme Ltd., which oversees the pensions of employees at more than 400 universities and higher education institutions including Oxford and Cambridge, is shunning stocks, said Elizabeth Fernando, an adviser to the fund’s investment committee.

‘An Awakening’

The U.K.’s second-largest pension fund, which managed 23.1 billion pounds ($38.1 billion) in Liverpool at the end of 2008, is diversifying investments after trustee boards got “scared enormously” during the bear market, Fernando said. The fund is boosting its allocation to alternatives that deliver “equity- type returns” but are uncorrelated with stocks, she said in an interview Aug. 4. She declined to give more details.

A third of U.K. pension funds in an April survey by Mercer Investment Consulting said they plan to cut domestic equities. Only 2 percent planned an increase, according to Mercer, a unit of New York-based Marsh & McLennan Cos. There has been no update of the survey since then.

“The fact is there has been an awakening towards the risk of equities and the part that equities should play in the overall pension-fund strategy,” Tom Geraghty, the Dublin-based head of Mercer’s European investment consulting business, said in an interview. “Not to say that equities should not be part of a pension’s asset-allocation arrangement, but that they will have a less influential part to play.”

An awakening towards the risk of equities?!? Hello! That’s why they call it dumb money! One of the portfolio managers I used to work with told me to “always short pension funds,” adding that “they are always the last ones in and the last ones out. Even retail investors are smarter than most pension funds.”

The fact remains that there is a time to cut risk and there is a time to crank it up but most of these large pension funds cut their equity allocations at the bottom of the market and now they are stuck chasing stocks higher. And trust me, they will chase the indexes much higher or risk losing their jobs after severely underperforming their policy portfolio.

Unfortunately, this is how absurd markets have become. On one side, you have large, lethargic pension funds that have to pass investment decisions through committees and their board of directors and on the other you got large, aggressive and nimble hedge funds that are looking to capitalize on market opportunities knowing that dumb money (and I include mutual funds in this category) will follow their lead.

Bloomberg reported today that Ken Griffin’s $12 billion Citadel Investment Group LLC is trying to set up a leveraged-loan trading unit as the market for the debt has returned 42 percent from a December low:

The hedge fund sought unsuccessfully to hire four members of Barclays Capital’s loan sales and trading team for its effort, said another person, who declined to be identified because the discussions are private. It’s unclear how many people Chicago-based Citadel seeks to hire or when the group may start trading.

Citadel would join firms such as Macquarie Group Ltd. and Jefferies Group Inc. establishing operations for trading leveraged loans, often used to fund corporate buyouts. More than $57.1 billion of the debt has been underwritten this year, down from $229.7 billion in the same period of 2008, according to data compiled by Bloomberg. Some firms expanding into loan trading hired from investment banks that laid off employees when the market deteriorated, reaching an all-time low in December.

Now if you ask me, Ken Griffin doesn’t want to expand into leveraged loan trading because he is cutting risk and worried about the future. He sees an opportunity and wants to capitalize on it. True, Citadel will act as market-maker and make some nice juicy spreads in the process, but they obviously believe the leveraged loan market will expand in the coming years.

And if I were a betting man, I’d bet with Ken Griffin who has a proven track record and skin in the game and against the large pension funds who have for the most part made one huge investment blunder after another.

Then again, why should pension parrots care? It’s not their money they are betting with.

I was recently contacted by Steve Patterson, host of a podcast titled ‘Two Beers With Steve‘, which I added to my blog roll. Steve informed me of a recent podcast featuring Dr. Chris Martenson discussing inflation vs. deflation.

This is an excellent interview and Mr. Martenson is very knowledgeable on the subject. He has his own website, www.ChrisMartenson.com, which I added to my blog under market links and he answers some very tough questions on the inflation/ deflation debate. Again, click here to go directly to the podcast and take the time to listen carefully to the entire interview.

Readers of my blog know this is a topic that I have covered in many posts. I agree with Absolute Return Partners who in their July letter, state: “The most important investment decision you will have to make this year and possibly for years to come is whether to structure your portfolio for deflation or inflation.”

Last week, the WSJ reported that Treasurys Up On Decent Demand For 30-Yr Bond Auction,Weak Data:

Treasury prices rose Thursday afternoon on a strong 30-year bond auction following a bout of U.S. data that damped optimism on a quick turnaround in the economy.

Long-dated Treasurys led the gains as they benefited the most from the successful 30-year bond sale with a record size of $15 billion. Treasurys have been well-bid so far this week, with the 10-year note’s yield falling more than 25 basis points from the week’s peak set on Monday.

Traders said part of the buying Thursday afternoon was a result of the 30-year auction turning out better than expected. Many market participants who had put bets on further declines in bond prices, known as shorts, were caught off-guard and had to buy back Treasurys to cover the shorts on the heels of the auction.

Demand on long-dated Treasurys also picked up after the Federal Reserve reassured investors Wednesday afternoon that inflation pressure remained subdued in the near term. Inflation erodes bonds’ fixed interest payments over time, and the longer the maturity, the bigger the potential losses due to a rise in consumer prices.

The 30-year bond auction wrapped up this week’s $75 billion Treasury note and bond supply. The $37 billion three-year note supply Tuesday enticed strong demand, while the $23 billion 10-year note auction Wednesday was less well-received, mainly because it came less than two hours before the outcome of the Federal Reserve’s monetary-policy meeting.

A proxy of foreign demand, including demand from foreign central banks, was strong throughout all three auctions. That should be a relief to the U.S. government as it is selling record amounts of debt this year to finance programs to get the economy back on track. So far, Treasury auctions have managed to entice investors even as the sizes of the auctions have steadily increased.

“It is a relief to get through another round of supply,” said Chris Ahrens, head of U.S. interest rate strategy at UBS Securities LLC in Stamford, Conn. Ahrens said with debt supply still sluggish in the private credit market following the financial crisis, Treasury auctions still drew demand despite the increasing size of the auctions.

In recent trading, the two-year note’s price was up 1/32 at 99 25/32 to yield 1.12%, the 10-year note was up 25/32 to 100 3/32 to yield 3.61%, and the 30-year bond was up 1 5/32 at 96 21/32 to yield 4.45%. Bond yields move inversely to prices.

The 30-year bond auction came in at a yield of 4.541%, matching the when-issued paper just before the auction. The bid-to-cover ratio, a main gauge of demand on the auction, was 2.54, compared with 2.36 for the previous auction in July, which was a reopening issue for the June auction, and the average of 2.31 from the past eight auctions.

The indirect bid – demand from domestic and foreign institutions, including foreign central banks – for the 30-year bond auction was 48.05%, compared with 50.2% from the previous auction in July and the average of 35.8% for the last eight auctions.

“This auction was a good capping stone to an overall smooth August refunding. The appetite for 30Y duration was impressive,” said George Goncalves, head of fixed-income rates strategy at Cantor Fitzgerald in New York.

With this week’s supply out of the way and no supply until the end of the month, Goncalves said longer-dated maturities should be “the best performing sectors on the curve as seasonals carry us to higher prices and lower yields.”

In economic data, the Labor Department reported initial claims for jobless benefits rose by 4,000 to 558,000 on a seasonally adjusted basis in the week ended Aug. 8. The four-week average of new claims, which aims to smooth volatility in the data, rose by 8,500 to 565,000 – the highest since July 18.

Retail sales last month dropped 0.1%, the Commerce Department said Thursday. Economists surveyed by Dow Jones Newswires forecast a 0.8% increase in July retail sales. June sales rose 0.8%, revised up from an originally reported 0.6% increase.

So if inflation is in the offing down the road, why is the appetite for 30-year U.S. bonds so strong? They have zero inflation protection. A recent Bloomberg article notes the following:

U.S. government securities have handed investors a loss of 4.3 percent so far this year, according to Merrill Lynch & Co.’s U.S. Treasury Master index, versus a 17 percent return for stocks on the MSCI World Index. U.S. debt has declined amid record government borrowing as investors seek higher yields than those available from government debt.

The difference between rates on 10-year notes and Treasury Inflation Protected Securities, which reflects the outlook among traders for consumer prices, was 1.73 percentage points, the least in a week. The five-year average is 2.20 percentage points.

The Treasury sold $75 billion of 3-, 10-, and 30-year debt this week, the largest so-called quarterly refunding to date. President Barack Obama has pushed the nation’s marketable debt to an unprecedented $6.78 trillion. The U.S. budget deficit reached a record $1.27 trillion for the first 10 months of the fiscal year, the government said this week.

The Fed has more than doubled the size of its balance sheet in the past 12 months to $2.02 trillion by purchasing Treasuries and other securities to thaw credit markets that froze last year. Policy makers decided this week to let a $300 billion program to buy long-term Treasuries expire in October, even as they pledged to keep interest rates near a record low for an “extended period.”

The 10-year note yield surged 37 basis points last week, the most since March 2003, after better-than-forecast employment, home-sales and manufacturing data.

Yields indicate other parts of the credit markets are normalizing.

The London interbank offered rate, or Libor, for three- month dollar loans fell to a record low 0.43 percent. Libor is about 18 basis points more than the upper end of the Fed’s target rate for overnight loans, narrowing from last year’s high of 3.32 percentage points in October.

The spread between what banks and the Treasury pay to borrow money for three months, the so-called TED spread, was 0.26 percentage point, close to the least since March 2007.

The Libor-OIS spread was 24 basis points today. Former Federal Reserve Chairman Alan Greenspan said in a June 2008 interview he wouldn’t consider credit markets back to “normal” until the spread narrowed past the 25 basis-point level.

U.S. 30-year fixed mortgage rates declined to 5.38 percent yesterday from this year’s high of 5.74 percent in June. They were as low as 4.85 percent in April, according to Bankrate.com in North Palm Beach, Florida.

In late July, Bloomberg reported that BlackRock Inc. is buying index- linked bonds in the U.S. and the U.K., betting record-low interest rates and a flood of money into the economies through central-bank asset purchases will fuel inflation:

The company favors U.S. Treasury Inflation Protected Securities with maturities of 10 years or more, and U.K. index- linked gilts due between five and 10 years, said Brian Weinstein, a fund manager based in New York. It’s avoiding euro- region inflation bonds, anticipating the European Central Bank will act to stem any signs of price acceleration. BlackRock, the largest publicly traded U.S. money manager, oversees $1.37 trillion, with $18 billion in index-linked assets.

“Central banks are injecting money until they find the right amount to get the economy growing again,” Weinstein said in an interview. “They might have a hard time pulling it back. The market is overinvested in short-term protection and underinvested in the nuts and bolts of inflation, which is the long end.”

TIPS are the only long-term U.S. government securities to post gains in the worst year for the country’s debt since at least 1978. They handed investors 3.85 percent, while nominal Treasuries slumped 4.87 percent, according to Merrill Lynch & Co. indexes.

So-called U.K. linkers posted a quarterly return ahead of the country’s nominal bonds for the first time in a year in the three months through June, gaining 2.93 percent, compared with a loss of 1.84 percent in the January-March period.

Right now, I would say the conventional wisdom is that that it’s only a matter of time before inflation rears its ugly head. As I have written in the past, I am not convinced that there is a bubble in bonds. Moreover, I agree with Henry Liu that liquidity is drowning the meaning of inflation. And let’s not forget the excellent commentaries from Hoisington Investment Management who in their second quarter outlook noted the following:

Investments in long term Treasury securities are motivated by inflationary expectations. If fixed income investors believe inflation is headed lower, they will invest in long-dated securities, while they will invest in Treasury bills, or inflation protected securities if they believe inflation is headed higher.

In the normal recessions since 1950, the low in inflation was, on average, 29 months after a complete economic recovery was underway, and bond yields moved in a similar fashion. If this recession were normal, then the low in inflation would be in late 2011, at which time investors would begin to consider shortening the maturity of their Treasury portfolios.

However, because of our highly-indebted circumstances and the movement of private sector resources to the public sector, the trough in inflation will be moved out, meaning that the low in Treasury bond yields is a distant event.

The path there will be bumpy, as it was in the U.S. from 1929 to 1941 and in Japan from 1989 to 2008. Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield level may be similar to that of the Japanese.

I also note what is going on in the rest of the world where Japan producer prices slide a record 8.5% amid slump and where Europe and US still at risk from deflation trap:

Consumer prices in America slipped by 2.1pc in the year to July, according to official data released yesterday. It coincided with Eurostat figures showing that the eurozone’s consumer price index dropped by 0.7pc in the past year, compared with deflation of 0.1pc in June.

The figures underline concerns that despite the sharp rebound in a variety of economic indicators, and despite news that France and Germany have both now pulled out of recession, the threat posed by deflation has not yet been extinguished. Indeed, the fall in consumer prices over the past year in the US represents the biggest such drop since January 1950, and means that the country has now been in deflation for eight months.

Gabriel Stein, of Lombard Street Research, said: “Ultimately, US consumer prices will not rise on a sustained basis until the negative output gap has closed and a positive output gap opened instead. At some stage, this will happen. But not for some time.”

The price figures, which showed that despite the annual fall prices were flat on the month, coincided with data showing that US consumers’ confidence has slid yet further amid worries about the state of the jobs market and wages.

The University of Michigan consumer sentiment barometer dropped from 66 points to 63.2 this month – the lowest since March, from 66 in July. The measure reached a three-decade low of 55.3 in November. The Labor Department said its consumer price index was unchanged from June as forecast, and dropped by 2.1pc – the most in six decades – from July 2008. Economists had expected the index to rise to around 69.

Chris Rupkey, of Bank of Tokyo-Mitsubishi UFJ, said: “If consumers are lacking confidence, then they will not be able to help us spend our way out of this long, dark recession. Households are still concerned about the jobs outlook, and certainly, Fed policy is also gearing off of the labour markets as no Fed has lifted interest rates while the unemployment rate is rising.”

However, there was brighter news from the manufacturing sector, as separate figures showed that industrial production rose for the first time in nine months. Output rose by 0.5pc last month, following a 0.4pc fall in June. The White House’s so-called “cash-for-clunkers” incentive scheme to encourage homeowners to replace their old cars with new models is also thought to have helped.

This brings me to some concluding remarks. The Fed is not going to raise interests rates for a very long time. They will err on the side of inflation because they’d rather this outcome than a protracted period of debt deflation. All the indications are that the global economy has bottomed but this will be the weakest recovery ever and the risks of a W-recovery are high.

That brings me to my final point. Who is buying 30-year Treasury bonds? In that podcast, Chris Martenson said that anyone buying these bonds “deserves what is going to happen to them” and his suspicion is that investors are buying them and hedging inflation risk through credit-default swaps. If that is true, then Mr. Martenson is right, a sudden move in interest rates – say because of a currency crisis – can easily give rise to another systemic crisis in high risk derivatives.

[Note: That end-game is also deflationary! I also wonder if any Canadian pension funds are buying 30-year bonds and hedging inflation risk through the CDS market...YIKES!].

But there is another reason why bonds are being bought. While most global funds are betting on stock market beta to deal with their underfunded status, other more mature plans are buying bonds as they move towards the final end game of offloading pension liabilities and the winding-up of pension schemes.

Importantly, the global pension crisis is highly deflationary and yet very few commentators are discussing this!!!

One thing is for sure, despite stimulative monetary and fiscal stimulus, as well as massive quantitative easing, the world has yet to avoid the deflation trap. Get ready for a hell of a bumpy ride ahead.

Submitted by Leo Kolivakis, publisher of Pension Pulse.

On Wednesday, The Sceptical Market Observer, Luc Vallée, posted a piece on his blog, a simple bailout plan for housing and US economy.

Luc cites Martin Feldstein’s article, “How to Save an ‘Underwater’ Mortgage“, published in the Wall Street Journal last Friday:

“Here is an alternative: Make an attractive offer to all homeowners but tweak the incentives so as to attract only those needing help. Specifically, offer to all existing homeowners (of owner-occupied homes), mortgage relief up to 33% of the value of their mortgage in exchange for the same percentage of equity in their home. As a virtue of being offered to everyone, all individual decisions to accept or refuse the government’s offer would provide much needed information about the quality of individual loans. This information would represent the Holly Grail for the financial sector as it would allow banks and investors to finally put a fair value on mortgage pools.

“The opportunity for each individual homeowners to “sell” a portion of their home to the government (in a debt-equity swap fashion) also offers the following: truly significant mortgage payment reductions for borrowers, some breathing room to support consumption and a huge quality improvement in banks’ balance sheets. If designed as a simple mortgage pre-payment program, such a plan could be implemented by motivated banking loan officers within six months.

“Consider a homeowner who bought a house in 2006 for $250,000 with a $240,000 mortgage ($10,000 down payment). This homeowner may now be contemplating foreclosure as the value of his home is likely closer to $200,000 today and/or his monthly mortgage payments too high. Under the proposed plan, the homeowner could choose to accept mortgage relief for $60,000 (25% of the original $240,000 mortgage) in exchange for a 25% equity stake in his home. By selling the property for $300,000 in 7 years (assuming a reasonable 6% annual nominal appreciation), the homeowner’s share of the house would then be $225,000; $35,000 above the $180,000 modified mortgage. Not bad for a $10,000 initial investment, largely under water today! The government would get back $75,000; enough to recoup its capital and protect against inflation.

“A simple example would also convince the reader that the offer would be rejected by homeowners with enough home equity. This means that each individual decision to reject the government’s offer would also send a strong signal to the market as to who would repay their mortgages in full without government help.

“In the previous example, if the house were to be sold early for $220,000, the outstanding bank mortgage ($180,000) would be repaid first to the bank and the balance of the proceeds from the sale ($40,000+) would go directly to the restructuring government entity. The balance of government equity ($20,000-) would then be converted into a fully recourse loan yielding 3%. The conversion of the equity into a full recourse loan would provide a disincentive for the owner to sell his/her house early or to enter foreclosure. This would help stabilize the housing market by keeping more homes off the market until prices have appreciated enough. Moreover, the full recourse conversion would also deter borrowers with no prospect of ever repaying their loans from entering the swap agreement; providing much needed information about which loans which should be definitely written off. Moreover, the relief effort would focus on making sure that only troubled, but salvageable, borrowers are turned into viable homeowners.

“Assuming an average mortgage relief of $60,000 for the 12 million homeowners with little or marginally negative equity today, the total cost of the plan would be $720 billion. However, as we saw, most of this money could be recovered, once the homes are sold. Moreover, if banks were forced to first write down each mortgage by 5% before being entitled to the debt-equity swap money, the initial funding for the scheme and the ultimate cost to taxpayers could be substantially reduced.

“Allocating the bail-out money directly to American homeowners would be a politically superior strategy than buying up banks or let hedge funds and private equity investors buy the toxic waste; not least because it would allow many families to stay in their home. Banks, on the other hand, would be much closer to assessing their loan portfolios at values that might actually reflect their true worth under more favourable market conditions. This prospect alone would promote the strong support of banks which in turn would speed up implementation and thus could help avert bank nationalization.

“By taking an equity position in homes, the government insures a certain fairness as it extracts something (i.e. equity) from over-leveraged homeowners, without passing moral judgment, rather than trying to determine administratively who should get it. Finally, as the leverage is transferred from over-leveraged owners to the government most able to support it, the risk to the economy is also considerably reduced.”

Isn’t this simple enough? As I said above, please let me know what you think!

This past week, I received an email from Ralph Liu, Chairman & CEO of Advanced e-Financial Technologies, Inc. (AeFT).

Ralph sees problems with Feldstein’s proposal and he wrote me the following comment on how he is working on innovative solutions to tackle the US housing crisis:

There have been many proposals on how to fix the mortgage crisis. It does not seem that the politicians have not been presented what the better ways may be to fix the foreclosure problems but rather the politicians lack of political will to adopt those good ideas. Looking back in history, most of the time people do not get what they deserve that makes most economic sense. They get what the politicians tell them to get. This time around it seems not much different from before.

So irrespective of what route we may take to get out of this current crisis. Even no measure is taken there will still be an end to it when the last house gets foreclosed. At that time what alternative housing finance system should we adopt for the future? Are we going to tread on the same old path or should we look for something that will give us a paradigm shift in the way people own homes going forward?

FARM (Flexible And Reversible Musharakh or Mortgage) is one of such paradigm shifting new methodologies that many governments could consider. We been working on developing consumer financial products that could offer the same economic benefits of the conventional complicated financial derivatives without its opaqueness and potential shortcomings for the past 8 years. It has been a long way to get to this fine-tuned and come up with a mature design of a new consumer housing financial product.

First we developed a quantitative methodology based on the cost differentials between owning and renting a real estate property in order to put a value of the two major benefits of owning a real estate property. The first is the right to occupy and use a property similar to a conventional renting. Second is the right to future financial gains from appreciation and the obligation of bearing the risk of financial losses due to depreciation. We created a new financial instrument called a SwapRent contract to represent this financial profile of a property ownership. We then took one more step and split the SwapRent contract into two more sub-contracts to separately represent each of the future upside appreciation and the downside depreciation risk.

The secondary marketplace for people to trade these new SwapRent contracts is called REIDeX and currently hosted at http://www.REIDeX.com . For those interested in more details please visit our research web site at http://www.SwapRent.com .

Those quantitative methodologies are the hard part. Once a new way to quantify and trade these future appreciation units of owning a property is done then things could get a lot more interesting when you start applying these new methods. For example, FARM is a new consumer property financing product where would-be homeowners could start out as a renter and buying these appreciation units along the way based on his economic monthly income capability. His down payment will entitle him as a co-owner with the bank in a trust account that he rents from. This co-ownership legal trust structure is already a common practice in many conventional Islamic mortgages that FARM is also based on.

Here are two original product design white papers, FARM – A new type of housing finance products without foreclosure possibility ( http://www.scribd.com/doc/18306698/FARM-A-new-type-of-housing-finance-products-without-foreclosure-possibility ) and FARM vs HELM – The Two Opposite Entry Points to Adjust Economic Ownership in Real Estate Property ( http://www.scribd.com/doc/18596828/FARM-vs-HELM ).

The homeowner could purchase the entire property from the bank any time if he has the money. If he doesn’t, then the monthly payment will first go to the rent so that he will have the right to occupy and use the property. Whatever additional monthly income capability will then go to purchase these appreciation units to mimic a conventional property ownernership. Two immediate benefits are first, he could purchase the appreciation potential of the property for only part of the entire house value if he does not have enough income to own entirely. This opens up opportunity for a lot more people to own homes who normally may not become homeowners without such a new product, hence the increased portable housing affordability. In the past, the way for these low income families to own homes was to be offered a subprime mortgage. That was the root cause of our current financial crisis. SwapRent and FARM allow them to occupy and use the property and still get to own part of the future appreciation without the risk of being foreclosed.

That leads to the second advantage which is when the homeowner loses his monthly income capability due to loss of job or disability in the future, he will only lose part of these future appreciation units. As long as he has the monthly income to rent he could continue to own, occupy and use the property for whatever length of time he wishes. Nobody will be able to foreclose and evict him as in addition to being a renter of the house he himself is still a part owner of the house in the co-ownership trust he set up with the bank before. That is why we call this new invention FARM a new housing finance product without foreclosure possibility.

From the institutional investors’ perspective, pension funds for the first time could have a liquid way with very low transaction cost to establish a position in pure residential real estate market exposures through these SwapRent contracts that either the homeowners or the co-owning banks would like to pass on to other investors. They could therefore easily further diversify their investment portfolios with many residential properties located in different parts of the country or even different parts of the world. The residential real estate could finally be treated as a separate investable asset class in the institutional investment world.

There are more details to the execution part of the methodology then could be covered here. If you have any questions, contact Ralph Liu directly at ralph.liu@swaprent.com and he will be pleased to answer them.

[Important disclaimer: I have no affiliation to Ralph Liu or his firm.]

Submitted by Leo Kolivakis, publisher of Pension Pulse.

The Globe and Mail reports that CPPIB rides market rebound:

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Last October, I wrote an article asking, Is Commercial Real Estate Ready To Tank? Of course, I knew the answer to that question and saw the writing on the wall a long time ago. Today, the Boston Globe published an article stating commercial real estate woes weigh on Fed:

The collapse in commercial real estate is preventing Federal Reserve chairman Ben S. Bernanke from declaring the economy and financial markets are healed.

Property values have fallen 35 percent since October 2007, according to Moody’s Investors Service.

That’s making it tough for owners to refinance almost $165 billion of mortgages for skyscrapers, shopping malls, and hotels this year, pressuring companies such as Maguire Properties Inc., the largest office landlord in downtown Los Angeles, to put buildings up for sale.

The industry is likely to be high on the agenda when Bernanke and his colleagues sit down in Washington today at the Federal Open Market Committee meeting on monetary policy. Lawmakers including Barney Frank and Carolyn Maloney are pushing the central bank to extend an aid program designed to restore the flow of credit.

If nonresidential real estate remains in the doldrums, the Fed may be forced to leave emergency-lending programs in place and keep its benchmark interest rate close to zero for longer than some investors expect, given positive signs elsewhere in the economy.

Commercial property is “certainly going to be a significant drag’’ on growth, said Dean Maki, a former Fed researcher who is now chief US economist in New York at Barclays Capital Inc., the investment banking division of London-based Barclays PLC. “The bigger risk from it would be if it causes unexpected losses to financial firms that lead to another financial crisis.’’

The Fed is “paying very close attention,’’ Bernanke, 55, told the Senate Banking Committee on July 22, the second of two days of semiannual monetary-policy testimony before the House and Senate. “As the recession’s gotten worse in the last six months or so, we’re seeing increased vacancy, declining rents, falling prices, and so, more pressure on commercial real estate.’’

The pressure may be easing in other areas of the economy. Gross domestic product shrank at a better-than-forecast 1 percent annual pace in the second quarter after a 6.4 percent drop the prior three months, and residential housing starts rose unexpectedly by 3.6 percent in June as construction of single-family dwellings jumped by the most since 2004, according to data from the Commerce Department.

Employers cut fewer workers than anticipated last month as the jobless rate fell to 9.4 percent from 9.5 percent in June – the first decline since April 2008, based on Labor Department figures.

Amid such glimmers of improvement, commercial real estate is a “particular danger zone,’’ said Janet Yellen, president of the Federal Reserve Bank of San Francisco, in a July 28 speech in Coeur d’Alene, Idaho.

Now, I know many economists will dismiss the troubles in commercial real estate because it lags the economic cycle. But this isn’t just any cycle and many economists still do not understand what drove asset prices so high.

In short, many economists ignore the role of global pension funds and other institutional players like insurance funds and endowment funds. All that money chasing “alpha” was bound to end badly. The global pension Ponzi scheme played a huge role in feeding this bubble and now the alternatives nightmare continues.

And it will continue for a very long time. No V-shape recovery in commercial real estate or private equity. You can forget about that. That’s why when it comes to alternative investments, I prefer liquidity and tell institutions to focus on liquid absolute return strategies that offer true alpha (don’t pay fees for disguised beta!).

Commercial real estate and private equity woes are also hitting pension funds. Today, the Caisse reported it took a $5.7 billion hit in the first half of the year:

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Tara Perkins of the Globe and Mail reports that the life insurance industry pushes pension fix:

Canada’s life insurers are proposing sweeping changes they say would allow the industry to help fix troubles in the pension system, lobbying against a push by some provinces for a new national plan.

The industry’s drive comes amid a raging debate over the problems, exacerbated by the recession and tumultuous stock markets, with how Canadians save for retirement. Aging baby boomers and the slow extinction of defined benefit plans are among the factors that have left many without sufficient financial protection for their retirement.

Alberta and British Columbia have been pushing a proposal to create a new national system for Canadians without a workplace plan. This voluntary plan would be in addition to the Canada Pension Plan and would be in the form of defined contribution, meaning the participants would receive payments that depend on the plan’s investment income.

Provincial premiers met in Regina last week and called on Ottawa for a national summit on retirement income, directing their finance ministers to report this year on ways that both private and public sector plans can be improved.

The life insurance industry, which is responsible for about two-thirds of defined contribution plans in Canada, has also been talking to provincial and federal governments about “private sector solutions that we think will be as effective as any government-sponsored ones,” said Frank Swedlove, president of the Canadian Life and Health Insurance Association.

“Some of the proposals that have been made raise some concerns for us,” Mr. Swedlove said. “Some of these proposals relate to a government-sponsored defined contribution plan, and we don’t think that that’s the best way to go.

“We think there are opportunities to increase pension activity for Canadians by changing some of the pension rules that exist in the country.”

Donald Stewart, chief executive officer of Sun Life Financial, the biggest industry player in the game, agreed the private sector can service the country’s retirement needs, and said it is calling on government to update pension laws to spur further involvement.

The industry wants the government to alter the Income Tax Act so that a pension plan sponsor need not have a specific relation with, or be an employer of, a participant in a defined contribution plan.

That would mean life insurers and others could sponsor an umbrella plan that could take in a number of companies and, the industry argues, make it easier for many small and mid-sized businesses to offer pensions to their employees.

It could also mean more self-employed people are able to access pensions.

The industry also wants changes to employment standards laws that would allow for the indexing of pension contributions so that contribution rates could be automatically indexed based on age and other factors. That could help new employees who aren’t yet prepared to contribute as much.

More broadly, life insurers want a major overhaul of federal and provincial pension laws in general. The laws were written in an era of defined benefit plans, and have not been properly updated following the dramatic shift toward defined contribution plans, they argue. The laws also fall into a patchwork system of federal and provincial rules that the insurers believe must be harmonized.

“If you have consistent plans, individuals can be mobile across the country,” said Sue Reibel, senior vice-president of Manulife Financial’s Canadian Group savings and retirement solutions. She has spoken to the Alberta and Ontario finance ministers, and travelled to Ottawa on the issue. “One of the things that we all agreed on is that we need to do more,” she said. “We agree that we need to enhance Canadian savings.”

She would like to see changes to the savings legislation that would give Canadians a lifetime RRSP contribution limit, rather than an annual one, similar to what Britain now has. That would give people the flexibility to contribute more when they can, and also account for the natural tendency to save more with age.

With such changes, government can spur retirement savings without intervening in the system further, the industry argues. “As a taxpayer, if I divorce myself from my company, I would step back and say that we’ve got a private sector that built everything,” Ms. Reibel said. “They’ve been building the business for the last 10 years, which is when the defined contribution business really started to grow. Why would you build a new one to do exactly what’s there, unless to point to it and say it’s broken? And I don’t think anyone’s pointed to it and said we’re not doing a good job.”

I am not surprised to see the insurance industry lobbying hard to get a piece of the pension pie. There is a lot of money at stake here and they want a piece of the action.

But no matter what the insurance industry of Canada claims, a “private sector solution” to our pension ills will not be anywhere near as effective as setting up large government sponsored defined-benefit plans that cover all Canadians. Some want an expanded CPP but I have serious problems giving the Canada Pension Plan Investment Board more money and more power. They are big enough and they have not been nearly as transparent as they claim to be.

I think we need to get rid of private sector pension schemes altogether and replace them with several large public defined-benefit plans (similar to what they have in Sweden), cap them at a certain size, set up the best governance rules and oversight possible and let these funds manage money on behalf of all Canadians, not just public sector workers.

The solution to this crisis is not more “private sector” defined-contribution plans sponsored by the insurance industry. Sure, the insurance industry will lobby hard for to get a piece of the pension pie because they want to increase their profits, but they know that a public defined-benefit plan is the only credible long-term solution. That is exactly what they fear the most which is why they are going to fight tooth and nail against any publicly sponsored universal pension plan.

***UPDATE***

Read Linda McQuaig’s article, Profit takes precedence over reform. I quote the following:

Like health care, pensions cry out for public programs. Our public pensions – Old Age Security and Canada Pension Plan – have helped keep seniors out of poverty. But the amounts provided under these programs are low and need to be topped up. Yet less than 40 per cent of Canadians have private pensions to supplement their retirement incomes.

The best way to ensure better pension coverage for all Canadians would be to put more money into our public programs.

Another promising idea, promoted by some provincial governments, involves government setting up multi-employer “super pension funds” that would operate on a non-profit basis.

Jack Mintz doesn’t like this idea. In an op-ed piece in the National Post last May, he attacked it as “dangerous.”

Just why is it dangerous? Well, it seems it’s dangerous to the interests of banks and insurance companies because, as Mintz explained, they would have trouble competing with the non-profit pension funds.

Interestingly, this is the same argument American conservatives use against Obama’s public health-care plan – that private insurers would have trouble competing with it.

Which raises the question: whose interests come first? If we have to choose between leaving elderly Canadians at risk of slipping into poverty or making it harder for banks and insurance companies to compete in the pension market, is that really a tough choice – except perhaps for Jack Mintz, Stephen Harper and others on the Canadian right?

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Bloomberg reports that U.S. stocks rose for a fourth week, pushing the Standard & Poor’s 500 Index above 1,000 for the first time since November, as better-than-estimated employment, manufacturing and home sales data boosted confidence that the worst slump since the Great Depression is ending:

Bank of America Corp. and Wells Fargo & Co. rallied more than 11 percent following an unexpected profit at HSBC Holdings Plc, Europe’s biggest bank, and a report from the National Association of Realtors showing contracts to buy existing homes increased for a fifth month. American International Group Inc., the insurer rescued by the U.S. government, more than doubled on its first profit in seven quarters.

“If you step back and look at fundamentals, you have to say that things are lining up in quite a positive way for the next several months,” said Linda Duessel, who helps oversee $402 billion as equity market strategist at Federated Investors Inc. in Pittsburgh.

The S&P 500 rose 2.3 percent to 1,010.48, the highest since Oct. 6. The Dow Jones Industrial Average climbed 198.46 points, or 2.2 percent, to 9,370.07. The Nasdaq Composite Index advanced 1.1 percent to 2,000.25. The Russell 2000 Index of small companies added 2.8 percent to 572.40.

The S&P 500 has jumped 49 percent from a 12-year low on March 9, the steepest surge over the same number of days since the Great Depression, as three quarters of its companies posted second-quarter earnings that beat estimates and the economy improved. Wal-Mart Stores Inc. and Macy’s Inc. are scheduled to report results next week.

The stock index must rally 55 percent to surpass its all- time high of 1,565.15 set on Oct. 9, 2007. Before November, it remained above 1,000 for five years.

So what is fueling this steep surge in stock indexes? There is no doubt that heading into year-end, big funds are experiencing serious performance anxiety. As indexes grind higher, portfolio managers who were short or neutral stocks are forced to chase returns.

But how much more steam does this rally have? On Thursday, Goldman Sachs’ Abby Cohen (yup, the Queen of Bulls!) came out to say that new bull market in U.S. stocks has begun and possibly started in March:

“We do think the new bull market has begun,” she said. “It may prove it began in March of this year.”

Cohen sees the Standard & Poor’s 500 index .SPX at between 1,050 and 1,100 toward the end of this year. She also said it appears job losses are slowing but that she sees many more months of “difficult labor situation ahead.”

It is hard to argue against the bulls. Many of the financial stocks are up huge since March and the latest U.S. manufacturing and employment reports suggest the worst is behind us.

When I wrote my outlook 2009 back in January, I was bearish on financials. My biggest mistake was not to see that the banksters on Wall Street manufactured this crisis and benefitted from government assistance and printed money on the spreads. Moreover, instead of lending money to businesses, banks are making huge profits on their trading books.

But I didn’t really care because I made good money on my solar stock positions as I knew things were getting way overdone on the downside. These are trading markets and will likely remain trading markets for a long time. Read my piece on the investment labyrinth and why in these markets, small is beautiful.

[Note: Eric Roseman is right, on a risk-adjusted basis, convertible bonds lead the way in 2009.]

My brother was telling me today how regulators are going to crack down on high frequency “flash’” trading. Great news but I would like to see them crack down on naked short selling too.

I any case, you might see more short squeezes in August and some wild moves in stocks. Just check out AIG’s move last week where it opened at $13.20 and closed the week at $27.14, more than doubling in a single week (click to enlarge):

The thing that strikes me is the volume surged in both the stock and call options before the release of earnings on Friday. There is no way that somebody did not leak out the numbers beforehand and yet nobody investigates these all too common occurences.

So how much more upside do we have after a nearly 50% move from the bottom? Technicians will tell you that you can go up to 60% or 70% from the bottom, which means we still have more room to run. But legendary investor, Paul Tudor Jones, thinks this is just another bear market rally:

Tudor Investment Corp., the $10.8 billion hedge-fund firm run by Paul Tudor Jones, said equity markets could decline later this year, creating buying opportunities.

Slowing growth in China and the return of front-page stories on swine flu may be “further catalysts for global equity markets to pause in September,” the Greenwich, Connecticut-based firm said in an Aug. 3 client letter, a copy of which was obtained by Bloomberg News.

Tudor said the 47 percent gain in the Standard & Poor’s 500 Index of the largest U.S. companies since March 9, when it fell to a 12-year low, is a “bear-market rally.” The index topped 1,000 for the first time in nine months this week after companies reported better-than-expected profits.

“Impressive counter-trend rallies are a feature, not an oddity, of secular bear markets,” Tudor said. “We are not inclined to aggressively chase the market here. Many doubts remain about the sustainability of this recovery, most prominently the weakness of household income growth.”

Tudor’s biggest hedge fund, the $8.9 billion Tudor BVI, gained 10 percent this year through July after losing 4.5 percent in 2008. Hedge funds on average lost a record 19 percent last year, according to Chicago-based Hedge Fund Research Inc.

The firm said that a year-end gain in stocks may be another bear market rally with equities falling in 2010.

I agree with Mr. Jones but I also warn you that this counter-trend rally has legs so focus on high beta plays like the Nasdaq Powershares (QQQQ), the Semiconductor Holders index (SMH) and Chinese solar stocks like LDK Solar (LDK) and Yingli Green (YGE).

[Note: Some other Chinese solar stocks that have already broken out and continue to head higher are Trina Solar (TSL), Suntech Power Holdings (STP) and Canadian Solar (CSIQ).]

When the markets do pull back, keep an eye on the Ultrashort Real Estate Proshares (SRS) and the Ultrashort Financials (SKF). But I warn you these leveraged ETFs are not for retail investors and there are lawsuits filed against Proshares because they do not always behave accordingly.

Finally, I urge you all to read the Sceptical Market Observer’s Good and Bad News on the Economy and especially Hoisington Investment Management’s second quarter outlook, from which I quote the conclusion:

The combination of an extremely overleveraged economy, ineffectual monetary policy and misdirected fiscal policy initiatives suggests that the U.S. economy faces a long difficult struggle. While depleted inventories and the buildup of pent-up demand may produce intermittent spurts of growth, these brief episodes are not likely to be sustained. In several years, real GDP may be no higher than its current levels. However, since the population will continue to grow, per capita GDP will decline; thus, the standard of living will diminish as unemployment rises. These conditions will produce a deflationary environment similar to the Japanese condition.

Investments in long term Treasury securities are motivated by inflationary expectations. If fixed income investors believe inflation is headed lower, they will invest in long-dated securities, while they will invest in Treasury bills, or inflation protected securities if they believe inflation is headed higher. In the normal recessions since 1950, the low in inflation was, on average, 29 months after a complete economic recovery was underway, and bond yields moved in a similar fashion. If this recession were normal, then the low in inflation would be in late 2011, at which time investors would begin to consider shortening the maturity of their Treasury portfolios. However, because of our highly-indebted circumstances and the movement of private sector resources to the public sector, the trough in inflation will be moved out, meaning that the low in Treasury bond yields is a distant event.

The path there will be bumpy, as it was in the U.S. from 1929 to 1941 and in Japan from 1989 to 2008. Presently the 10-year yield in Japan stands at 1.3%. Ultimately, our yield level may be similar to that of the Japanese.

So while the bulls cheer on Wall Street, I tell people to focus, not to get too excited and don’t be afraid to raise some cash as asset prices keep going up. There is a lot of liquidity out there driving prices higher, but there will be more than a few hiccups along the way as inflationary headwinds eventually give way to deflationary headwinds.

Submitted by Leo Kolivakis, publisher of Pension Pulse.

The Financial Posts reports that the Supreme Court rules on treating pension surpluses:

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Canada’s premiers met in Regina on Thursday, talking tough about the “Buy American” policy in the United States, pledging to equip Prime Minister Stephen Harper with provincial backing for his meeting with President Barack Obama next week.

But the premiers also discussed another important issue, the pension crisis:

McGuinty said he has another priority – the number of Canadians facing retirement without adequate income. A recent study has shown that by 2030, two-thirds of Canadians will not have enough retirement income to pay for their necessary living expenses, he said.

McGuinty headed into the meeting Thursday by calling for a summit on pensions, saying it’s a national challenge that warrants a national conversation.

“This is an issue that is in some ways independent of this global recession, but the recession has exacerbated or has highlighted some of the challenges associated with folks who don’t have an adequate level of retirement income,” he said.

“We don’t impose ourselves on our kids, who turned to our generation and say … ‘Why didn’t you ensure that you had enough money to retire on?’ “

McGuinty said governments may have to create more incentives to persuade people to sock away money.

Other premiers have discussed setting up provincial public pension plans, which would top up the Canada Pension Plan for people without workplace pensions.

A national summit on pensions? It’s about time! I wonder if his ‘Pension Eminence’, Claude “PE” Lamoureux (he loves private equity, it’s been good to him), the former head of Ontario Teachers’ Pension Plan will be invited. Last time I saw him was when I testified at the Standing Committee on Finance.

Mr. Lamoureux told me to “shut up” after that session, which was a clear sign that I did a good job exposing the shenanigans going on at Canadian public pension funds with bogus benchmarks in alternative investments, most prevalent in private equity and real estate. I understand why Mr. Lamoureux was visibly irritated. He is considered to be part of the “pension aristocracy” and his whole legacy risks being questioned after Ontario Teachers crashed and burned in 2008.

But Teachers’ wasn’t the only one with disastrous results. OMERS took a drubbing in private equity; the Caisse suffered a $40 billion train wreck but had the wisdom not to pay any bonuses whatsoever; Canada Pension Plan Investment Board (CPPIB) lost $24 billion in their FY2009 but their senior managers are smiling; and finally, the Public Sector Pension Plan (PSPIB) lost 23% in their FY 2009 , underperformed their Policy Portfolio by a staggering 5.1% and still managed to dole out $4 million in bonuses ($1.4 million total compensation went to PSP’s President and CEO, Gordon Fyfe, after this disastrous year).

I tell you, those hedge fund and private equity managers are wasting their time. The best gig in town is to be a senior officer at a Canadian public pension fund, especially if you’re working in private markets. You get to fly all over the world first class, get wined and dined by investment managers and get evaluated based on some bogus benchmark that does not accurately reflect the risks of the underlying investments.

And even if you lose billions of dollars, you can always fall back on a four-year rolling return and still pocket a few millions in bonus along the way. If you’re real lucky, some investment manager you invested billions with will hire you away, make you a Vice-President of his Canadian regional office and pay you big bucks while you wine and dine your former colleagues.

Forgive my cynicism but I have seen so much nonsense in my career that I can write books on this stuff. The sad fact is that most of these guys are slimy politicians who do not have a clue about making money in the markets. They look polished, they sound reassuring, but put them in front of a Bloomberg screen and ask them to make you money and they wouldn’t know where to begin. I call them “pension parrots” because they all talk the same nonsense.

Speaking of nonsense, DBRS (remember them? ABCP…) came out yesterday stating that private-sector pension plans in Canada are doing better than one might expect after the drop in stock markets in 2008, and funding pressures should remain manageable.

After reviewing 70 defined-benefit pension plans at Canada’s largest private-sector companies, DBRS said the plans were 95% funded, a “relatively moderate drop” from being 98% funded in 2007.

“In fact, with the past emphasis on reducing pension deficiencies, pension plans are in a strong position to fulfill this goal over the medium term, once an economic recovery begins,” said Peter Schroeder, managing director at DBRS.

The plans, which do not include public-sector behemoths such as Quebec’s Caisse de depot or the Ontario Teachers’ pension plan, had $149-billion in plan obligations and $141-billion in plan assets, representing an $8-billion underfunding gap.

DBRS said challenges do not begin to arise until pension plan obligation funding falls below 80%.

Fifteen of the 70 plans in the study, or 21%, had funding gaps of greater than 20%. That’s an improvement from 2002, when 31% of plans were underfunded, it said.

“For the vast majority, the situation is manageable as plans started in a relatively solid position and there has been some regulatory relief. It is safe to say that 2009 performance will be better than 2008, but it remains uncertain whether plans will meet expectations or not,” Mr. Schroeder said. “From a long-term perspective, most plans would improve reasonably quickly with higher asset returns.”

Pension plan assets declined around the world in 2008 as investment values tumbled alongside global markets. But DBRS said abnormally high discount rates in 2008 helped cushion the impact.

Included in the 70 pension plans were those at big Canadian-based companies Air Canada, the major banks, Manulife, Nortel, Rogers Communications, Teck Resources and BCE Inc.

Noting the inherent risk to companies in offering defined-benefit pension plans — which promise benefits in retirement that the company must fund — DBRS said it expected to see a continued shift into defined-contribution plans, in which future funding obligations rest with the employee.

“Defined benefit pension plans have created pressure on liquidity, albeit manageable, at a time when companies have reduced financial flexibility to resolve underfunded positions,” DBRS said. “When they have a choice, companies have been moving to defined-contribution plans that effectively shift the burden to employees. This trend is expected to continue for the foreseeable future.”

Shift the burden to employees? Is that the solution to this pension crisis? I guarantee you that “solution” will ensure pension poverty for millions of Canadians. We are already there.

The time for a summit on pensions in Canada couldn’t come soon enough. I hope to see people like Susan Eng, Vice-President Advocacy at CARP who put out this press release today, sending a strong message to politicians:

CARP calls on the provincial premiers meeting in Regina to take the lead in pension reform starting with a Pension Summit at which retirees have a seat at the table.

The federal government appears unmotivated to act, choosing instead to create yet another research working committee after the Finance Ministers meeting on May 25, 2009 at Meech Lake.

“The issue has been researched across the country by no fewer than three major provincial expert panels. The need now is for the Premiers and their Finance Ministers to sit down and start constructing the solutions and to make sure that those most affected have a seat at the table,” said Susan Eng, Vice President, Advocacy of CARP.

CARP has called for pension reform that will rebalance the interests of plan members and their employers, including strengthening deficiency funding obligations and giving pension members a higher priority in a bankruptcy. There are two current high profile cases – the Nortel bankruptcy and the CHCH pension fund wind up – which are unfortunate examples of why such reform is immediately necessary.

“The time for action is now – how many more pensioners have to be robbed of their retirement security before the government acts. If the federal government refuses to take a leadership role, the provinces can act within their own jurisdiction,” added Eng.

Incremental, or minimalist, change is no longer acceptable to a growing segment of the Canadian public, not least because this market turmoil has reached deeper and wider than ever before. Now, people with “guaranteed” pensions find common cause with the people, without such pensions, watching their RRSPs evaporate.

This crisis has also exposed the flaws in the existing pension regulatory regime and the current plight of the Nortel and CHCH pensioners is a prime example. Pension reform that seeks to rebalance the interests of the employees/retirees and the employers/plan sponsors is long overdue but requires bold political leadership.

The federal government includes in its talking points that “on June 16, 2009, a motion proposing that the Government of Canada work with the provinces and territories to ensure the sustainability of the retirement incomes of Canadians received unanimous support in Parliament”.

CARP is very familiar with that motion having called out to its membership to email their MPs in advance of the vote to voice their support for the motion. http://www.imakenews.com/carp/index000372659.cfm?x=bfP3GB3,0& and http://www.imakenews.com/carp/index000373300.cfm?x=bfP3GB3,0&

More than 6,000 members responded and MPs across the country heard directly from CARP members in force over just two business days. The Finance Minister alone got over 500 emails from CARP members and he also voted for the Motion.

“Retirees ravaged by this economic downturn cannot wait for more studies. This tremendous and immediate response from our members shows how important this issue is for them. Government needs to act immediately to give them help now by increasing OAS, GIS and CPP and better protecting the interests of those with pension plans. It is also time to act for those without pensions”, added Eng

“CARP’s message to politicians has been: ‘seventy percent of older Canadians vote regularly and now that we’re also living longer, we will be voting regularly for a lot longer. So either you help protect our retirement or we’ll help you get to yours’.”, added Eng

There has been growing recognition that Canadians are not saving enough for their own retirement and that even those with workplace pensions are at risk in the current economic climate. CARP has called for a Universal Pension Plan modeled on the CPP for the estimated one in three Canadians who retire without any retirement savings.

Three provincial pension review panels [BC-Alberta, Nova Scotia and Ontario] identified the need to provide broader access to larger well-managed pension funds for Canadians who do not have access to workplace sponsored plans.

“All Canadians will benefit if the federal and provincial governments immediately start constructing a Universal Pension Plan – a universally accessible and affordable retirement savings vehicle that is robust enough to withstand demographic and economic challenges like those we are now witnessing. The first step is to convene a Pension Summit at which representatives of retirees have a material role”, added Eng.

CARP is a national, non-partisan, non-profit organization committed to advocating for a New Vision of Aging for Canada, social change that will bring financial security, equitable access to health care and freedom from discrimination. CARP seeks to ensure that the marketplace serves the needs and expectations of our generation and provides value-added benefits, products and services to our members. Through our network of chapters across Canada, CARP is dedicated to building a sense of community and shared values among our members in support of CARP’s mission.

The first thing the Canadian government should do is revamp the RRIF rules so that people do not have to extract a certain percentage of their retirement savings when they reach 65. I would scrap those rules altogether because they hurt many retirees who had to cash out at the market bottom. There also needs to be a lot more favorable tax incentives for retired people and workers looking to save more. But most important, we need a universal pension plan that covers all Canadians adequately so they can retire in dignity.

Finally, apart from Susan Eng, I also hope to see Canada’s current Chief Actuary, Jean-Claude Ménard and Canada’s former Chief Actuary, Bernard Dussault at this summit. There are other people I’d like to see there like Jean-Pierre Laporte and Diane Urquhart.

And despite his rude remarks, I think Mr. Lamoureux should be invited to this summit on pensions because he is an intelligent man who knows a lot about the pension industry. Just make sure he is not sitting anywhere near me.

Submitted by Leo Kolivakis, publisher of Pension Pulse.

On Monday I reported that some UK pension schemes are shifting assets into bonds. On Tuesday Reuters carried an article, Dow rally for real? “Big Money” thinks so:

Pension managers and mutual fund houses have been among the biggest buyers of the Dow Jones industrial average .DJI in recent weeks, underscoring the growing belief the recession is over, according to an analysis conducted by Thomson Reuters.

Between July 14 and July 21, when the Dow gained almost 600 points to 8915, net buying by pension managers and mutual fund managers — or so-called “long-term” or “big” money managers — totaled $1.9 billion, said Jeff Shacket, vice president of corporate services at Thomson Reuters, who analyzed settlement records of the Dow components.

The following week, when the Dow approached 9000, pensions and mutual funds were net sellers but only at $578 million, while hedge funds were net buyers of $19 million in Dow stocks but not after selling $166 million the previous week, the settlement records showed.

“There is some momentum lost among pensions and mutual fund investors, but the move is still generally positive,” Shacket said on Tuesday. “These buyers are saying that this market is going to go higher — and not lower any time soon.”

The move by these institutional investors into Dow stocks corroborates with economic data and earnings that have been better than expected.

Tuesday, in fact, the number of contracts to buy previously owned homes in the United States rose in June for a fifth straight month while a report last week showed sales of new homes soared 11 percent in June, the most since 2000. For their part, the 370 Standard & Poor’s 500 index companies .SPX that have reported second-quarter earnings are surpassing estimates by 14.9 percent, according to Thomson Reuters.

Shacket said the settlement records reveal to some degree how “there is some confidence on the part of long-term investors that we won’t have a bad second half.”

So far, the second half has been anything but: The Dow posted returns of over 7 percent in July alone and on the first trading day of August investors saw the Standard & Poor’s topped 1000 and the Nasdaq passed 2000.

Hedge funds, which have appeared to miss the huge rally in recent weeks, also are becoming less bearish.

The Greenwich Alternative Investments Macro Sentiment Indicator — which is based on hedge fund investors employing a macro view who collectively manage a total of $30 billion in assets — showed that 50 percent of those macro managers expect the S&P to continue to move lower.

That’s down from 60 percent in July.

“All of this suggests how investors overreacted to the downside during the first quarter,” Shacket said.

So what is going on? Why are these long-term investors so confident all of a sudden? I am not sure it has to do with confidence as much as it has to do with performance anxiety. In fact, the case for more upside was made today by Mark Dow, fund manager at Pharo Management, a global macro hedge fund with about $2 billion of assets. Dow believes the market can “continue to grind higher for a while” for a number of reasons:

Performance anxiety: Market psychology moves in three phases Dow says, denial, migration and capitulation. After having “denied” the rally in its early phase, many institutional investors are now “migrating” back into stocks, he says, mainly out of fear of missing more upside. “They’re buying not because they want to but because they have to,” he says. In other words, big money is only just starting to come off the sidelines.

Upside surprise: While not a believer in the V-shaped recovery story, the former IMF and Treasury staff economist believes the market still has a “bearish bias” when it comes to the economy, which he thinks will prove better than consensus.

Weak Dollar: In case you haven’t noticed, the dollar has fallen as stocks, emerging markets and commodities have rallied. Dow believes this trend will continue and doesn’t believe a weak dollar is a sign of impending doom (as we’ll discuss further in an upcoming segment).

Mr. Dow makes several good points, especially on the USD. As the Fed reduces the balance sheet because banks demand less dollars, you would expect the USD to decline.

If you look at financials, they have been on a tear. On Wednesday, the “scrap financial stocks” rallied sharply, most likely due to massive short-covering. Click on the image below to enlarge and see for yourself:

As you can see the big moves were from AIG (+63%) and Radian (+83%) which soared today on massive volume. And you still think the markets are rational and not driven by sentiment and speculation? Yeah right. There is a reason why they call it casino capitalism. And this isn’t the first time I have seen days like this. There is a lot of nonsense that goes on in the markets on a daily basis.

But let me get back to the topic at hand. Big money isn’t just betting on beta, they are chasing indexes higher. Pension funds need yield so they are buying up stocks and mutual funds need to outperform the overall indexes or else they risk losing business.

But pensions are also betting on other asset classes like real estate and commodities. The bet on real estate is way too premature and will lead to more losses for pensions. As far as commodities, I agree with Mike Masters who testified before the CFTC today to ban all investors from making passive investments in commodity derivatives markets.

But for now, pension funds are making a one way beta bet on stocks. They are probably late to the party and chasing the indexes up. The sharp rally in global stocks has brought much needed relief to many pension funds. For example, Irish pension funds saw positive returns for the fifth month in a row in July, with average returns of 6%.

In North America, the Boston Globe reports that the state pension fund is bouncing back:

After suffering its worst year in history, the state’s public pension fund bounced back in July, with a 4 percent gain that boosted its balance to $39.8 billion.

“July was the best single month we’ve had in some time,” said Michael Travaglini, executive director of the Massachusetts Public Reserves Investment Management Board, which runs the pension fund.

The state fund lost 23.6 percent for the fiscal year ended June 30, the biggest decline since the fund was created in its current form 24 years ago. Travaglini also said that performance put the fund in the bottom of quartile of large pension funds tracked by Wilshire Associates for the first time in seven years. He blamed the performance on the fund’s large holdings in stocks, which performed badly, while bonds enjoyed better returns. The fund also fired several investment managers for poor performance during the year.

But now the stock market has turned, and with it the fund’s performance. “It really is a testament to having a longterm focus and a disciplined approached,” Travaglini said. “As bad as 2008 was, we didn’t panic.”

In fact, the board is so bullish on stocks that it yesterday it voted to increase the amount of money the fund invest in equities, and to decrease its holdings in hedge funds, from 11 percent now to 8 percent, based on the advice of its investment consultant. Ironically, hedge funds performed better than the state’s investments overall last fiscal year.

But Travaglini said the investment changes are marginal and added that the board regularly tweaks its investment allocation by a few percentage points.

No mention of private equity but I can tell you that if stock markets keep going up, the private equity market will start to recover too. As far as hedge funds, big players like UBP are scaling back their hedge fund investments to invest more in traditional stocks and bonds.

But this one way bet on beta carries huge risks too. If for any reason growth falters and deflationary headwinds get stronger in Europe, Japan, and in North America, then these one-way beta bets will come back to haunt pension funds.

On that note, I will give pension funds my advice. Start investing in hedge funds that are truly market neutral funds. The big money was made in L/S equity, global macro and CTAs and while I still like these strategies, I think it’s time to focus on finding managers that specialize in market neutral strategies (less beta, more alpha).

If you are going to make beta bets, focus on certain sectors with long-term potential: alternative energy, biotech, pharmaceuticals, infrastructure (both public and private), semiconductors (SMH,USD) and country plays like China and India.

Last but not least, learn to use a few easy option strategies to protect your downside. It’s alright to buy some premium when vol is cheap and sell premium when vol is expensive. Talk to your brokers or independent experts to figure out which is the best strategy for you .

Whatever you do, don’t just make one-way beta bets. This will just lead to more substantial losses down the road.

***Death of Jack Lawrence, founder and CEO of Burns Fry Ltd***

Hugh Urquhart, Diane Urquhart’s husband, sent me this message:

Jack Lawrence, the founder and CEO of Burns Fry Ltd. died in a plane accident, while flying home from his cottage on August 3rd. Jack Lawrence was one of the men that appointed Diane to Head of Research at Burns Fry, making Diane the first woman in North America to hold such a position. It is interesting to note that Jack and the executives at Burns Fry never attempted once to alter Diane’s reports to advantage the firm in its underwritings. Burns Fry was known for its integrity. Jack Lawrence appreciated and respected the employees of Burns Fry, whose work made an enormous contribution to the stability and growth of the Canadian economy. An independent firm meant that the employees were share owners, which meant each employee carried a huge responsibility for the success of the firm.

It was having had the opportunity to work at this former great firm, Burns Fry, under Jack’s leadership that must have given Judge Collin Campbell the faith to appoint Diane Urquhart as the financial analyst for the under one million dollar owners in the Asset Backed Commercial Paper Bankruptcy Court Proceedings. The settlement for the retail sector was one of the largest in Canadian history – $190 million for 1800 retail families. It was very sad news to learn of Jack Lawrence’s death. There were few people like him, who shared the ownership of the firm and who entrusted the survival of the firm to his many employees. Jack set a standard for employee relationships, that few people do today.

Jack has left us, but his integrity, and desire to contribute to Canadian society lives on through many people he worked with. Jack Lawrence gave Diane an opportunity for which the Urquhart family is extremely grateful .

Submitted by Leo Kolivakis, publisher of Pension Pulse.

Reuters reports that British pension funds have begun exerting pressure to change proposed European Union rules that would impose new regulations on the hedge fund and alternative investment sector:

The National Association of Pension Funds (NAPF) and a director at Hermes, manager of Britain’s largest corporate scheme, told Reuters the rules could damage investment choice and hit returns, affecting the affordability of pensions.

Their comments came as the Alternative Investment Management Association (AIMA) focused its lobbying efforts on the effect the European Union rules might have on retirement savings.

The draft legislation affects hedge funds, private equity funds and real estate products and demands that funds register and disclose information to regulators such as levels of leverage. The directive, announced in April, also restricts the ability of non-EU managers to sell funds in Europe.

Kathryn Graham, a director at Hermes Pension Fund Management, which acts as direct advisers to trustees of the more than 30 billion pound BT Pension Scheme, said it was time for the industry to speak up.

“There are unintended consequences from the structure of the directive which would lead us to have substantially smaller choice in terms of the investments we’re able to make, but also, I would imagine, a significantly increased cost to the investments we are able to make,” she told Reuters.

“This legislation really casts some doubt … on how we’d be able to invest in those investments going forward. We will make sure that our voice is heard.”

Pension funds have increased allocations to asset classes outside bonds and equities as they seek to diversify portfolios and boost returns to meet the demands of ageing populations.

“The directive, if passed in its current form, will reduce investment choice and mean that the return pension schemes can get for any level of risk will be reduced,” Joanne Segars, NAPF chief executive, told Reuters in an emailed statement.

“Even a small reduction in return will have an impact on the affordability of defined benefit pension schemes,” she said.

Representatives of the fund sectors affected by the draft rules have been lobbying hard to soften the final stance taken by the EU. They believe the directive was influenced by political grandstanding and did not take a measured look at their industries’ roles in the financial crisis.

Their efforts, and sustained pressure from British government and U.S. Treasury officials, have led many observers to predict changes before the rules become law.

AIMA said on Tuesday that the EU legislation could deliver a 25 billion euro hit to the European pension fund industry if passed in its current form.

“This (25 billion euros) is an estimated figure, but it shows the potentially enormous impact that the directive could have on Europe’s pension funds and, in the longer term, Europe’s pensioners,” said Andrew Baker, chief executive of AIMA.

AIMA used an estimate that the aggregate exposure to hedge funds, private equity funds and property funds equates to 20 percent of all pension money in Europe.

It also estimates that changes envisaged by the new legislation would shave 2.5 percent off pension funds’ returns through reduced choice, switches to other asset classes, or by reduced returns from alternative investments due to extra compliance and leverage demands.

So what’s got these pension funds all wound up? I can sum it all up in one word: LEVERAGE. The only reason pension funds invest in alternative investments is to use the power of leverage to boost their returns. Think of it as “beta on steroids”, which is what most of these alternative investment funds offer charging the pension herd 2 & 20 (2% management fee and 20% performance fee) for this “alpha”.

Speaking of fees in alternative investments, Bloomberg reported yesterday that hedge fund fees firm as LBO managers bow to pensions:

Larry Powell, deputy investment chief for the $16 billion Utah Retirement Systems, was convinced in January that hedge funds finally would buckle under the pressure of record losses in 2008 and lower their fees.

He figured it was appropriate to insist on a reduction in the standard industry charge of 2 percent of assets and 20 percent of gains on investments as low as $25 million, according to a memo Powell circulated with hedge funds and investors. Performance fees should be assessed only after a minimum return is exceeded and paid over several years rather than annually, he said.

Powell’s plan proved to be wishful thinking. Unlike many private-equity firms which have reduced fees, hedge funds aren’t budging without concessions such as longer lock-up periods and commitments of at least $100 million, according to money managers and consultants.

While Powell could crow at a June industry dinner in New York that more than half of Utah’s 40 hedge-fund managers agreed to changes in their fees, with four adopting his recommendations, top-performing managers haven’t adjusted yesteryear’s top-dollar fees.

“There is no wholesale reduction of fees taking place,” said Stewart Massey, who runs Massey Quick & Co., a consulting firm in Morristown, New Jersey, that caters to wealthy individuals, endowments and foundations.

Relative Returns

Daniel Och’s $20 billion Och-Ziff Capital Management Group LLC, Steven Cohen’s $14 billion SAC Capital Advisors LP and Highbridge Capital Management LLC’s $23 billion fund haven’t reduced performance fees and are demanding a three-year lock-up in exchange for any cut in management fees.

SAC Capital, which charges 3 percent of assets and takes 50 percent of investment gains, may end up keeping fees where they are because market returns are on the rise again, said a person familiar with the Stamford, Connecticut-based firm, who declined to be identified because the discussions are private.

Private-equity funds are having less success holding the line on management fees, which averaged 2 percent in 2008, according to London-based research firm Preqin Ltd. Companies starting new funds this year are seeking an average of 1.8 percent. The figure is about 1.65 percent for offerings with more than $1 billion, Preqin reported.

One reason for the difference is investment performance. Buyout funds recorded a 28 percent decline in value last year, according to Preqin. That compares with a 19 percent drop for hedge funds, according to Hedge Fund Research Inc. Hedge funds climbed 9.5 percent this year through June. Comparable figures for buyout firms aren’t available.

‘Adverse Selection’

Another difference is liquidity. Private-equity funds tie up money for as long as 10 years. Investors can pull out of hedge funds as frequently as once a quarter.

When a hedge-fund manager reduces fees without seeking concessions, “that means they are negotiating from a position of weakness, and that manager must be scrutinized more,” said Massey, the consultant. “It’s an adverse selection process.”

Hedge-fund managers collected fees of about $55 billion in 2007, when returns averaged 10 percent, according to Hedge Fund Research. Fees shrank to about $25 billion last year as returns fell the most since the Chicago-based firm began tracking the data in 1990. They will be about $45 billion in 2009, assuming returns and assets under management are constant for the rest of the year.

Lock-Up Performance

The industry had $1.43 trillion in assets as of June 30, down from a peak of $1.9 trillion in mid-2008. Hedge funds are private pools of capital whose managers can buy or sell any assets, bet on rising as well as falling prices and participate in profits from money invested.

Hedge funds considering changes have proposed cutting asset-based management fees by half a percentage point for investors who are willing to put up $100 million and not touch the money for three years, said people on both sides of the talks. It’s a commitment that only institutions with multibillion-dollar hedge-fund holdings can afford to make.

Performance fees, the managers’ slice of investment profits, aren’t falling. Some funds are talking about instituting a hurdle, or minimum gain, that must be cleared before they can take their cut, and about collecting the payments over the entire lock-up period rather than annually.

“There has been lots of talk, but I haven’t seen lower fees except for new funds, which are charging a 1.5 percent management fee now,” said Larry Chiarello, director of research at Red Bank, New Jersey-based Riverview Alternative Advisors LLC, which farms out money to hedge funds. “Established managers seem very unwilling to lower fees on existing funds.”

Utah to Calpers

Utah’s Powell wouldn’t comment, citing the “no press” policy of his Salt Lake City-based employer. The pension fund tumbled 22 percent in 2008, according to its Web site. Utah doesn’t disclose performance for its hedge-fund investments or how much it invests in them.

The $184 billion California Public Employees’ Retirement System, the largest public pension fund in the U.S., told hedge- fund managers in March that it was looking for changes similar to those proposed by Utah. Clark McKinley, a spokesman for Calpers in Sacramento, declined to say which if any of its 30 managers had revised terms. Talks with hedge funds “have been going favorably,” he said.

Calpers lost 23 percent in the fiscal year ended June 30. Its hedge-fund holdings fell 15 percent to $6 billion in the 12 months ended March 30, the most recent data available.

Exits Blocked

Supply and demand has helped hedge funds resist fee erosion. Private-equity firms buy companies, hoping to profit by selling them later at a higher price, as well as invest in real estate, debt, infrastructure and venture-capital startups.

Investors are less inclined in declining markets to lock up their money for five to seven years, said Brad Alford, head of Alpha Capital Management LLC in Atlanta and a former managing director of the investment division of Duke University’s endowment. With fewer initial public offerings and corporate mergers, private-equity funds aren’t able to exit investments and return capital to their limited partners, he said.

More than three-quarters of hedge funds charge between 1.5 percent and 2 percent of assets, Preqin said in a report published last week. Seven out of 10 funds take 20 percent of investment profits. Larger funds tend to have higher management fees because they are more in demand, the report said.

Cutting management fees for a large investment is nothing new, said Peter Gilbert, chief investment officer for the endowment of Lehigh University in Bethlehem, Pennsylvania, and former investment head of the Pennsylvania State Employees’ Retirement System, where he worked for 14 years.

Fund Liquidations

“There is a long history of certain managers being willing to provide fee concessions in exchange for significant allocations,” he said.

Most hedge funds that have reduced fees are new managers or those hoping to keep clients after big losses or redemptions.

Jeffrey Gendell, whose Tontine Associates LLC in Greenwich, Connecticut, liquidated two funds after losing more than 60 percent in 2008, was raising money for a new fund this year that charges 1 percent of assets.

Harbinger Capital Partners, whose assets dropped by about 70 percent between June 2008 and early this year, offered new clients or those adding to their positions the option of investing for two years at a time, in exchange for paying 1.25 percent of assets and 15 percent of investment gains. That compares with 1.5 percent and 20 percent for investors who choose an initial one-year lock up.

Weak vs. Strong

Investors can now pull as much as 25 percent of their assets every quarter and don’t pay a performance fee unless the funds return more than 7 percent. The New York-based firm, run by Philip Falcone, managed $7 billion as of March.

Firms with large institutional clients and strong long-term track records are driving a much harder bargain, including some that manage money for Utah, according to people familiar with the state’s portfolio.

Highbridge, owned by JPMorgan Chase & Co., has discussed a separate share class for large institutions with a management fee lower than its usual 2 percent. Clients may be asked to commit $100 million or more and agree to keep their money in the fund for three years, rather than being able to exit quarterly, said people familiar with the New York-based firm.

Its main fund, which has $7 billion, climbed 27 percent this year through July, the people said.

Stark to Och-Ziff

Stark Investments, with $8 billion under management, has discussed similar arrangements with investors, said people familiar with the St. Francis, Wisconsin-based firm.

Och-Ziff, whose Master Fund rose 12 percent in the first half of the year, has had talks about cutting management fees by half a percentage point in exchange for a three-year lock-up and a sizable commitment, according to people familiar with the New York-based firm.

Among other managers, Marc Lasry’s $17 billion Avenue Capital Group in New York also has talked about cutting management charges in exchange for a large investment, according to a person familiar with the firm. The performance fee wouldn’t change.

SAC Capital, which recently told investors in its main fund that they could take money out each quarter instead of waiting three years, is considering an institutional share class with a longer lock-up in exchange for lower fees, according to potential investors with the firm. The main fund has climbed 17 percent this year.

Officials for all the hedge funds declined to comment.

Depends on Performance

With strong performance to draw in new clients, some managers may decide not to offer any breaks at all because that would cut into their revenue for years to come.

“In the previous downturn, a number of managers were forced to lower fees,” said Robert Sutton, a partner at New York-based Kirkland & Ellis LLP, who advises hedge funds. “It took some time before they could command higher fees for new investments again.”

My advice to the pension herd is to never lock-up your money with any hedge fund for three years. You got that? NEVER! I do not care if it’s Steve Cohen, Ken Griffin, George Soros, Jim Simons, John Paulson or any other “royal” hedge hog. Never lock up money with any hedge fund because when the shit hits the fan, you’re stuck paying management fees to some arrogant hedge fund manager who is losing money but still thinks he is God’s gift to finance. Been there, done that. [Note: Read my comment, closing the gates of hedge hell.]

Will CalPERS and Utah have any success lowering hedge fund fees? Fat chance of that happening because there is enough dumb money around for the hedge fund community that they can continue charging ridiculous fees for “disguised beta” on steroids. Of course they’ll call this “alpha” and package it up so the dumb board of directors of these multi-billion dollar pension funds stamp their approval and then brag that they got into so and so’s fund.

Let me end by stating that there are some excellent hedge fund managers out there but they are few and far between. The same can be said of private equity managers. Most of them are glorified financial engineers who never rolled up their sleeves to restructure a company from the bottom up. And they lock up pension money for ten years. If they screw up, pension funds are in deep trouble. Just ask Harvard and Yale, the two endowment funds that everyone wanted to emulate.

Finally, as the royal rumble draws closer pitting regulators versus alternative investment managers, think about the poor pensioners. I find it sad that pension funds are making the case for “more choice” when they played a huge part feeding the great pension con job.

If the only solution to the pension crisis they can come up with is more hedge funds, more private equity funds, more real estate funds and more commodity funds, then God help us all.