naked capitalism

Defined-benefit pension plans are famously a headache for the many firms that, once upon a time, offered them. Managing far-future liabilities related to employee career choices and life spans is far outside the core competence of nonfinancial firms. Pensions accounting is its own little universe, just like nightmares are. So doesn’t it make sense to outsource the management of those plans to financial firms, whose bread and butter is managing assets to fund liabilities? And wouldn’t it cut down on “moral hazard” if the firms managing the plans owned them, and were actually liable for any shortfalls?

A BusinessWeek article by Matthew Goldstein (hat tip to Calculated Risk commenter “synthetic-guarantee groupie“) describes a proposal to do just that, transfer ownership of closed pension plans from Main Street firms that find them burdensome to Wall Street firms that see an opportunity. Why am I (along with the article’s author) not entirely enthused?

The folks who brought you the mortgage mess and the ensuing hedge fund blowups, busted buyouts, and credit market gridlock have another bold idea: buying up and running troubled corporate pension plans. And despite the subprime fiasco, some regulators may soon embrace Wall Street’s latest scheme…

[T]he world’s biggest big investment banks, insurers, hedge funds, and private equity shops have been quietly laying the groundwork for such deals over the past year. They would be a big prize for Wall Street. The $2.3 trillion pension honey pot has $500 billion in “frozen plans” that are closed to new employees and whose benefits are capped… By managing those troubled plans, Wall Street also gains entrée to an appealing set of customers to whom it can sell a broad array of fee-generating products…

The concept of off-loading pension funds sounds great. For businesses it’s a chance to rid themselves of struggling plans, which can weigh down a balance sheet. It’s especially good timing now. New accounting rules take effect in the next year or so that will require companies to mark their pension assets to prevailing market prices each quarter—a change that could devastate some companies’ profits…

Critics, including some on Capitol Hill, worry that financial firms don’t have workers’ best interest at heart, which would put some 44 million current and future retirees at risk… The biggest fear is that Wall Street could use retirement portfolios as a dumping ground for its most toxic and troublesome investments. It’s not unlike what regulators allege UBS officials did with its stockpile of risky auction-rate securities by trying to off-load them to wealthy clients.

If Wall Street gambles with those pension assets and loses, U.S. taxpayers would probably foot the bill. When a company with a pension goes belly up today, the PBGC, under federal law, has to take on the fund’s obligations and dole out money to its beneficiaries. It’s a costly burden: The PBGC currently runs a $14.1 billion deficit.

Former PBGC director Bradley Belt argues that pension buyouts could actually strengthen the agency. If financially strapped companies could dump the plans rather than ponying up money for them, they might stay out of bankruptcy. That would mean the PBGC wouldn’t have to step in and pick up the pieces of the pension… [According to Belt,] “This is really in the public interest if it’s done correctly.”

The federal agencies that oversee the nation’s pension system are expected to weigh in on the issue—potentially paving the way for big firms that have been pursuing it, such as Aon, Cerberus Capital Management, Citigroup, JPMorganChase, Morgan Stanley, and Prudential… Regulators are almost certain to put the kibosh on buyouts by free-standing, independent firms that aren’t tied to the books of any big firm. The worry is that such a weakly capitalized company wouldn’t have the balance sheet heft to deal with the pensions if their assets soured. After all, even big Wall Street firms have been crippled by the $400 billion in subprime related losses.

In theory, this is a win-win proposal. So why, in practice, does it leave me cold? Since these are defined benefit plans, the plan owners take the loss if they mismanage pension money, so retirees should be indifferent to the transfer unless they believe that a potential sponsor will go belly up. Similarly, taxpayers are only on the hook when plan sponsors go bankrupt. If transfers are restricted to firms with strong balance sheets, the likelihood of sponsors collapsing might diminish, leaving both taxpayers and retirees better off. Financial firms could benefit from economies of scale in managing the plans, invest in expertise, and profit by increasing efficiency while totally delivering on plan promises.

I’m nervous not because this is a bad idea in theory, but because I no longer have confidence in the firms that would run these plans. Large financial firms have proven too adept at circumventing prudential regulations until a crisis erupts, and then compelling rule-changes that offload the cost of errors to third parties, which would be taxpayers and retirees in this case. In theory, taxpayers shouldn’t be on the hook for whatever happened at Bear (and every other bank the Fed is lending to), but look where we are.

Supporters of these transfers are right that not permitting the proposal to go forward has real costs. Potentially salvageable, productive firms may buckle under the weight of legacy pension guarantees that expert financials could successfully bear, harming both the private economy and the public purse.

There are costs to not having a financial system worthy of confidence.

One of the more depressing bits of emerging conventional wisdom is the notion that the financial system took on “too much risk” in recent years. I think it is equally accurate to suggest that the financial system took on too little risk.

Consider the risks that were not taken during the recent credit and “investment” boom. While hundreds of billions of dollars were poured into new suburbs, very little capital was devoted to the alternative energy sector that is suddenly all the rage. Despite a “global savings glut” and record-breaking levels of “investment” in the United States between 2005 and 2007, capital was withdrawn from a variety of industries deemed “uncompetitive” in large part due to obviously unsustainable capital flows. Very few brave capitalists took the risk of mothballing rather than dismantling factories and maintaining critical human capital through the temporary downspike. Under the two to five year time horizon of our most far-sighted managers, whatever is temporarily unprofitable must be permanently destroyed. To gamble on recovery is far too great a risk.

I don’t pretend to know where all that capital, that incredible swell of human energy and physical resources, ought to have gone. But it doesn’t take an Einstein to know that it probably should not have gone into building Foxboro Court. Sure, hindsight is 20/20. But lack of foresight really wasn’t the problem here. In 2005, how many macroeconomists or big-picture thinkers were arguing that the US economy lacked suburban housing stock of sufficient size and luxury? We gave the building boom the benefit of the doubt because it was a “market outcome”. But the shape of that outcome was more matter of institutional idiosyncrasies than textbook theories of optimal choice. It resulted as much from people shirking risk as it did from people taking big bets.

The big central banks, whose investment largely drove the credit boom, were (and still are) seeking safety, not risk. The banks and SIVs that bought up “super-senior AAA” tranches of CDOs were looking for safe assets, not risky assets. We had a housing boom, rather than a Pez dispenser bubble, because housing collateral is (well, was) the preferred raw material for fabricating safe paper. Investors were never enthusiastic about cul-de-sacs and McMansions. They wanted safe assets, never mind what backed ‘em, and mortgages are what Wall Street knew how to lipstick into safe assets. The housing boom was born less from inordinate risk-taking than from the unwillingness of investors to take and bear considered risks. Agencies, asset-backed securities, it was all just AAA paper. It was “safe”, so who cared what it was funding?

Finance is not a closed system, a zoology of exotic contracts and rocket scientist equations. The job of a financial system is to make real-world decisions, “What should we do?” A good investment is a simple answer to that question, with clear consequences for getting it right or wrong. Mom and Pop can have FDIC insured bank accounts, and imagine that there is such thing as a “risk-free return”. But that’s a lie, a sugarcoated subsidy. Foregone consumption does not automatically convert itself into future abundance. People have to make smart decisions about what to do with today’s capital. If they don’t, no amount of regulation or insurance will prevent all those savings accounts from going worthless. When huge institutions treat the financial system like a bank, depositing trillions in generic “safe” instruments and expecting wealth to somehow appear, they are delegating the economic substance of aggregate investment to middlemen in it for the fees, and politicians in it for whatever politicians are in it for. And we are surprised when that doesn’t work out?

Of course we should regulate and manage the risks that were the proximate cause of the credit crisis. Anything too big to fail should be no more leveraged than a teddy bear, and fragile, poorly designed markets should be fixed. But that won’t be enough. We’ve trained a generation of professionals to forget that investing is precisely the art of taking economic risks, then delivering the goods or eating the losses. The exotica of modern finance is fascinating, and I’ve nothing against any acronym that you care to name. But until owners of capital stop hiding behind cleverness and diversification and take responsibility for the resources they steward, finance will remain a shell game, a tournament in evading responsibility for poor outcomes.

Investors’ childlike demand for safety has made the financial world terribly risky. As we rebuild our broken financial system, we must not pretend that risk can be regulated or innovated away. We must demand that investors choose risks and bear consequences. We need more, and more creative, risk-taking, not false promises of safety that taxpayers will inevitably be called upon to keep.

Crossposted from Interfluidity.