Guest Post: Pensioners Taking a Back Seat to Bondholders?

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 “Our bankruptcy law is way out of date with respect to new developments in the marketplace.”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”?

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  1. rd

    A question on this post:

    would it make sense to require pension funds and disability plans to purchase CDS's to cover unfunded liabilities? That could put those plans on the same footing as the bondholders again.

  2. Martin, the Netherlands

    In the Netherlands all pension fund assets are held by a separate legal entity. When the company/plan sponsor bankrupts, the most the fund can lose is a month or so of contributions. I work in the treasury dept. of our organisation, and I can actually see the contributions being paid with a one-month delay. The North American solution of making a pension plan -as I see it- a sort of addendum to a company's HR department, exposing it to the vagaries of the company's finances, would be seen as quite unacceptable.

  3. Anonymous

    Most of the traders I know are having a hard time locating stock to short.

    They believe the market is rigged so that shoring is now almost impossible.

  4. Anonymous

    Here is what i don't understand:
    As per Canadian laws, employees and bondholders share equal pain. Which seems to be the case. Now just because somebody bought insurance doesn't mean you have to take into account insurance payout. The original author actually says that it is unfortunate that pensioners were not able to get an insurance. I think the whole point is that pensioners are unhedged.

    There is nothing wrong with the CDS market in this situation.

    Remember that the hedged bondholder actually had the foresight to pay premium out of his pocket to cover his position.

    How do you deal with bond holders who didn't hedge? This article is more a socialist talking. It is unfortunate that Nortel employees are suffering. But the bigger issue that is swept under the carpet is that fraud has been committed at Nortel.

  5. Leo Kolivakis

    If shorting stocks is so hard, then why is short interest so high on some stocks? Perhaps hedge funds do not have any problem finding shares to short.

    As for the article being "socialist", this is the typical response akin to the fear mongering going on right now in the U.S. on the public option for healthcare (what a travesty that is!).

    Pensioners, disbaled workers and employees who were dismissed without severance deserve first rights on claims after Nortel's bankruptcy. The law should be changed as soon as possible despite the fear mongering that Canada's bond markets will implode!

    As for the "Nortel fraud", yes, it should be investigated but that is a separate issue.

  6. David Merkel

    I don't get your argument. The pension plans could have bought default protection on Nortel, as well as some bondholders, but they didn't.

    So where is the inequity? Some buy insurance, some don't. Some insurance pays off, some doesn't. Are you alleging that those buying protection pushed Nortal under? Difficult to do… companies die from their own malfeasance, not side bets that don't affect their cash flows.

  7. BarryL

    Has anyone considered what this will do to the corporate bond market? This would make it near impossible for a company with large pension plan liabilities to sell bonds.

  8. urquhart

    I agree that the imbalance between debt owners and pensioners that I refer in Canada's Bankruptcy and Insolvency Act is based on the bond owners having access to insurance through CDSs and Canadian pensioners not having access to public pension benefit insurance. The free enterprising US has comprehensive pension benefit insurance at a maximum of US$54,000 per year, whereas the so-called socialist leaning Canada has none. I do not believe it is possible to have CDSs to cover pension fund deficits, since there would be systemic risk with most pension funds going into deficit at the same time due to stock and bond market corrections.

    The BIA amendment I propose is in lieu of Canada gearing up a defined benefit pension guarantee plan. I have estimated the impact on the cost of debt to be 0.05% to 0.26% for the debt market as a whole, with the amount depending on the term, the quality of the debtand whether the issuer has a defined benefit pension plan. This extra cost compensates the debt owners. The debt issuer is likely affected no more than it would be if it had to pay premiums to the public pension benefit guarantee fund for insurance coverage.

    For the record, separate from the matter of bond owners having access to insurance to compensate for their credit loss, I think that pensioners should have preferred status over the unsecured creditors in bankrupty due to equitable principles: they are individuals and not commercial enterprises, without diversification and the means to work again to recover losses. Pensions are deferred wages from employers that persons chose to work for, often for less pay due to desire for pension security. Finally, pensioners have no tax deductions for their pension income loss.

  9. Kevin Smith

    State Pension Funds Down 59% On Private Equity Bets
    Joe Weisenthal|Aug. 20, 2009, 2:46 PM|
    Ah, the good old days, when diversification meant splitting your money between levered instruments (securities), somewhat levered and less liquid assets (like timber and commodities) and extremely levered investments (like private equity).

    That kind of diversification didn't work out so well, when everything collapsed at the same time — those most-leveraged positions got crushed.

    Bloomberg compiled the ugly details:

    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.

    And this is really what all the controversy about placement agents and pay-to-play exploitation of state pensions is all about. If these investments had just kept sailing on, nobody would have cared. But when you're staring at a loss on all investments in the last 7 years, someone's got to pay.

    The good news for private equity: these funds need to hit such aggressive numbers going forward that they're forced to keep making the same bet, hoping the law of mean reversion starts to work back in their favor.

  10. gw

    Sorry, the problem is that Nortel pensioners are not protected via being invested elsewhere and in a diversified manner.

    The problem with the CDSs is quite a different one i.e. that a lot more were written than there was capital against them and the US taxpayer is funding them.

    And if one looks more closely a lot of the bondholders are …drum roll… pensioners.

    There are losses and bagholders are in demand. The question that should be discussed is what is a reasonable way to share those losses so the impact on the overall economy is acceptable. This is partly an economic question and partly a political one.

    Bondholders, Pensioners, asian national banks all have too high claims on future production that projections show can not be satisfied. Losses need to be eaten by individuals, shared via tax funded schema to even out the worst hits (social security network for the bare basics and impact mitigation for systemic players) and by global meassure i.e. printing money.

    It is unfortunate that so far this discussion is happening in a piecemeal fashion and this article is a good example.

  11. Anonymous

    personally i think the pensions should be seperate from the company. It should also be managed indepedently. But in my opinion, defined benefit plans are dinosaurs. Going forward it should work like 401(k)s with more independence. Let the individual decide what to do. It is not perfect but it atleast gives more control over the monies. One doesn't feel cheated by somebody else.

    Leo regarding a call for "socialist", government changing rules in the middle of a game is socialism.

  12. Anonymous

    Any fund buying such bonds in the future would be in breach of fiduciary duty to protect shareholder capital. Without the bondholders' money, the company would have collapsed sooner and the worker/pensioner would have lost their job/benefit sooner. Let's stiff the bondholder.

    If this continues, CDS hedges will become prohibitively expensive. "Gaming" the collapse will not be possible.

    Socialism? Sure. GM sold billions in bonds, plunked the cash into the pension plan and refused to pay. Government-sanctioned theft anyone?

  13. Blissex

    «The North American solution of making a pension plan -as I see it- a sort of addendum to a company's HR department, exposing it to the vagaries of the company's finances, would be seen as quite unacceptable.»

    Quite the opposite in the USA — the idea is that the penson plan is in effect a profit centre, something that increases manageen bonuses by making unhedged stockmarket bets.

    This means that when the stockmarket is rising, the pension plan makes money on capital gains, and thus management can reduce contributions to the plan and boost reported earnings and get larger profit related bonuses.

    Of course when the market goes down then the company has to make additional contributions as the plan has capital losses, but if the market is going down it is likely that the company is not making money anyhow, so there is no bonus to lose.

    In other words a company based pension fund grealy helps making bonus-driving reported earnings more pro-cyclical.

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