Tag Archives: pension funds

Wall Street’s Next Ticking Time Bomb: Pensions

Make no mistake, the criminality and fraud of most, if not all, DC politicians that is being exposed now is also occurring in corporate America and at pension funds, especially with regard to fraudulent financial reporting.   As an example, Exxon is now being investigated by the SEC over its asset valuation and accounting practices.   The same concept can be applied to pension funds (public and private).  The Dallas Fireman and Police Pension fund is the postcard example of both investment and accounting fraud:  LINK.

The pension time bomb has been activated for a long time but it’s now in the final countdown.   Pensions are woefully underfunded even if we give them the benefit of doubt on their current use of market-to-market.   Every pension fund under  the sun in this country – because rates are so low – has monthly negative outflows of cash:   beneficiaries are being paid more money than is flowing into the fund.  If the stock market declines more than 10% for an extended period of time, nearly every pension fund in the country would blow up.   This is why the last two stock plunges, which took the S&P 500 down over 10%, were met by heavy, if not blatant, Fed intervention which produced a steep V-bounce in the stock market both times.

Yesterday I spoke to a friend/colleague who works at a public pension fund.  He said the latest fad in pension management land is to shift money out hedge funds – which are woefully underperforming the market – and to put even more money into private equity funds.  This allows the pension funds to subject that capital to a quarterly mark to market test rather than an daily or monthly valuation accounting.  The only problem:  private equity investments are highly illiquid and the valuation of the underlying investments is an “art” that is not at all based on actual market transactions.   This private equity investment mark-to-market “Picasso”  leads to extreme “over-marking” of private equity investment valuations at pension funds.

This is also one of the primary reasons that the Fed can not raise interest rates even if it were true that the economy was improving and the labor market was tight, both conditions of which we know are not even remotely close to accurate but everyone seems content to play along with the joke.  

Many pensions have now allocated as much as 20% of the fund to private equity.   This is because they can control to a degree where the investments are marked and as long as the stock market does not decline, they never have to market them down.  But with the example of the Dallas pension fund above, if the beneficiaries are allowed to withdraw all of their money, the fund will have to unload its illiquid private equity investments to meet the outflow requests.   Good luck getting anything close to where those investments are marked in the fund.  The beneficiaries won’t receive anything close to the current stated value of their pension account.

If the status quo in the markets were to continue for the foreseeable future – which it won’t – pensions funds will run out of cash to pay beneficiaries well in advance of the “foreseeable future.”  Without cutting benefits drastically or, in the case of public pension funds raising taxes steeply to cover pension beneficiary outflows, some public pensions will hit the wall within 12-24 months.

Away from private equity investing – which is just another of the many asset bubbles spawned by the Fed’s near-zero interest rate and money printing policy (by the way, the Fed unbeknownst to many is still printing money) – Wall Street has been busy stuffing a plethora of  high-fee generating asset-backed “investment” securities into the market. These securities exploit the need by pensions to generate much higher investment income.   When you hear the term “reach for yield,” think:  pigs are greedy, hogs get slaughtered.   These securities are hog food.

The only problem is that interest rates are so low now the risk embedded in the underlying asset pools are much greater than the interest rate compensating the investor for buying these securities.   Ratings agency fraud is also present again. This is another instance of the current period of financial insanity “rhyming” with the Wall Street-fueled insanity that led to the 2008 financial collapse.

A perfect example is the latest “brain child” of Wall Street in which the payables from cell-phone bills (the mobile carrier’s receivables) are packed into pools and securitized into “bonds” – LINK.  Verizon is the first to do a deal like this.  It’s receivables from cell-phone bills were packaged into bonds, received a triple-A rating and were priced at 55 basis points over the benchmark triple-A corporate index.  That means it was issued around a 2.67% yield.

Think about this way, would you lend money to a stranger to pay his cellphone bill in exchange for receiving the amount you loaned plus receive a 2.67% annualized rate of interest on the loan next month?  There’s a reason the bonds were priced at 55 basis points over standard triple-A bond.  If the implied reason were apparent to all, the bonds would be yielding substantially more.  Eventually that reason will come to light and the bonds will tank in price.

The Dallas police and firemen had the right instinct:  if you are eligible, contact your pension administrator and demand to receive any pension money that can claw out of fund now.   Your alternative is to face substantial payment cuts at some point.  Eventually your fund will collapse and you will otherwise receive nothing more than an “Oops, Our Bad” letter from your pension fund.

The Square IPO Just Caused Pensions To Become Even More Underfunded

The Square IPO is an event that will deliver a big blow to Silicon Valley private equity valuations and further exacerbate the already near-catastrophic condition of most, if not all, pension funds.

It’s been well publicized that most, if not all, State pension funds are moderately to significantly underfunded.  Notwithstanding the fact that States have been “borrowing” cash from these funds in order to pay for State and local Government spending deficits, every pension fund has been earning significantly lower rates of return on its asset base relative to future benefit funding requirements.

The math is pretty simple.  Every pension fund, public and private, has an established (actuarial) forecast of future benefit outflows vs. fund member contributions and invested capital earnings.  Most, if not all, pension funds have been assuming either a long term ROR of 7.5% or 8% on assets.  This is the rate of return required every year in order to fund the long term beneficiary payment obligations.  Every year that a fund underperforms its 7.5/8% “hurdle” rate of return is a year in which the fund becomes more underfunded.

Pension funds were disastrously underfunded after the stock market crash that bottomed in the spring of 2009.  Most pension funds are allocated 60% in fixed income and 40% in equities, real estate, alternatives.  Even with the “remarkable” move in the stock market over the last five years, and because fixed income has returned almost nothing over the time period, pension funds never were able to dig out of the “hole” created in 2009.

Most of them over the past few years have chased returns by literally shoveling money at private equity funds and speculative real estate funds.  The investments which do not have continuously observable markets in order to evaluate pricing and appropriate market-to-market are perfect for these funds because they can mark up their private equity and real estate investments quarterly based on “mark to model” pricing assumptions.  On the flip side, they can drag their feet on marking these investments down when those asset classes head south.

Keep in mind that many of these funds were never properly marked down to market after the financial crisis, so when you hear Calpers or the Illinois State Retirement fund is 40% or 50% underfunded, on a true mark-to-market basis it’s probably closer to 60% or worse.  All the accounting games used by corporations are also used by corporate and public pension funds.

Several pension funds are now allocating as much as 20% of their capital to private equity funds.  Most of this money is invested in Silicon Valley, biotech and real estate.  Biotech has already been crashing.   Real estate is starting to crash.

And it looks like the private equity Silicon Valley bubble is now popping.  The valuations became absurd, as small start-ups with no revenues were routinely valued in the billions, based ridiculously on, say, a $10 million dollar funding that valued the entire business on paper at $1 billion.  It was, to say the least, retarded.

But along with the soaring paper valuations, private equity fund valuations were marked up to fairytale levels and long with them the value of pension investments in these funds.

It looks like all of that has changed now, as the highly touted Square IPO was priced yesterday 42% below its last round of private equity funding.   Think about what this means.  It was only a matter of time before Silicon Valley “unicorn” slow motion train wreck ran out track and hit a wall.  This is an utter disaster for the pension industry.

Naturally Jim Cramer, who probably has not even bothered to look at any part of the Square deal or its related documentation and instead is vomiting out the smoke blown up his ass by his hedge fund cronies, has issued a strong buy on Square.  This will be the final kiss of death for this stock.

I’m not saying that Square doesn’t have intrinsic value.  Surely it does as it actually is a real business with real revenue, although the revenues are slowing and the losses are growing. But what does this say about all the companies in private equity portfolios that have been assigned huge bubble valuations and don’t have revenues?  Mark them down at least 60%.

The point here is that now big pension funds, which are already underfunded, just become even more unfunded with the mark to market event provided by the Square IPO.  While these pension funds will drag their feet on marking down their private equity investments, this reality is going to get worse over time and these funds will become insidiously underfunded.

And then what happens if the Fed does raise rates, which will knock down fixed income and stock investments?   Lights out.  And, by the way, everything I just said about public pension funds also applies to corporate pension funds, some of which are likely even more underfunded than their public counterparts.

Pension “Armageddon” Got Closer Today

The IMF fears underfunded pension funds could be encouraged to chase returns through riskier investments such as direct credit exposure or by engaging in securities lending in order to improve their funding ratios….The IMF’s comments echoed similar warnings from the OECD in May, when the Paris-based body said pension funds’ move towards riskier asset classes could result in their solvency position being “seriously compromised” in turbulent markets.  The Financial Times

Yesterday I published a post in which I outlined the reasons why pension fund underfunding is likely much worse than the level admitted by the funds themselves and industry professionals.  The biggest culprit is “mark to market” of illiquid investments into which pension managers have “shoe-horned” themselves in order to give the appearance of rates of return that are higher on paper than in reality.  A good friend and colleague of mine, who happens to be very bright, had this comment in response to my post:

Pension funds are collectively insolvent.  Basically the asset managers running these funds have refused to MTM them properly, expecting the assumed X% annual return to normalize.  Sorry, buddy: this IS the new normal (which is why the unfunded situation gets worse every year… assume 8% and get 0% for enough years and the chasm only widens… in fact, by the rule of 72, your funding gap will double every 9 years if that 8% gap is reality).  This is where the rubber hits the road, the issue which is going to punch the middle class in the gut like a steel 2×4.

This is the same dynamic that torpedoed the big bank balance sheets when the housing/subprime credit bubble popped, as big chunks of home equity, mortgage and other credit products were marked close to par when in reality most of it was worth zero. And this is one of the primary reasons that the Fed is devoting significant resources to keeping the stock market propped up:  pension fund insolvency is at risk.

One of the biggest areas of concern for pension funds is their private equity investments. Most pension funds have been literally “throwing” cash at private equity firms who have been shoveling money into real estate rental schemes and, even worse, have fueled the private market Silicon Valley bubble.

No one ever admits to a bubble until after it’s popped and has destroyed trillions in value – just ask Alan Greenspan and Ben Bernanke.   Bernanke never saw the housing bubble that he and Greenspan blew and Janet Yellen can’t see the tech bubble that she and Ben inflated. Fortunately for Ben,  Yellen will get tagged with the Silicon Valley collapse.

It looks like the process has begun.   Dropbox tried to IPO at its private market valuation of $10 billion and had to pull it, as the public market disagreed with BlackRock, who led the last round of funding for Dropbox.  Dropbox has revenues of a little more than $200 milion and zero net income.  The $10 billion valuation was insane.  But the game is over now.

As more Silicon Valley “unicorns” fail to monetize at levels even remotely close to their private market bubble value, the value of the private equity holdings of pension funds will vaporize.  The valuation process for a tech start-up is typically a “bi-nomial” function.  It either works and is a home run or it’s worth close to zero because the company’s technology will never generate income (Amazon?).

This implies that private equity holdings held by pension funds are significantly overvalued on the “mark to fantasy” basis and will eventually be subjected to massive valuation write-downs.  It’s a vicious negative feedback loop that is magnified by the “leverage effect” created by the existing level of pension fund underfunding.

Here’s what the problem looks like visually (source:  Zerohedge):

This graphic shows five of the steepest declines in stock price for tech companies IPO’s in the last Untitledfew years. Note that the steep decline occurs since 2014. This means that private equity funds with investments in comparable companies have mark down their private market holdings to reflect better the valuations given to these companies in the “cash out” market. This also means that pension fund private equity fund holdings are likely already significantly overvalued.

As for real estate?   One of the primary source of funds for the buy to rent portfolios amassed by private equity firms like Blackstone has been pension funds.  A recent merger of two public buy-to-rent REITS valued one of the entities’ current home rental portfolio at 50% of its original carrying (i.e. investment) value.   As with tech p/e investments, this transaction effectively revalues down significantly pension fund investments in this sector.

The bottom line is that pension funds are already significantly underfunded.  Recent developments in the real estate and tech investment private equity market suggest that the level of underfunding is about to be bludgeoned.