We need to know more about the risk of public pension assets

April 18, 2013

There has been a lot of discussion about the general underfunding of public pensions in muniland. Now credit rater Moody’s is reviewing cities in light of this:

The potential fiscal drag that under-funded pensions can have on cities is very important, but several other issues need to be examined further. First is the level of fees that public pensions are paying to investment managers and hedge funds, and the second is the level of risk in specific assets that the funds hold. Kevin Roose of NY Magazine wrote about the excessive fees that pension funds pay to outside “active managers”:

Private-equity firms and hedge funds, in particular, tend to love pensions, which typically provide a majority of the money they manage. (In fact, many private-equity firms and large hedge funds couldn’t exist without pensions.) But they haven’t held up their end of the deal. Start with their subpar returns, and subtract their onerous fees, and you get a very bum deal for the average pension fund.

But CalPERS — a large and influential fund, which can act as a Pied Piper for lots of smaller pensions — is waking up to the fact that it’s paying too much to active managers and not getting enough in return. After years of pushing for lower and lower fees from the private-equity firms and hedge funds who manage its money, CalPERS is considering saying, “You know what? Nevermind,” and giving up on active management altogether.

There is a very strange situation in Rhode Island where the State Treasurer, Gina Raimondo, says the office needs to “perform substantial research and analysis in order to comply with [any] request to produce all documents showing management fees in basis points.” To perform the work, Raimondo’s office said it would charge $1,485. Either this is a case of very weak oversight, or Rhode Island’s treasurer’s office has something to hide. That is pension transparency going backwards.

And then we have a more serious problem: How much do we really know about the specific assets that pensions hold? Pension fund disclosure is often done in asset class “buckets” with little detail, and this can be a problem. The New York Times Dealbook reported about banks that are finding investors to buy credit defaults swaps that allow the banks to shift the risk of default to pension funds or other investors who buy these. This is reminiscent of AIG’s disastrous strategy:

The Orchard Global Capital Group has raised a fund to invest in regulatory capital trades, and the New Mexico Educational Retirement Board is among its investors.

In December 2011, Allan Martin, a representative with an investment consultant firm that advises pension funds, met with the New Mexican pension fund over investing through Orchard in a regulatory capital trade, according to the minutes of a board meeting.

Mr. Martin explained to the retirement board that these transactions had been created to allow the banks “to continue to hold the assets on their balance sheet” while selling some of the risk.

At the meeting, Jan Goodwin, executive director of the New Mexico Educational Retirement Board, asked about the use of credit-default swaps, which got A.I.G. into trouble. Mr. Martin admitted that the Orchard deal “has a little flavor of that” but said Orchard had done “a great deal” of due diligence on the underlying collateral, something he said A.I.G. often didn’t do.

In an interview, Mr. Martin said that “a lot of clients ask how this is different than A.I.G.,” and he said it was because Orchard had a better understanding of the risks involved in the assets it was dealing with.

Relying on a “representative with an investment consultant firm” to assess the risk in the underlying collateral held by the bank is ridiculous. It is exactly the issue that helped lead to the 2008 financial crisis. The Federal Reserve and others have said that investors must independently assess the underlying assets in a structured finance product and not rely on credit ratings alone. That says nothing about a third party representative with no fiduciary duty to the buyer. When the word “muppets” emerged in a letter by a former employee of Goldman Sachs, it was not hard to image the meaning.

A source sent me the offering document of an extremely risky investment held by the San Bernardino County Employees Retirement Association. SBCERA includes 21 municipal entities with 32,824 members. It has had dismal five year annualized investment returns of -0.41 percent . My source wrote this about the deal:

Credit Suisse structured the new European CDO called Cairn Capital CLO III. It is packed with leveraged loans, so a subset called a CLO [Collateralized Loan Obligation].

This deal needs to be compliant to Article 122a of the Capital Requirement Directive [a European regulation], meaning an entity needs to take the ‘skin in the game’ and retain a first loss position in the securitization.

I was surprised to see a small pension fund taking this risk and it doesn’t appear to have the skill to manage the position, probably under the advice of someone who does not have any skin in the game.

The small public pension fund is the San Bernardino County Employees Retirement Association. From the Offering Memorandum page 175:

Any losses sustained in this deal get swallowed by the county workers and retirees of SBCERA. Bloomberg reported on the deal when it was structured, but SBCERA’s spokeswoman declined to comment on its participation at that time. On top of everything, Cairn’s risk manager was formerly with AIG:


One of the leading experts on investment risk, Don Van Deventer, Chairman and Chief Executive Officer of global risk firm Kamakura, said this on San Bernardino County’s investment in the Cairn CLO:

This is incredible. The taxpayers of San Bernardino County are being taken to the cleaners by Wall Street.  Whoever at SBCERA that (a) voted for an investment policy that would allow such an investment and (b) executed this trade should be fired. I am speechless than anyone could do something so stupid after the experience of the last credit crisis. This document could have been written in 2006.  Have they learned nothing?

Are we making the same mistakes over and over? Have no safeguards been put in place to keep highly risky assets from being buried in public pension funds? We need more clarity on the fees and risks that public pension funds are carrying. I wrote previously that pension spiking was the worst contributor to the public pension underfunding problem. Now I think these factors may be equally at fault.

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