Friday, April 24, 2009

Are most pension funds ponzi schemes?

Hedge funds, mutual funds, pension funds, pre-need funds…you name it, they’ve all taken a beating these past couple of years. Many are likely one step away from possible liquidation, as security assets across all classes, across all sectors, and across all types have all fallen from their all-time highs. And as fund assets fall, many open ended funds have experienced massive withdrawals, which have resulted in further writedowns, further losses, and further fund deterioration.

We are a long way off from the time when investing in funds were thought of as sensible savings. Now, many types of funds are proving to be major wealth destructors. Could this have been foreseen by more people beforehand?

It seems , for now at least, that the biggest source of growth for many of these funds was not their managers’ asset selecting prowess, but their ability to continually attract more capital into their portfolios. As more money came in, fund values increased, and as more funds resulted in more purchases of security products, it all resulted in the virtuous cycle of investor confidence leading to better results. Now, it’s the other way around. Now, it’s panic leading to the vicious cycle of even worse results.

So just how much of these funds’ previous success was really due to asset selection vis-à-vis funds attraction? Getting at an answer should be crucial in determining whether continuing to have a multitude of funds, all independently striving to attract capital to redeploy towards various assets, really results in increased wealth creation over-all. After all, if it turns out that many of these arrived at their previous stellar returns merely because they were successful in growing their assets under management, then it can lead us to believe that many funds are really giant ponzi schemes – with stellar results only possible for as long as more investors are being attracted into the game.

Another question I keep asking is, just how much higher can we expect the return on investing in funds, on average, supposed to be than over-all growth in the economy? After all, if the general performance of securities assets depend on the fundamental performance of the companies who issued them, and the fundamental performance of companies, on average, depends on over-all economic growth, well….you get the message.

Is it then more sensible to just have one giant fund, one whose performance will correspond to that of the economy, and be divorced from success in attracting capital? To do this, it would be important to make it the only game in town. In other words, anybody wishing to invest in a pension fund will have no other choice but this fund. This fund will grow as the population of premium payors grows, not because a multitude of funds constantly involve themselves in a pyramiding scheme of selling assets at constantly higher rates to one other. Just make sure that those receiving pension payouts are always outnumbered by those making premium payments.
I admit I’m no actuarian, and I haven’t run any numbers. But at a conceptual level, it seems having one giant fund can make sense, more than having a multitude of small funds, many too small to weather major economic storms, to be the arbiter of people’s savings.

For more detailed ruminations on this particular subject, Leo Kolivakis over at Pension Pulse would probably be your best source.

Friday, April 17, 2009

A time for regulation

The free market has been responsible for a lot of technological progress. It is also responsible for the improvement of life standards and the continued increase of productivity in the economy. It has also been known to bring prices down through price competition.

But a free market has also been responsible for a lot of the problems and inefficiencies in the economy today. This comes largely from the selfish pursuit of individuals to maximize their gains, or their utility, even if it comes at the expense of the whole.

A doctor wishing to guard against malpractice liabilities may prescribe more tests than is necessary, thus increasing healthcare costs for everyone. Meanwhile, patients seeking to recover more than is justified may also be contributing to the doctors’ fears of malpractice liabilities. Meanwhile, overall costs go up, not just for those whose healthcare really warrants it, but also for those who may otherwise have gotten treatment for much less.

A bank trying to earn more fees will underwrite more loans than is prudent, but unload the risky assets to investors seeking more yield. To fool themselves of their prudence, they will seek the input of ratings agencies, themselves seeking to earn more fees, to provide AAA ratings to these assets. As more transactions make underlying asset prices go higher, the greater momentum there is for everyone to earn more by doing more of the same.

Individual agents doing what is best for them in a free market society. Actions that lead to worse consequences for society as a whole. So, do we dismantle the free market?

Unfortunately, there is no better alternative for now. The free market works best because of two things: As an organism, it has 1) no ideology ,and 2) no conscience. Hence, we could say that there is no one vested interest in a market that is truly free. What happens is the consequence of actions made by consenting parties to achieve their individual goals. What clears a free market is generally the greatest good for the greatest number.

Nonetheless, not everyone in the market is equally bright, equally informed, or equally just. Very often, the best outcomes in a market go to those who can game the system – those who are more bright, more informed, and less attuned to justice and fairness.

Sometimes, market outcomes come about from unintended consequences of actions made by individual agents not trying to gain more, but just seeking to protect themselves. Consider the doctor in the example above.

We might say that these outcomes happen precisely because the market has no conscience. We might also say that the market is myopic, only seeking what is best among participants at that point in time. Who’s to say that the best outcome is being attained when companies mine all the world’s oil, and pollute the environment, in order to meet the never-ending demand for goods of a growing population, at the most affordable price for the greatest number? What happens tomorrow, when all the resources are mined out, and the environment is unalterably changed? Who’s to pay for that?

Other people might say this is where government comes in, to provide the macro insight, the long-term planning, and….to wit, the necessary conscience to society. But is the government really the best entity to provide these? And what if its efforts to undertake these functions undermines the original advantages of having a free market?

There is no permanent right answer. We should just do our best to see what is most optimal given current circumstances, and know that since society is made up of individuals and group making actions that affect the whole, there will come a time when the pendulum will lead us back to where we were before.

Today is the day for more regulation. Tomorrow, we can dismantle those that just get in the way.

Friday, April 10, 2009

Is The Geithner Plan necessary? Rationale of the Public Private Investment Program

There have been many articles out that criticized the Geithner Plan, mainly because it it’s a mechanism that further privatizes the gains and socializes the loss from the toxic assets held by US banks. With a mechanism where the government leverages the private sector bidder for the assets 7 times, and has a proportional share of the loss but a 50% sharing in the gains, this is indeed a private sector subsidy of a massive scale.

But we have to ask ourselves the question – why did the government decide to make this kind of lopsided proposal? To get the toxic assets out of the bank’s books. Keeping the toxic assets, which have continually slid in value as more home defaults arise, has continually eaten away at the banks’ equity capital. If more defaults are to happen, more writedowns will have to occur, and more banks will end up insolvent.

The Geithner Plan provides a nice way to entice private sector investors - the hedge funds and investment banks – to buy the assets and take them out of the commercial banks’ books. Because the leverage provided by government increases their potential returns on the investment, it incentivises them to bid higher for the assets, thereby restoring capital to the commercial banks.

But we have to ask ourselves a question again – Does anyone really believe that these toxic assets may be worth more than how much they are currently valued? Because if current market value is correct, any rational investor shouldn’t bid more than that, and perhaps should bid less to account for further possible writedowns. The only way anybody can earn a positive return is if these toxic assets end up more valuable than they are currently worth. And many investors seems to think that way, given the various ways they are now trying to game the public private investment program, the “Geithner Plan”. Even the commercial banks, the entities supposed to be helped by the plan by being rid of the assets, seem to be coming up with ways to still end up with the assets.

So what gives? Perhaps insiders know these assets are worth more than the market is currently pricing them. After all, if the banks have thought all along that the toxic assets were to end up continually writing down their equity capital, they would have rid of them a long time ago. Yet they continue holding on to them. Perhaps some people really believe that home defaults will end up a small minority in the toxic asset pool, and more borrowers will end up paying out to maturity.

If that’s the case, the Geithner Plan is a mechanism that will transfer wealth not just from the taxpayer to the hedge funds, but from the commercial banks to the hedge funds. If you were a commercial bank, you’d find ways to end up with the assets back in your hands. Otherwise, hedge funds will end up with the largest gains, at taxpayer’s cost, while taking the gains away from commercial banks.

So is the Geithner Plan the best way to help the banks? If everybody – the government, the commercial banks, the hedge fund investors – believe that toxic assets will end up worth more than they currently do, then maybe we should just suspend marking-to-market for toxic assets, until we do see if they're right. They may end up right, and the taxpayer and the commercial banks need not lose out on anything. I don’t need to repeat what my stand is on mark-to-market acounting (See previous posts here, here, and here). That, or just nationalize the banks where government will buy the assets, so taxpayers get both possible gains and losses.

Friday, April 3, 2009

MENA and ASEAN, new regional trading centres on the rise

We could be seeing a pick up in mergers and acquisitions activity some time soon. Perhaps not in the developed markets, but in the emerging markets. I have been anticipating something like this to happen for some time, and the recent confluence of events could naturally lead to this.


As I have previously noted, the companies and businesses that will best weather these uncertain times, and get out of it alive, will be those that are the biggest in their industries. Smaller companies, even those that occupy specific niches, are in for wild times ahead.

To recover and regroup in this turbulent time, multinational companies from the developed world will likely focus more on their home markets, or those markets where they have the greatest competitive advantage. They will probably scale back in emerging markets, leaving wide open opportunities for local companies based in those markets to fill.

Going forward, both developed and developing economies will each become more equally focused on being both consumer and producer economies. However, developing economy companies will have a natural limit to their growth, and again, that limit is what local demand can sustain.


The question therefore is, which of these emerging economy markets vacated by multinationals will have a big enough local demand to sustain a viable local supplier? On a case to case basis, with multinational companies leaving their markets, some local companies bold enough to step up to the plate will finally find the chance to gain market traction without severe competitive pressures from Western firms. And yet, companies located in countries with smaller populations and poorer citizens will still likely remain smaller than those in countries with larger and more prosperous countries. This limitation is also a crucial constraint to how much higher local levels of local wages can increase, which, again, is a crucial function of the rise of a viable local consumer market.

In this new economic reality, the biggest advantages, will go to companies fortunate enough to be located in countries with large domestic populations. Larger economies provide much larger opportunity base for local companies to grow. That’s why we always hear Brazil, Russia, China, and India, large countries with large populations and large markets.

Much smaller countries, therefore, are better off forming into regional trading blocs with their closest neighbours. The European Union is the best model for this. The much bigger common market in which to create demand for their products significantly offsets any reverse growth from a much smaller home market. In the tradition of the EU, I suspect the rise of the regional blocs MENA and ASEAN.

MENA, the acronym for Middle East and North Africa, is the regional commodity and financial powerhouse bloc, now reeling from the drop in oil prices. ASEAN, the association of Southeast Asian nations, is the group of manufacturing and off-shoring centres previously responsible for bringing world consumer goods prices down, until China entered the picture.

In response to the rise of these blocs, previously nationally-based firms and conglomerates in these areas will have to start looking beyond their borders, and MERGE with like companies – to create the scale, the scope, and the size they need to profitably and effectively create a sustainable local market.

Likely, these mergers will be in the consumer staples industries, retail, and in banking, precisely those industries where the largest multinaltionals are currently scaling back the most.


The goal of becoming the back-end supplier of finished goods for some other global company is now insufficient to guarantee continued economic prosperity. To maintain economic prosperity for all, countries need to diversify away from focusing on exporting specialized goods to global but narrowly specific sectors into selling a greater array of products and services FOR DOMESTIC CONSUMERS.

The rising pan-Middle Eastern and Pan-Asian emerging economy companies therefore need to be willing to pay better than lowest wage, and focus their business-building efforts on developing niche markets in their new regional economies, rather than simply trying to be the lowest cost global producer for a commoditized and undifferentiated product.

For this mental reorientation to work, change efforts need to be macro in scale. Only in an environment where all businesses are focused on creating greater value for the local consumer, while at the same time creating a local consumer able and willing to buy their goods, will this change work. Macro-scale efforts can only start making sense when small countries stop thinking in terms of just their local economies, and start thinking in terms of creating regional markets.

With regional markets, companies can finally have the scale, the scope, and the size they need to successfully spruce up a big and affluent customer base. After all, Henry Ford could not have done what he did had he been limited in growth opportunity to just Michigan. For him to grow and successfully profit from his innovations, he benefited significantly from having the entire US economy as a platform to roll out his business. Equally, since his competitors, suppliers, and partners also had the entire US economy as their oyster, they too could plan and organize and cost their businesses with that scale in mind.

When the developing world has finally succeeded in getting much of its local wages and standards of living to developing world parity, then maybe globalization can start to work, and we can once again strive to bring down international barriers everywhere else.