Hedge Funds: Kiss Our Assets Goodbye?

It looks like the hedge fund bubble may be about to burst. With more competition in the industry spreads are shrinking, leaving many funds with no greater gross returns than on conventional mutual funds, but with far greater fees. We are heading for a housing bust, with foreclosure rates soaring as a result of exploding cost loans peddled to, among others, sub-prime borrowers. Rumor has it that in order to get higher interest rates, hedge funds were buying the most risky pieces (tranches) of groups of these loans – the piece that becomes worthless if more mortgages than expected don’t pay. Other rumors say the hedge funds were gambling on commodities, and have been caught when commodity prices suddenly dropped. Some may have been trading derivative instruments without the hassles of a formal exchange – hassles like showing you have enough money in reserve to pay off your counterparties if your bets go bad. The last firm to do this on a large scale: Enron, which would have gone down much sooner without the fraud. Far from “hedging,” that is accepting a lower return but limiting the potential for loss, most of these firms are leveraging, borrowing big so that a trend slightly in your favor yields a big payoff, but one slightly against you delivers a massive loss. It is likely that some of these firms could use a greater fool. They may have just found one.

The New York Sun reports that NYC Comptroller William Thompson is considering putting some of the city’s pension funds in hedge funds. The Sun suspects pay to play, with the hedge funds, through lobbyists, contributing to Thompson’s campaign in exchange for the city’s business. But there is a more likely, and more troubling, explanation.

The higher the rate of return a pension fund will earn, the more it can pay out to beneficiaries, and the less the employer has to put in. How were the city and state able to drastically reduce the amount of money they contribute to the funds, have public employees with more than 10 year’s seniority stop contributing, and enact an inflation adjustment with a big retroactive increase for long retired employees that no money had been set aside for, in the late 1990s? They simply decided to assume, beginning in 2000 – the peak of the stock market bubble – that their investments would earn more money. Voila! Something for nothing! The current assumed return is 8%, up from the prior assumption of 7%. How are we doing on that prediction? Well, if the S&P 500 had yielded that much since the 2000 peak, it would be at 2660 right now. It is at about 1415.

I remember a state official in New Jersey, which pulled similar stunts at the time, telling a reporter "I know it sounds too good to be true, but it is." Bad grammer. Can't say if he meant to say "but it is true" or "but it is too good to be true." It turned out to be the latter, in New York and New Jersey.

Here is the problem: even today, no reasonable investment is earning 8%. The world is awash in liquidity, assets of all kinds are overpriced, and future returns are likely to be low. Just look at the Wall Street Journal.

For example, 10-year treasury bonds now yield 4.7 percent. Tie up your money for ten years, take a risk that inflation will reduce its value, and that is all you get. Want to invest in mortgages? You get 5.5% on your mortgage-backed securities. Corporate bonds? You get 5.7%, unless you invest in junk bonds, which pay 7.2% and have a high chance of a loss.

Stocks? The price/earnings ratio on the S&P 500 is close to 18, which means your return is around 5.7%. But profits are today at an all time high relative to wages, and this can only be achieved because business is paying workers less but still selling more things to them, because they are going deeper and deeper into debt. That means eventually profits will have to go down, because business will either have to pay more or sell less. Things that can’t go on forever, like 80% of Americans living beyond their means, won’t.

Commercial real estate? Just as the price of houses has been bid up to unsustainable levels relative to people’s incomes, so has the price of commercial real estate been bid up relative to the income the buildings produce. Cap rates, which are the equivalent of a return, are 5% to 7% right now.

Not 8%. No way.

What to do? Comptroller Thompson (and his state equivalent) could tell the truth and admit that long term returns are lower, and that the existing pension and health care benefits past city employees are already promised will require much more pain in terms of reduced public services and increased taxes. Or they can gamble on higher risks in the hopes that all will come out in the end. Under the circumstances, the Comptroller may feel compelled to take more risk. “Easy is what we have had.”

The Comptroller’s office is advised by Wall Street, which thought stocks were best for the long run in 2000 at the peak of the bubble, but reconsidered and thought bonds were best for pension funds three years later with interest rates at all-time lows – and future bond losses all but guaranteed. Now, quotes the Assistant Comptroller “What we’ve been seeing is a projected decrease in the traditional markets we invest in…What that has caused us to do is to become creative in trying to look at alternative investment areas.” Wall Street’s recommendation: hedge funds. More return if you win. More risk for someone else in the future if you lose. Getting higher returns for higher risk isn’t creative; it’s finance 101, at the level taught to city planners not hedge fund managers.

Looking at my own savings, I wouldn’t assume a return of any more than 4% higher than inflation, and 3% is probably more like it. Remember, public employees now have inflation-adjusted pensions, a benefit they neither worked nor bargained for and that no money was set aside for when they were on the job, so half of any return attributable to inflation doesn’t help pay for the pensions.

But any money I save now is going into cash. Why? Because no other alternatives provide enough return relative to the risk, and it is likely that all those assets are heading for a fall in the next year or two until a reasonable balance between risk and reward is re-established. I’m not an MBA, but if I had to invest in something right now it would be the stocks of large multinational companies (except financial) and office buildings in major transit-served centers. But as a small saver, most of my savings is invested by intermediaries. I hope there isn’t too much in mortgage-backed securities, except for standard conforming loans (not sub-prime, not option-Arm, etc) in tranches where someone else takes the first loss. Hedge funds? Forget it, unless they are bottom feeders (which could have lots of pickings in a year or two). As a taxpayer, however, I’m on the hook for whatever the pension plans do.

The “prudent man” rules will probably prevent Thompson from investing too much in hedge funds. But as far as I’m concerned, any amount is too much. Rich folks want to get higher returns in exchange for higher risks? Fine. It’s their money. The pension funds are my money, even though I’m no going to get a pension, because I’m on the hook for them. I can’t win. I can only lose. He, and the new State Comptroller, should drop the bubble estimate of future returns, and substitute a reasonable long term average, adjusted downward for the high prices of assets right now. Admit what the pensions actually cost, and start putting aside the money, taking that cost into account when discussing what is fair for other contract issues. Otherwise, it will be disaster – for the pensioners, taxpayers, and public service recipients – in a future that no one seems to care about, but that gets closer all the time.