The Other Pension Crisis

by Dave Schuler on August 20, 2014

Yves Smith explains how the Employee Retirement Income Security Act of 1974 contributed to the housing crisis and may have rendered company pension funds a lot more secure than they might otherwise be:
The result was that the pension funds, which had long been limited to safe assets such as corporate bonds and Treasury securities, could put some money into riskier investments such as stocks and venture capital — on the assumption that diversification, both by asset class and within each asset class, would reduce risk in the broader portfolio.

Unfortunately, over-reliance on the power of diversification has led fund managers to be less attentive to the hazards of particular investments. Consider two examples: private-label mortgage securities, which are issued without government guarantees, and private-equity partnerships, which acquire public companies with the aim of restructuring them and selling at a profit.

Seduced by AAA ratings, fund managers often ignored the extraordinary complexity of mortgage securitizations, which typically involve hundreds of pages of documents defining the circumstances under which different investors get paid or suffer losses. As a result, they failed to notice some significant pitfalls.

For one, the contracts governing the securities gave an outsized, badly conflicted role to the mortgage servicer, responsible for interacting with borrowers and passing payments along to investors. Because the servicers were often the same banks that had made other loans to the borrowers, and because they could make more money by foreclosing than by fixing troubled loans, they had strong incentives to act against the investors’ (and the borrowers’) best interests.

The evidence is overwhelming that servicers abused their powers. They gave their own loans preference in making modifications and when counseling borrowers on what to pay first. They increased their profits by precipitating foreclosures and by forcing borrowers to buy insurance. They skimmed extra fees from money that they were supposed to pass on to investors.

Such abuses made the housing crash far worse than it should have been, and left badly burned investors wary of ever buying private-label securities again. As a result, nearly six years after the crisis, the mortgage market remains on government life support.

As the demographic bump of Baby Boomers passes through the U. S. python, pensions—whether public, private, socialized, or personal—will become a matter of national concern. Pension agreements whoever engage in them are statements of future behavior and, consequently, hedges against future circumstances. We aren’t as rich as we thought we were and it is increasingly looking as though we won’t be as prosperous in the coming decades as we thought we would be.

{ 9 comments… read them below or add one }

... August 20, 2014 at 8:40 am

Whosvthis “we” you speak of? Plenty of people seem to be as rich or richer now than they were then, especially after massive amounts of government intervention on their behalf.

There isn’t any “we” to speak of.

TastyBits August 20, 2014 at 8:41 am

While I never knew the driver, this is what I have been saying for years. Wall Street was not pushing crappy investments on unwary fund managers. Fund managers were demanding were demanding as many high return, low risk investments as possible.

The main reason the loans in the MBS’s are not modified is the way the MBS is structured. I never go into it because it gets messy. An MBS is a bundle of mortgages, but it is sliced lengthwise into tranches.

Each of these tranches has a group of various quality loans, but the rating will depend upon the actual make-up. A tranche with mostly prime, some sub-prime, and a few Alt-A will get a higher rating than one with the opposite rating.

Prime mortgages will only return a low rate. Sub-prime and Alt-A will return a higher rate, but they are riskier. By mixing and matching, you can get a higher return than you would with only prime with a lower risk.

The tranches are rated like any other bond, and the returns are the same. The BBB rated tranche gets a higher return than the AAA, but the mortgage failures will occur in the BBB tranche first. The AAA tranche will continue to payout.

The AAA tranches do not want the mortgages modified because they have mostly prime mortgages, and as I understand it, the MBS cannot be restructured. While the AAA tranches may not be performing at 100%, they are bringing in cash, and the holders need the cash.

@Drew can fill in the details.

Guarneri August 20, 2014 at 10:31 am

Drew would only point out a technicality in TB’s comment that the tranches were cut sideways by risk (tenor, terms, collateralization)level based upon investor desire, not lengthwise. Further, they didn’t want high returns for low risk. They were just making asset allocations based upon the various risk/return options available.

Far more importantly, Ms Webber is peddling shit to those not steeped in the business, and obviously with an ax to grind. A few points:

The “portfolio” theory she refers to is the efficient frontier. If you don’t know what that is or why it is important then you have no standing in the debate. It is simply a fancy way to say you get paid (“expected return”) for the risk you take, not more or less, or you have a poorly constructed portfolio.

But Ms Webber has an ax to grind. No risky securities belong? She makes a rookie error – she can’t define risk properly. Are short duration, high quality fixed income securities safe? Really? Ask Mr Bernanke and Ms Yellen about interjecting themselves into the capital markets and your 1% nominal return. And what about inflation that eats that return to nothing, or negative. Not so safe. (Academics measure risk as the volatility of return) And god forbid the equity bubble they have created goes poof…………like housing did.

Switching gears – and why you can’t take her seriously – is the intentionally inflammatory language about stealing and no transparency. Did you notice that neither Bowden or Smith cared to give a set of concrete examples? I wonder why. The overwhelming number of “violations” cited were created by Dodd-Frank itself. And you can’t get a straight answer from the DF consultants or the SEC on what you are supposed to do. ObamaCare light. But since I actually know what I’m talking about I’ll give you some concrete examples:

PE firms put partners on the board. You see, well, heh, these are CONTROL investments. That means you control the board. Sometimes they take board fees. Our firm has chosen not to do this, but there is nothing wrong with it – just tell your LP’s. PE firms also very often employ operating executives to work with management, and it is currently all the rage and looked upon very favorably by LP’s. In Ms Webber and the SEC’s world if the PE firm does that its “stealing.” If you hire an (unknown) outside consultant it is apparently OK. Hmmm. Dave, are you stealing, or providing high quality services? By the way, these ghastly “diversions” of cash flow are a pittance compared to targeted capital gains measured in the tens to hundreds of millions of dollars. This is trumped up and faux outrage.

Monitoring? No monitoring?? The portfolio companies are audited. The PE funds have a set of books that are audited. By real firms, like Deloitte or McGladrey.

Valuation? Do you know what the value of an illiquid private equity investment is up until the wire transfers occur at sale? Zero. If you don’t know that then your commentary is worthless – you have no clue. You can hire people to give you estimates, but they are usually 23 yrs old and clueless. The valuations are worthless. And how long are PE investments held? 3-7 years? Tell me what the value of a public equity share, corporate bond or the ten year treasury will be in five years. Good luck.

This whole bunch of BS by Webber and the SEC is really all about castigating an industry out of the “easy money” notion. Let me leave you with this. 10-15 years ago the various fees charged by a PE firm were split 80/20 GP to LP. Today its 20/80. Why? Market forces moved it that way in a maturing business. It makes their J-curves look better. (Calling steve – market forces, not regulation) Without diving into the weeds, the net effect is that you have to spend about 2 years raising funds, you have to pay staff for years to find, administer and harvest companies that eats up the management fee except for the mega-funds. You then have to aggregate the performance of all 8-15 companies that might make up your portfolio and wait until about 8-12 years to get paid your carried interest based upon that performance………….if it exists. How many people have the balls to go 8-12 years to see if they get paid? I haven’t made current income in our latest fund for 7 years. Maybe Ms Webber should shut her yap about stealing and join the party if the money is so easy.

I won’t hold my breath.

The only thing worthwhile in her whole piece is the notion that servicers rigged the game. I don’t know if that is true or not. If so it falls under the heading of fraud or criminality, not proper portfolio allocations. I do know one thing, banks almost always are losers in loan foreclosure. There is a reason they call it a loan loss reserve.

TastyBits August 20, 2014 at 8:46 pm

When Glass-Steagall was repealed, the financial industry should have asked why it was so easy. Instead, they began popping open the champagne.

The financial industry got what it wanted. Was it worth it? Dodd-Frank is not going away, and it will only grow.

Guarneri August 21, 2014 at 3:58 am

Commercial bankers wanted to wet their beaks in those inv banker salary structures. When I was in the business the whole crew of leveraged loan originators, syndicator a etc were considered a superior breed. Yet the old line commercial guys and gals were the best at credit and how to use the balance sheet.

Dodd frank is like lancing a boil with a machete and is really just a government “solution” to a government made problem. Typical. How’s that war on poverty going 50 years later?

Dave Schuler August 21, 2014 at 6:31 am

From my point of view Dodd-Frank should have been called the “This Time For Sure” Act. It assumes that given the same incentives right down the line people will just behave differently, darn it.

Our problem is moral hazard. The big banks know they will be bailed out. They know they will be absolved of their sins, however black. The only way to re-educate them is to stop doing that.

Guarneri August 21, 2014 at 10:22 am

Little understood about Dodd-Frank (basically an exculpatory piece of legislation attempting to wash the blood from the hands of two of the biggest perpetrators) is that like most such pieces of legislation it helps the big at the expense of the small – just what you (correctly) lament, Dave.

As long as there is profound ignorance or willful deceit you will have the SEC types self-congratulating their handiwork and the “Yves” of the world grinding their ill-explained axes. She’s not dumb – but she knows better.

Guarneri August 21, 2014 at 10:29 am

PS – I should note, PE firms are no different than any other person or organization. They have bad apples. That’s no excuse for a systemic “fix.” Just prosecute the crooks.

Further, contra the impression “Yves” want to give, CALPERS, the Harvard Endowment, Howard Hughes Medical Endowment etc etc know exactly what they are doing. They are not babes in the woods. And they have first rate counsel who know exactly what words to use in the LP documents to properly reflect the business deal.

You know who the worst pension administrators are? steve and Michael need to put their ear plugs in. Its the public pension administrators. That’s why so many hire consultants.

TastyBits August 21, 2014 at 12:22 pm


… Its the public pension administrators. …

If it is not clear, that is who I mean.

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