PBGC — Lessons Learned From a “Federal Corporation”

Good Evening: Stocks rallied back to recoup some of yesterday’s losses and exited the month of March with the best monthly gain in six years. Even with today’s pop, though, the S&P 500 still managed to lose almost 12% during the first quarter. The rally was certainly good news for the folks at the Pension Benefit Guaranty Corporation. The PBGC is an oxymoronic “Federal Corporation”(I kid you not; go to www.pbgc.gov), and it turns out the “company” hitched its wagon to Mr. Market just before the storm hit. The sad tale of how it positioned its investments in 2008 is a cautionary one for those who would like to see our government take an ever larger role in our economy.

In sympathy with stronger markets overseas, U.S. stock index futures were 1% higher prior to the release of today’s batch of economic data. The Case-Shiller home price index registered a 19% year over year decline in January. This hefty setback was soon brushed aside as “old news” by investors, since everyone now knows January was a poor month. No such rationalizations were appropriate for either the Chicago NAPM (which fell off the table) or the Consumer Confidence number (a reading of 26 vs. 110 only 18 months ago). Both are March readings, but market participants ignored them, too.

Stocks went sideways for most of the morning and held on to their early gains before powering to new highs in the early afternoon. Whether the push was due to quarter end mark ups or not, I have no idea, but the major averages were up 3% with an hour to go in the trading session. The sellers then took over during the final hour left all the averages with gains ranging from 1.15% (Dow Transports) to 1.75% (NASDAQ). Treasurys seemed to pay closer attention to the economic data and were firm all day. Yields declined 5 to 7 basis points as the entire curve shifted down. The dollar was 0.5% less valuable by day’s end, and commodities regained the footing they lost yesterday. The agricultural complex led the way higher and the CRB index finished 2.5% higher.

If you thought the Pension Benefit Guaranty Corporation was a sleepy, backwater agency of the federal government that took in pension insurance premiums, assumed the pension liabilities of a few failed companies, and then invested its pool of assets in government securities, you would only be right about the premiums and liabilities. Like Fannie Mae and Freddie Mac before it, this neither fish nor fowl “federal corporation” has made a hash of it in trying to reach too high. The final two articles you see below chronicle the PBGC’s ghastly decision to increase its exposure to riskier assets made by a manager who came aboard in 2007. The Krugman article takes a politically motivated swipe at the situation, but the Boston Globe piece does an excellent job of summarizing how the PBGC landed in the soup.

Like many pension managers, the PBGC’s Charles Millard took a long term view toward investing. His unstated, short term goal, though, seems to be that he wanted the PBGC to look more like Yale. His corporation, which is NOT (yet) backed by the full faith and credit of you and me, was in deficit and Mr. Millard felt it was invested too conservatively to fill the breach. It may not have helped that Congress wouldn’t let him raise the premiums the PBGC charges, but Mr. Millard sought in 2007 and received in 2008 the permission to up the firm’s exposure to risky assets to 55%. Of the $64 billion under management, 20% was earmarked for U.S. equities, 19% in foreign stocks, 6% in emerging market equities, 5% in real estate, and 5% in private equity. Early last year. Ouch.

The sin here is not one of misguided ambition (these allocations are not unusual in the pension world), nor is it a minor one of exceptionally poor timing (we’ve all made this mistake). It is instead a major sin of poor governmental oversight (the Secretaries of Treasury, Labor, and Commerce all signed off on the move), and the cardinal sin of getting doubly long. By this I mean that Mr. Millard’s investment allocation for a pension insurance fund was exactly wrong because its higher exposure to risky investments was likely to come a cropper in a recession — which is exactly when the pensions of more failed companies would wash up on his doorstep. Insuring failed pensions is a business that has an embedded long exposure to growth assets like stocks. The PBGC should invest conservatively, e.g. in bonds, because those assets will tend to perform well when the PBGC’s business is performing poorly — and vice versa. Perhaps a couple of excerpts from the Globe article will make this concept more clear:

“But (Zvi) Bodie, the B.U. professor who advised the agency, questioned why a government entity that is supposed to be insuring pension funds should be investing in stocks and real estate at all. Bodie once likened the agency’s strategy to a company that insures against hurricane damage and then invests the premiums in beachfront property.”

“The worst case scenario is coming to pass,” said Mark Ruloff, a fellow at the Pension Finance Institute, an independent group that monitors pensions. He said the agency leaders “fail to realize that they are an insurer of pension plans and therefore should be investing differently than the risk their participants are taking.”

Perhaps an analogy I sometimes trot out to friends seeking general advice will help illustrate why everyone has to understand where their own embedded longs and shorts lie before they decide how to invest. A farmer who respects the Peter Lynch dictum to “invest in what you know” decides to check out stocks in the ag sector. He uses and likes both tractors from John Deere and fertilizer from Agrium. The farmer does his homework and they look appealing, but should he invest in them? The answer is no, since his business is long crop prices and farm incomes and so is the business at DE and AGU. Staying with what you know can still work, however, if the farmer invests in grain processing companies like either Archer Daniels Midland or Corn Products International. While a decline in crop prices hurts our farmer, the businesses of both ADM and CPO see their margins expand when crop prices fall. This concept is less about hedging and more about understanding the fundamental correlations between one’s business and one’s investments. Not only should Charles Millard have understood this basic principal, but the Cabinet Secretaries above him should have known better, too.

Let me close with a personal example of how I view embedded longs and shorts. During the 1990’s, the vice chairman of what was then Salomon Smith Barney made a trip to Chicago and he asked me if I had availed myself of the company’s stock purchase plan. “No” was my reply, and he was confused. “Why not? Our stock is doing great!” I simply told him buying stock in excess of what I received via compensation would leave me with a “triple long”. “My income already depends upon the brokerage business (long #1); part of my investments are already tied up in company stock (long #2); so buying more would be foolish” (long #3). Of course, Salomon Smith Barney would later become part of Citigroup. The current quote is $2.53. The vice chairman just stared at me and then shook his head. Would it surprise you to learn that this gentleman then went on to become the Chairman of a large asset management firm? The only wonder is why Tim Geithner hasn’t tapped him for help in Washington.
— Jack McHugh

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