Pensions and Liquidity Squeeze

More than a few people have declared the beginning of the end. A reference to halcyon market conditions, it looks like they are right (at least for now). A flurry of headlines address what this blog author has been saying all along. Watch the collateral, assess liquidity risk and take stress testing seriously. Where does one begin?

1. On March 5, a Pension Governance sponsored webinar (Fiduciary Risk, Trading Controls and External Asset Manager Selection) emphasized to need to be wary of the risks you don't know and manage the ones you can measure. In his remarks about global bank and pension regulation, Mr. Gavin Watson (Institutional Business Strategy Head, RiskMetrics Group) correctly pointed out that risk management is no longer a luxury. Basel II seeks to better link capital reserves with banks' economic risks. UCITS III (Undertakings for Collective Investments in Transferable Securities) requires asset managers to have a daily risk monitoring program that is easy to understand. Pension plans are not immune from new rules. Risk forecasting is a statutory reality for Dutch plans. UK plans must take underfunding risk into account or pay a punitive levy. The Pension Protection Act of 2006 in the US imposes a variety of rules that relate to fiduciary risk mitigation, including the selection of a proper advisor for 401(k) plan investment selection. Mr. Anthony Turner (Principal - Financial Tracking Technologies) talked about the need to examine managers' holdings and track deviations from approved limits.

2. In a separate webinar on March 6, I urged audience members to pay attention to the quality, quantity, price behavior and transferability restrictions attached to pledged collateral. Part of "Liquidity Risk Managemenft," hosted by Knowledge Congress and co-sponsored by Pension Governance, LLC, my presentation addressed liquidity red flags, including but not limited to the following:

• Undue Concentration in a Few Number of Holdings
• Low Trading Volume
• Infrequent Trading
• Limited Number of Market Participants
• Contractual Limitations on Whether, How and When Withdrawals Can be Made
• Volatile Market
• Form of Withdrawals, if Permitted
• Correlation Changes
• Contagion 

3. In today's paper, famed New York Times reporter Gretchen Morgenson refers to investors as guests in Hotel California since "they have checked into an investment they can never leave." Referring to auction rate notes (debt instruments with long or no maturities that reset weekly), author of "As Good as Cash Until It's Not" describes how this market has screeched to a halt in recent days. Finding few bidders, mostly municipal issuers worry about growing budget gaps. Investors, on the other hand, are left holding the bag after investing in what they perceived to be relatively "low risk" securities.

4. In "Hedge Funds Frozen Shut," Business Week journalist Matthew Goldstein reports that "Since November at least 24 hedge funds have barred or limited investors from taking their money out, tying up tens of billions of dollars for an indefinite period. Among them: GPS Partners, a $1 billion fund that bets mainly on natural gas pipelines; Pursuit Capital Partners, a $650 million portfolio with troubled debt; and Alcentra European Credit, a $500 million fund that owns slumping loans used to finance private equity buyouts. For those institutional investors who failed to read the fine print allowing managerial discretion, these lock-outs are bad news. Arguably, hedge funds want to prevent a mass exodus of their investors for several reasons. First, a drain on assets makes it harder to recover losses (if possible at all). Second, fees drop as the size of their portfolio falls due to redemptions and sub-par performance. Making matters worse, prime brokers are turning off the money tap, create illiquidity problems for hedge fund managers at the precise moment when they need cash to stay in the game. Goldstein suggests that redemption restrictions may be postponing an inevitable collapse for some hedge funds.

I'd say "take two aspirin and revisit the situation in the morning" but that solution fars short of what looks to be rough times ahead.

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