Mortgaging future employees, such as teachers, nurses, police oficers
Weekly market view from New Oak Financialby Ron D’Vari, James Frischling & Asim Ali
The state of Illinois pension scheme is suffering from unfunded liabilities that are worse than any other state, endangering the stability of the state’s overall public finance system. Illinois’ legislature just revealed a proposed solution, which would reduce estimated liabilities by more than $160 billion over the next 30 years by 2044.
Moody’s has already downgraded Illinois general obligation debt to A3 with a negative outlook (the lowest rating for any U.S. state) after Illinois’ failure to pass a workable plan to deal with its massive unfunded public pension liabilities in the past.
The proposed solution will reduce cost-of-living adjustments while increasing the retirement age by five years for some employees less than 45 years of age. Similar to corporations, plan participants will also be able to choose a 401K plan providing a range of investment options. In return, Illinois commits to make additional contributions to cure the plan’s unfunded status over the next 30 years. Currently, the plan’s assets are $100 billion short of net present value of its future liabilities as-is and would be destined to run out of money.
While the proposal seems to have the backing of the leadership of both parties, it still may fail to get a majority vote in both houses. The union leaders are campaigning vehemently against the proposal already and are calling it unfair and unconstitutional.
Obviously, the savings come from reducing the benefits of current and future employee participants covering a variety of professions such as teachers, nurses and police officers. On the other hand, pension liabilities have become unruly and the state’s biggest credit issue. If left intact, there will be further downgrades which would undoubtedly increase the financing costs of the very system that is supposed to fund the escalating unfunded deficiencies. The recent restructuring ruling in the Jefferson County bankruptcy in Alabama should serve as a reminder that the end result could be worse if the pension and state’s finance issues are not addressed. While the proposal requires a meaningful sacrifice, the alternative of bankruptcy would be worse. The outcome of this delicate political debate will be watched by many states and municipalities facing similar structural issues that are primarily driven by retirement age and benefits.
Another public finance case that is being closely watched is Greece. Moody’s has just upgraded Greece by two rating grades for dealing with its structural issues as imposed by the European Union as a condition of their financial rescue package. In the United States, there are no federal rescue plans for states and municipalities so the taxpayers and pensioners have to bear the entire costs.
Wall Street Reforms Unintended Consequence: Hedge Funds Light?
It’s the perfect storm: the coming together of pension funds and endowments with U.S. hedge fund managers, resulting in the creation of alternative mutual funds.
As a result of the Fed’s near zero interest rate policies, investors are clamoring for yield and looking to deploy cash in alternative investments. Hedge funds, traditionally looking to stay out from under the supervisory thumb of the Securities and Exchange Commission, have not offered funds registered under the Investment Company Act of 1940.
With the onset of Dodd-Frank’s Wall Street reforms and the requirement that hedge funds with more than $150 million in assets register with the SEC, the disincentive for hedge funds to stay out of the mutual fund market has been removed. With $2.7 trillion of cash sitting on the sidelines looking to be deployed, hedge funds are offering liquid alternative funds that are registered under the 40 Act.
The investors need liquidity, but also want more attractive returns. Hedge funds that can offer more yield-driven strategies within the required mutual fund framework represent an attractive investment opportunity.
The demand for these alternative mutual funds is extremely high and hedge funds are creating these 40 Act funds to meet the demand. However, these investments aren’t without their risks. Operating under the liquidity requirement is a constraint most of these hedge fund managers aren’t used to. In addition, offering a cheaper version of their strategies could cannibalize lucrative parts of a hedge fund’s existing business. In short, what do hedge fund investors get for the traditional 2% running fees and 20% performance fees that aren’t being offered to the alternative mutual funds investors that pay far less?
Dodd-Frank, like other regulatory reforms, has unintended consequences. For hedge funds, it’s the opportunity to enter the mutual fund arena. The ultimate consequences of that remain to be seen.
CLOs: Regulatory Overreach?
Collateralized debt obligations (CLOs)—pooled syndicated leveraged loans with varied risk profiles—are back in vogue again. While there’s been much discussion as to why asset managers are gravitating back towards CLOs (e.g. for higher yields and subordination), one overlooked explanation has been the role CLOs play in the domestic financing sector, especially for U.S. companies and businesses.
The U.S. CLO market (a more than $300 billion market for loans to U.S. businesses and a major conduit of financing for syndicated loans) provides nearly $2.8 trillion in financing to US companies. CLOs act like quasi-banking channels providing access to the leverage loan asset class for investors that otherwise could not directly invest in leverage loans. Still, investors and corporations are resisting a ‘one-size-fits-all’ approach to CLOs. The regulators, replicating the risk-retention threshold required of banks and other asset-backed securities, are calling for financial entities that underwrite and originate CLOs to hold a 5% risk retention stake in the securities issued to investors.
CLOs, while volatile at times, ultimately performed better than similarly rated asset-backed securities during the 2008 financial crisis. Yet regulators and investors/businesses are at odds over the risks. For regulators, new rules for CLOs are about assuring stability of the financial system and having “skin in the game.” For investors, CLOs are about accessing a good asset class and attractive yields. And for corporations, financing is an important issue. CLOs are a natural conduit when banks are unwilling or cannot lend.
In this tight financing environment, it may be prudent for regulators to chart a course taking the specific risk/reward characteristics of CLOs into account. At issue are the possible negative externalities—both economic and financial—emanating from potentially ambitious regulatory regimes for different constituencies.