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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Category: BP Cafe, Markets

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

8 Responses to “PBGC — Lessons Learned From a “Federal Corporation””

  1. tom10023 says:

    Re: “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.”

    I question the word “excellent”. Many casual readers took from the Globe article that the PGBC had actually *implemented* the decision to increase their equity exposure. Hence the use of phrases such as “landed in the soup” or Krugman’s wild claim that because of this decision by a $68 billion fund “the Bush administration may have left us all a gratuitous loss of hundreds of billions”. Dollars? Yen?

    In fact, the shift had not been implemented as of Oct 24, 2008 – you can check Millard’s testimony to a Congressional committee:

    “Mr. MILLARD. Correct. The decline in our portfolio, the portfolio was approximately 70 percent [corrected to 30 percent] equities in September a year ago, and other than the fact that equities have dropped, we have not changed our allocation yet.

    I have lots of useful links at my humble blog.

    http://justoneminute.typepad.com/main/2009/03/prof-krugman-meet-prof-krueger.html

  2. freejack says:

    “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.”
    Or perhaps a cautionary tale about turning over the levers of government to a political party who’s self fulfilling ideology is that “government is the problem” and who political donor class/base stands in direct opposition to the very concept of a social safety net.
    What they can’t privatize, they sabotage.

  3. Keith D. says:

    Very good article, I especially enjoyed your analogy at the end. I never quite thought of that before. Oh, and when I did investment advising for clients, we had a farmer who had a bunch of stock in CPI, it was so difficult figuring out a cost-basis for him though…

    It is hard to believe that something like the PBGC would expose themselves to that kind of risk. Especially when there were early warning signs about problems in the sub-prime market and such. Doesn’t he know the basic rule of investing? Buy low, sell high? Seems to me, he got the PBGC in the market right at the high… if only he had waited…

  4. this: “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.”

    should be ink-jetted to paper, at the minimum.

    it is, truly, amazing, the Light– a little Reflection will bring.

    this: “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).” though, going fwd: is too telling..

    is Zero, really, the lower bound for either of those indices?

  5. leftback says:

    Amazing.

    I read this story yesterday, as I have the stories about other pension funds, and shook my head in amazement.
    This is just one of the reasons that we should retain considerable caution about both credit and equities.
    At some point, many of the fools who rushed in where angels fear to tread will have to liquidate.

  6. Simon says:

    Thanks for explaining embedded longs Jack. You can’t understand your investments until you understand their corrollations. Once you’ve got that you can know how specific or diverse your exposure is.

  7. usphoenix says:

    Another great, informative article from our bud Jack.

    I can recall friends bragging about how great the 401K stock investment plan was doing based completely and totally on the company stock, Lucent. Soaring, soaring, soaring. And buying in at a discount.

    They were going to soon be on the beach.

    What happened?????? Who would have thought.

    All their eggs were in one single basket.

    But they did not do their homework. They did not read beyond the press release babble.

    Wishful thinking.

    Most importantly they did not pick up on the disconnect between the “free market” and the government market. And no one wants to talk about that.

    Lucent had some extremely lucrative technology enterprises going on they deliberately split off. Micro cameras for one. Government contracts alone guaranteed …….

    Did that remain part of the Lucent portfolio to power all the long term contributors through? Or th4e corporate pension fund? NO.
    But I’m going to guess McGinn is still getting a dividend check.

    Just another example of how totally corrupt we have become.

    And the point is this: there was a brief interlude after WWII where we were all in this together and we won and lost together and shared the corporate wealth.

    And then that became passe. Cut them loose. Do portfolio management. You don’t owe them anything. Technologists are a dime a dozen., You are the Wall Street connected guy that can bank the billions and get on with your life. Totally independent of them. And they can just move on.

    So exactly why should PBGC be any different. Frustrated billionaires trying to match up. Salary and millions were not good enough.

    But they were also drinking the same Kool-Aid. Buds to the end.

  8. Jack McHugh says:

    Sorry, everyone, but I goofed yesterday in relying too heavily upon the PBGC story in the Boston Globe. While the PBGC did indeed adopt the asset allocation targets cited above back in February of 2008, the PBGC apparently was only just getting started in buying more stocks when the storm hit last fall. Here is a link to the annual report — http://www.pbgc.gov/docs/2008_annual_report.pdf . The important passages discussing the implementation of the asset allocation policy are on pages 16 and 17. The error was all mine.

    – Jack McHugh