One might argue that it does – it would give smaller funds access to the brain trusts running the big public funds, including access to certain deals and asset classes. But is that really so? Can’t smaller funds access venture capital, hedge funds and infrastructure deals by investing in funds dedicated to these asset classes? Well, the respondant argues, they could now get it at a lower fee. Even if that were the case (I believe it would be), there exists the danger of conflict of interest. Unless, of course, the funds are managed in one large pool.

Which brings me to the arguments against the superfund:

1. Asset mix- given the different nature of public vs private fund liabilities (inflation indexing), is it really appropriate to consider similar asset mixes?
2. Future Contributions- corporations must be more sensitive to ongoing concern of their entity than a government or quasi-government entity, which may lead to different risk tolerance of plan sponsors
3. Together We Fall – what if the “brain trust” at a superfund missteps? Recent scandals such as the ABCP blowup in Canada or Madoff in the US, which are not tied to the overall market decline, demonstrate the danger if a superfund has large exposure to a particular asset or fund. In an age where we support smaller banks in order that no single financial institution would pose significant danger economic stability, how can we advocate supersized pension funds which could just as easily wreak havoc? (Granted that it may not be as direct, since pension funds do not lend to retail, but the impact on the banking system would be substantial)

Just as stocks and other risky assets began to crater the Pension Benefit Guarantee Corp (PBGC) upped its allocation to risky assets. This from a government agency whose existence becomes essential in a time of declining risk allocations.

PBGC works like this: collect premiums from pension funds so that if a pension fund sponsor goes belly up and the pension plan has an unfunded liability (its assets are less than its liabilities), the PBGC makes up the difference. Basically, it insures pension plans.

So what on earth would possess these guys to strap on the same risks as the very funds they are insuring? Talk about misunderstanding one’s place in the world.

2007 annual report does acknowledge risk of a sustained equity market decline but all talk of variable annuities trumpets their abilities in the product and how quickly it was selling

Next up: Metlife

just a quick survey of indices and the insurance cos gives us a good idea of what their betas are really like:

Risk management failure? Perhaps – or management actively decided to take this risk. Looks like it is time to rummage back through the annual reports to find out if shareholders were warned that these risks were being taken. After all, if we expect oil & gas and gold mining companies to reveal their hedges of future production, shouldn’t we expect the same of lifecos?

In practice, it is a completely different story. First of all, how relevant is MTM on assets when liabilities are not really marked-to-market. What do I mean? Let’s talk about 2 aspects of liability MTM: interest rates and mortality tables.

Interest Rates: are the cashflows being discounted off a MTM curve? What curve should that be: a generic corporate bond curve, or could we consider that obligations of the pension are really obligations of the corporation and discount each corporation’s pension liabilities off that corporation’s credit curve?

While the latter makes intuitive sense (and creates more work), it results in the peversions we witnessed throughout 2008: financials in the US were recognizing huge gains from their liabilities when their credit spreads exploded.

With either choice we may be discounting liabilities using a bond curve that is not achievable for the asset managers in the real market due to duration, issuance size constraints or credit diversification constraints. Derivatives may be employed to circumvent some of these issues, which I will address in a separate post.

Mortality: Anybody who discusses mortality MTM is out of their mind. By its very nature these tables are constructed using time series data which eliminate outliers. This is best illustrated by an example: if too many people died in 2008 versus what we would have predicted by extrapolating historical death rates, we may want an extra few years of data before determining that a particular trend (say declining death rates) has come to an end. Or perhaps we are on the cusp of discovering a cure to a disease; how would we factor that into our mortality tables?

So, maybe MTM is not all it is cracked up to be. Have a look at this post on asset MTM.

What are the risks of this plan? By strong-arming banks into lending the Fed has basically undertaken to support the entire banking system. The money-printing press is in full swing and that once again encourages bad borrowing. At least bankers memories aren’t short enough that they would engage in bad lending….again.

And of course when that war against deflation has been won (and we will not know when) US Treasuries will be revalued a la currencies in a post-Bretton Woods world.

The real question is: what are the trading implications? What positions can be enacted to best take advantage of this? Short EUR/USD? What about against a cross like being short EUR/AUD or EUR/CAD? I would prefer the latter, if only that the US Dollar Index seems to be rolling over (see chart below, where uptrend has broken and MACD divergence with higher price but lower MACD).

What about fixed income trade in Europe? Like fixed income in the US, historical volatility is dropping hard and signals like ADX and Bollinger Bands indicate that it should break soon. The only problem is that in this environment it is unclear which way it breaks (I am biased toward lower prices, higher yields).Caution dictates waiting until the market tells us what our position should be.

In a recent study, 90% of banks are looking into risk management practices while only 42% expect to make any changes. Where does that leave the 48% who are looking into it, but not making any changes? I can tell you: boardroom and executive education.

How many times have we heard of executives who panic when a trader exceeds their VAR on the downside once a quarter? Or, more frightening yet all too common in the heady days of 2005-07, the executives who ignore repeated VAR threshhold violations because they occur to the upside? Everybody complains how useless VAR is, and, believe me, I am no huge fan of VAR; but most of the negatives of VAR stem from a lack of understanding of its limitations and its uses.