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We Own It

(as printed in the January 2012 APB)

Two months ago I wrote the article “Economic DUI.” The motivation for this article stemmed from an ongoing realization that the pension reform debate will never be satisfied. Yet the benefit levels, and the restructuring of/stripping away of benefits, seem to be the only solutions being discussed. If you have read any of my writings before, you know that I consider pension plans one of the most impacted victims of the biggest financial heist in our world’s history. And from my personal perspective, I think the worst part of this whole “pension mess” is that we are likely to see more financial shenanigans affecting long-term savers—the biggest of which are pension plans—in the future.

One of the main points of the “Economic DUI” article was that there seems to be an amazing disconnect between our financial markets and current economic conditions in our world. Our worldwide economy is inescapably intertwined and complex. It seems those in charge have determined the solution to our debt and liquidity excesses, the very things that drove us into financial disaster in 2008, is to add more debt and liquidity to our economy by keeping interest rates artificially low and by simply printing money and putting it into the economy. While this policy has kept the financial markets at least partially afloat and even given an appearance of “recovery and growth,” the reality is that our financial system is in withdrawal — full-on detox must occur, in my opinion, before we will see a recovery.

Historically, CalPERS has managed your pension fund so that 70 percent of the benefits paid out to retirees come from investment returns. Obviously, how your pension fund performs with respect to their investment returns is critical to the long term health and viability of the system. I find it very peculiar, in a disappointing way, that the topic of investment returns does not top the list of discussion points when we talk about unfunded liabilities in our pension plans or how pensions are eating up larger portions of public budgets.

Here is the conclusion I have come to. Pension funds require long term fiscal planning and discipline. Who, in this world controlled by the financial industry, is willing to stand up and say “you screwed us and you are not going to screw us any longer.” Why, on God’s green earth, do we invest in investment instruments that are too difficult to understand? Why would we pay a hedge fund manager a 2 percent fee on gross investments plus 20 percent of our investment returns for taking no risk? That hedge fund manager gets paid those fees whether the fund does well or does poorly. So what interest does he have in ensuring the fund performs positively? The answer is that he has none at all.

And speaking of hedging, how does it make sense to buy mortgage debt (as mortgage-backed securities) or buy a country’s debt (in the form of bonds issued by that country) and then, at the same time, buy insurance that pays if they default on their debt? These insurance contracts protecting against defaults are a form of derivative. *

In some cases, the very same entities who bought mortgage-backed securities bought the insurance against the mortgages going into default. These entities justify this practice by saying they can reduce risk through hedging strategies. Excuse me, but whatever happened to reducing your holdings of a questionable investment rather than essentially betting against your primary investment to “hedge the risk”? And while we’re speaking of derivative contracts, why do we need more than $700 trillion in derivatives in our world economy? And while we speak of big numbers, does anyone understand just how gargantuan $700 trillion really is? For starters, the world’s entire Gross Domestic Product (GDP) is $63 trillion; so derivatives have grown to a level that exceeds the world’s GDP by a factor of more than ten.

My point is not to depress you, the reader, but rather to say there is too much at stake to accept business as usual. Here is a thought: if no one is willing to ask these difficult questions, or think long term, or have some fiscal discipline then maybe we (those promised the benefits/the unions representing pensioners) should insist that pension reform includes investment reform. Otherwise, I see a dangerous potential, in the long term, of cost savings generated by restructuring benefits being quickly devoured by investment losses—or maybe not even investment losses, but investments that fall short of the assumed rate of return in investments of pension funds.

Public employee unions whose members are in public pensions have been put on the defensive. If we are going to have to move further in sharing costs or reforming benefits we must ask where it all stops and how we are going to shore up the largest factor in funding our pensions. It is not good enough to let the bet ride in the Wall Street rigged casino.

The long term viability of our pension plans are in our best interest. We must approach every decision with fiscal discipline and a very long term perspective. It is the absence of these two critical attitudes that cause us to be where we are today.

*For those of you who are unfamiliar with derivatives, they are like buying an insurance policy on a home you don’t own. Except you’re not the only one taking out an insurance policy on that home. Perhaps hundreds of other people are also buying insurance policies on that same home. And when the home burns down, all the policy holders need to be paid. This, of course, can be disastrous. For example, in 2008, investors bought trillions of dollars worth of derivatives when they wanted to bet that mortgage-backed securities would lose value when homeowners defaulted on their mortgages. In other words, they wanted to get paid when mortgages went bad. And once that began to happen in large numbers, all those investors needed to be paid all at once, resulting in the financial crisis. AIG, in particular, was a company who had sold many of those derivatives. And when the purchasers of those derivatives came to collect their money, AIG didn’t have enough to pay all of them. They were over-leveraged. They had sold too many insurance policies on the same product.

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