How Much More Will Pensions Lose in Financials?

Includes: AIG, LEH, MER, UBS
by: Susan Mangiero, CFA

One good thing about being an occasional night owl is that you get to blog about breaking news. Unfortunately, yesterday's headlines are gloomy indeed. Here's a quick recap.

  • According to a company press release (dated September 15, 2008), Lehman Brothers Holdings Inc. (LEH) intends to file for Chapter 11 protection, seeking a reprieve from creditors. "None of the broker-dealer subsidiaries or other subsidiaries of LBHI will be included in the Chapter 11 filing and all of the broker-dealers will continue to operate...Neuberger Berman, LLC and Lehman Brothers Asset Management will continue to conduct business as usual..." Click to read the Lehman Brothers press release. Various stories describe a rejection by the U.S. government to bail out this venerable financial institution. In stark contrast to this news, Reuters reporters Christian Plumb and Dan Wilchins report that the bank had just reported "a record $4.2 billion" net profit. (See "Lehman CEO Fuld's hubris contributed to meltdown", September 14, 2008).
  • New York Times reporter Edmund Andrews reports that the Federal Reserve has loosened collateral rules to allow investment banks to pledge "stocks and some debt that has junk-bond status." (Read "Federal Reserve Offers No Cash but Loosens Standards on Emergency Loans," September 15, 2008.)
  • Merrill Lynch (MER) is selling itself to Bank of America (NYSE:BAC) and AIG (NYSE:AIG) is seeking billions of dollars to keep it afloat. (See "Bank of America to Buy Merrill" by Matthew Karnitschnig, Carrick Mollenkamp and Dan Fitzpatrick, Wall Street Journal, September 15, 2008 and "AIG Scrambles to Raise Cash, Talks to Fed" by Matthew Karnitschnig, Liam Pleven and Peter Lattman, Wall Street Journal, September 15, 2008.)
  • According to Reuters ("Derivatives market trades on Sunday to cut Lehman risk", September 14, 2008), an emergency session commenced at 2 pm in New York, ran for two hours and was then extended for another two years, during which "trading involved credit, equity, rates, foreign exchange and commodity derivatives." Initiated at the request of the Federal Reserve, the goal was to net over-the-counter ("OTC") derivative instrument positions among major players in order to avoid a Lehman-related meltdown. (Lehman actively trades in the OTC derivatives markets.) Bond fund giant Bill Gross is quoted as saying that a "Lehman bankruptcy risks an 'immediate tsunami' because of the unwinding of derivative and credit swap-related positions worldwide in the dealer, hedge fund and buy side universe."
  • Reuters also reports that UBS (NYSE:UBS) is expected to write down an additional $5 billion "on its risky investments in the second half of the year." (See "UBS to write down extra $5 billion in H2: report," September 14, 2008.)
  • This collection of financial horribles follows quickly on the heels of a recent U.S. bailout of Fannie Mae (FNM) and Freddie Mac (FRE). Click to access the website page for the U.S. Department of Treasury - "Treasury and Federal Housing Finance Agency Action to Protect Financial Markets and Taxpayers."

The fallout for pension plans is not going to be pretty if pundits are correct. Interest rates will fall, boosting defined benefit liabilities. Plummeting equity market prices (especially if contagion prevails) are going to hammer asset portfolios, especially those traditional benefit plans with big allocations to stocks. Funding status could worsen, creating its own set of adverse outcomes. Exposure to troubled banks potentially spills over to pensions if (a) they are the OTC derivative counterparty on the other side and/or (b) their external money managers find themselves in that unhappy position and/or (c) they own stock in any or all of the banks in question.

On the flip side, a sagging U.S. dollar could be a blessing for institutional investors with exposure to multinational companies that earn most of their net revenue offshore. Additionally, non-U.S. equities and bonds will likely rise in value. Unless regulators curtail trades, some parties will pocket dramatic gains from having taken a direct or synthetic short position in certain stocks and bonds. Commodities might turn out to be another bright spot for some. For those with cash, if this truly marks a bottom, as some suggest, bargain hunters may have reason to celebrate.

We are hard at work, chasing down the pension-centric facts. We predict there is going to be much more to say about risk management and valuation. Hang onto your hats! We are in for a bumpy ride.

Author's Note: When testifying before the ERISA Advisory Council on September 11, 2008, I was asked to comment about the pervasiveness of "hard to value asset" issues. I said (and the inquiring Council member agreed) that: (a) defined contribution plan participants are not immune to potential valuation-related losses (b) "hard to value assets" might characterize some "traditional" mutual funds, separately managed accounts and money market funds and may or may not apply to alternative investments (depending on the strategy and other risk factors) and (c) the importance of the topic demands that considerably more attention be paid to model risk, independence of marking-to-model or marking-to-market and the extent to which an investor or trader integrates valuation with his or her risk management policies and procedures.

Disclosure: none