[but defined contributions funds (401k's and IRAs) won't be hurt.] August 22, 2008 / New York TIMES. High & Low Finance Profit Without Risk? Not Likely By FLOYD NORRIS
Perhaps the most remarkable aspect of the credit boom that preceded the current bust was the belief of professional investors that they had found a way to increase their profits without taking on risk. Very sophisticated financial models showed no risk whatsoever in AAA-rated mortgage securities. The underlying mortgages might lose money, the models showed, but built-in safeguards assured that the securities were well protected. It turned out the models were wrong. The idea that the route to higher profit runs through higher risk has been around for a long time. The phrase "nothing ventured, nothing gained," dates back to Geoffrey Chaucer in 1374, about six centuries before computers began to run regressions to find ways to get rich without risk. The Pension Benefit Guaranty Corporation, which is supposed to guarantee that those of us with pensions will get paid even if our employers go broke, has a $14 billion deficit. But it claims to have found a way to climb out of that hole while reducing the risk of its investments. It plans to move a lot of money out of bonds and into stocks, with sizable investments going into real estate and private equity funds. Its success or failure may matter to people who do not have pensions, but do pay taxes. Under the law, the government is not obligated to cover a shortfall at the P.B.G.C., just as it had no obligation to bail out Fannie Mae and Freddie Mac. In reality, it is hard to imagine Congress refusing to come up with money if the alternative were to see pictures of elderly people whose pensions were being cut or terminated because the government would not stand by the agency it created. "What we're doing here is literally less risky," Charles E. F. Millard, the director of the guaranty corporation, told me this week. Or as he put it in an article for Pensions and Benefit Daily, a trade publication, "The two most important facts about the new investment policy are that it significantly improves the probability the P.B.G.C. will be able to meet its obligations, and that it does so while taking less short-term and long-term risk." The risk reduction came from greater diversification, he said. "If sixth-graders in America took finance, I could say to you that, 'As every sixth-grader knows, diversification mitigates risk, and this policy is substantially more diversified, and that is why it has a lower standard deviation.' " More return. Less risk. Who could object? A lot of people, it turns out. I asked Peter L. Bernstein, the author of some of the best books on finance I have ever read, among them, "Against the Gods: The Remarkable Story of Risk," about the change in investment strategy. He agreed that it was likely to improve returns, but the part about risk left him shaking his head. "Diversification does reduce volatility, but the risk of a wipeout in the economy can only be hedged by owning Treasury bonds," Mr. Bernstein said. "So the big downside risk that really matters is not reduced by the greater diversification in the new portfolio. Smaller downdrafts, yes; lower volatility in normal times, yes; and much greater upsides, yes. No argument about the upsides. It is the downsides where I do not see where they can say what they say." The new policy differs greatly from the old one, which was adopted in 2004 — after the agency's paper surplus was wiped out as share prices slid from 2000 to 2002. The 2004 policy called for only 25 percent in stocks, although in practice the agency never got it down to that level. The argument then was that the P.B.G.C. should act like an insurance company and seek to match the maturity of its assets to its liabilities. "If we didn't match our liabilities, but just sort of shot for the moon, if you will, the taxpayer would be providing portfolio insurance for our bets in the market," said Steven A. Kandarian, who was then the agency's executive director. Zvi Bodie, a finance professor at Boston University who served as a consultant to the P.B.G.C. and helped write the old policy, says the fundamental flaw in a heavy reliance on stocks is that it is precisely a fall in the value of the American stock market that the agency is insuring against. Not only do pension funds own a lot of stocks — and become more likely to fail if share prices plunge — but the backup guarantee of a pension fund is the value of the equity of the company that established the pension plan. Mr. Bodie, never one for understatement, compares the P.B.G.C. relying on stocks with an insurance company investing the proceeds from hurricane insurance premiums in Florida real estate. The Congressional Budget Office, in a review of the policy, put it more gently. "The new strategy is likely to produce higher returns, on average, over the long run. But the strategy also increases the risk that P.B.G.C. will not have sufficient assets to cover retirees' benefit payments when the economy and financial markets are weak." "By investing a greater share of its assets in risky securities," the report said, "P.B.G.C. is more likely to experience a decline in the value of its portfolio during an economic downturn — the point at which it is most likely to have to assume responsibility for a larger number of underfunded pension plans." Mr. Millard, a presidential appointee who is both a former investment banker and a former Republican member of the New York City Council, says all that was taken into account, and that the reality he had to deal with was that the corporation has about $68 billion in assets and $82 billion in obligations. "The point of this policy is to substantially increase the likelihood that we will be able to pay our bills," he said. Told of Mr. Bernstein's comments, he replied, "That person must believe we should be 100 percent invested in Treasuries, and leave Congress to write the check. That is moral hazard." "It is important," Mr. Millard added, "not to get seduced by the lore of the high-math, high-logic guys." Part of the argument concerns the nature of risk. Mr. Millard points out that the corporation's consultant, Rocaton Investment Advisors, calculated that over a 20-year period, the new policy would produce much better returns under the worst circumstances than would be produced under the old policy, which relied more heavily on Treasuries and high-quality corporate bonds. How can that be? The stock market may not be likely to collapse, but it might. It is hard to imagine the government not paying its bills, given that it can print dollars. When I asked that question of Joe Nankof, a Rocaton partner, he said the "worst case" term "is just used for labeling purposes. It is not meant to suggest it is the worst possible case." Instead, it is the worst case that, under Rocaton's assumptions, has a 1 percent chance of occurring if the new policy is followed for 20 years. Anything worse, Mr. Millard told me, should be viewed as "statistically insignificant." Some of Rocaton's assumptions were challenged this week by the Government Accountability Office, which argued that the new policy posed more risk than the guaranty corporation acknowledged, and more risk than the old policy posed. But it agreed that the policy would probably produce better returns. Rocaton's analysis is based significantly on the use of standard deviation, a measure of how far from the average something is likely to be. The smaller the standard deviation, the smaller the expected difference between the return you get and the one you expected. One catch is that if something has not happened before, the model may assume it has little if any chance of ever happening. The rating agencies that determined mortgage securities were safe had models that assumed home prices would not fall more than 5 percent. No doubt they viewed the chances of what actually happened as being statistically insignificant. The other problem is that it is foolish to view standard deviation as the only measure of risk. The market value of a long-term Treasury bond will fluctuate over the years as interest rates rise and fall. But it will eventually pay off at par. Rocaton's report includes its estimates of standard deviation for various asset classes. If you think that is the same as risk, then you think that real estate investing has relatively little risk. Under Rocaton's numbers, a portfolio of hedge funds would have less risk than a portfolio of junk bonds, and either would have less risk than long-term Treasuries. How would you react if your broker suggested you reduce the risk of your investment portfolio by selling Treasuries and buying junk bonds and hedge funds? The guaranty corporation's new investment policy is not a wildly aggressive one. Despite their perceived low risk, the corporation will not invest in hedge funds. Investment profits probably — but not certainly — will be higher. What is certain is that this has provided a way for the Bush administration and Congress to put off any hard decisions about financing the $14 billion deficit at the P.B.G.C. The real risk is that the deficit will grow, and that instead of writing a $14 billion check now, Congress may have to write a much larger one later. That may be a risk worth taking, but it is a real risk nonetheless. -- Jim Devine / "Segui il tuo corso, e lascia dir le genti." (Go your own way and let people talk.) -- Karl, paraphrasing Dante. _______________________________________________ pen-l mailing list [email protected] https://lists.csuchico.edu/mailman/listinfo/pen-l
