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Great investors don't gamble. But after having gotten burned by the bear market, public pension funds are doing the financial equivalent of betting it all on red -- and the consequences could be devastating for the millions of public employees who are counting on them for their retirement.
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Most people think of public pension funds as conservative investors. After all, they're responsible for safeguarding billions of dollars that are earmarked to cover payments to retired workers for the rest of their lives.
Unfortunately, public pension funds can't afford to be conservative any longer. The market turmoil in 2008 and early 2009 left them sorely underfunded, and those that had turned to nontraditional investments like private equity and hedge funds found that they failed to deliver on their promise to help protect against losses in stocks during the bear market. Now, they're struggling to gather more money at a time when traditional methods like increasing tax revenue simply won't work.
That's why, according to the Wall Street Journal, public pension funds are turning to the much-scorned Wall Street tactic of leveraging their investment portfolios. By doing so, they're making a big bet on interest rates -- and if history is any indication, it could easily backfire on them.
Why pension funds are doomed to fail
The strategy is pretty simple. Pension funds will borrow money in order to make a leveraged bet on bond prices. Because short-term interest rates are low, their borrowing costs will initially be extremely low. And although long-term rates aren't all that high, they're significantly higher than those borrowing costs -- resulting in a net profit to the fund.
Does that sound familiar? It should -- because it's the same business model that banks like Wells Fargo (NYSE: WFC ) , JPMorgan Chase (NYSE: JPM ) , and Bank of America (NYSE: BAC ) use to generate income. Right now, the bets are small. But analysts expect pension fund leverage to increase dramatically in the near future.
Pension funds face two problems, though. Unlike banks, which can rely on a steady source of low-interest bank deposits from customers, pension funds will remain fully exposed when the Federal Reserve starts to raise interest rates. That will squeeze the potential profits from the strategy, and could even produce huge losses if interest rates move against the pension funds.
The other problem comes from ridiculous expectations. Pension funds are reportedly hoping for returns of between 7% and 8% from the strategy -- a far cry from the 4.5% yield that the 30-year Treasury currently pays. Granted, if you borrow money at near 0% and earn 4.5% in interest on that money, then you can easily boost returns on your actual assets. But as the folks at Long Term Capital Management found out when a similar strategy went awry, when the music stops, you could be the one left without a chair.
This is the smart money?
You'd think that after all the damage we've seen from the improper use of leverage, pension funds would be the last institutions to try to juice their returns with it. Yet after having been late to the bull market of the 1990s and the private equity bull market of the past decade, they're jumping on the bond bandwagon at what could easily prove to be exactly the wrong time as well.
At its heart, this strategy is no different from borrowing on margin to buy stocks. Of course, when things go well, margin users like Green Mountain Coffee Roasters (Nasdaq: GMCR ) executive Robert Stiller and Oracle's (Nasdaq: ORCL ) Larry Ellison can attest. But when things go wrong, they can go really wrong -- as we saw up close and personal when Chesapeake Energy (NYSE: CHK ) CEO Aubrey McClendon faced a margin call that forced him to liquidate nearly all of his holdings. And he's not the only one -- several executives at Boston Scientific (NYSE: BSX ) faced the same problem back in 2008.
A lack of accountability
The only reason I can think of why pension funds would be willing to take on such huge amounts of risk is that the people responsible for making those decisions don't really face the consequences of being wrong. It's unfortunate that the millions of people who are relying on them to do the right thing may end up suffering for the mistakes that public pension funds have made over the years.