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This Dumb Move Could Kill Your Retirement

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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. 

Place your bets
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.

If you want to retire rich, you need to do it on your own. Let Chuck Saletta show you how ordinary investors beat the lost decade.

Fool contributor Dan Caplinger is glad that he's not relying on the government to fund his pension. He owns shares of Chesapeake Energy, which is a Motley Fool Inside Value pick. Green Mountain Coffee Roasters is a Motley Fool Rule Breakers recommendation. The Fool owns shares of Chesapeake Energy and Oracle. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy won't leave you out in the cold.


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  • Report this Comment On February 02, 2010, at 12:38 PM, karlwmiller wrote:

    Are Hedge Funds and Financial Institutions Holding Natural Gas Producers Hostage

    Jan 30, 2010 11:31 PM | about stocks: CHK, DVN, EOG, APC, APA, OXY, XOM, CVX, MRO, WMB, EP

    For public interest, senior energy executive and institutional investor Karl W. Miller, today issued the following statement through his advisors regarding the U.S. Natural Gas Industry.

    CHK is a unique natural gas company, in that it is rated Outperform by a collection of 29 independent analysts, the number one (1) rated outperform natural gas company by retail investors, yet it is the most heavily shorted natural gas company by hedge funds and financial institutions.

    Mr. Miller has previously opined that based on his over twenty years in the commodity industry and specifically energy, that natural gas futures and swaps prices are being artificially manipulated downward in the current market.

    When you look at CHK as an example of why short sellers might be manipulating prices downward, some high profit reasons become clear. CHK is in essence a proxy for a natural gas futures contract, but with the asset protection of owning its natural gas production.

    CHK utilizes volumetric production payments or what we used to call the gas bank, whereby they finance future production by borrowing against reserves in the ground and then delivering physical gas to the lender who in this case is the financial institutions. This is in addition to having major global partners like Total, BP, Statoil, and others in club arrangements for its production assets, which Mr. Miller has opined is a very good strategy. Major oil companies have a long history of partnering and risk sharing in natural gas and oil production fields (consortium's) globally.

    Mr. Miller has also opined that CHK and other natural gas producers should not be hedging long term at the currently depressed natural gas prices. CHK has abided by that doctrine, believing that better prices are ahead, which Mr. Miller concurs. Therefore, if one takes CHK as a proxy for the entire natural gas producer community, one can easily see why the hedge funds and financial institutions would continue to manipulate natural gas futures contracts and over the counter swaps prices down, to profit substantially if natural gas producers hedge with them to lock in prices, as well as to lock in artificially low volumetric production prices for financing purposes.

    Keep in mind that financial institutions make a majority of their money from proprietary trading, not customer business. Customer business facilitates proprietary trading. Mr. Miller can say this from experience, as he used to trade proprietary capital for a major money center financial institution and has executed billions of dollars worth of structured energy transactions globally over his career.

    If we take a closer look at CHK, they have one of the industry's best

    collections of natural gas assets in the U.S. Chesapeake's future growth prospects are largely driven by its positions in what it refers to as the Big 4 shale plays - the Haynesville, Marcellus, Barnett and Fayetteville Shales. The company is less hedged than normal for 2010, as management believes there will be better opportunities to secure more favorable pricing than are currently available, consistent with Mr. Miller's views and recommendations for the entire natural gas sector.

    Positive Factors on CHK Valuation (per MarketEdge Research):

    The Price/Book Value ratio is 1.39. The average Price/ Book for this Industry

    Group (Oil-Exp. & Prod.) is 13.71.

    The Price/Cash Flow ratio is 20.14. A low ratio shows a strong ability to

    generate cash and reflects well on a company’s stock price and liquidity. The

    average Price/Cash Flow ratio for this Industry Group (Oil-Exp. & Prod.) is

    97.15.

    The Price/TTM (Trailing Twelve Month) Sales ratio is 1.89. A stock with a low

    Price/Sales ratio indicates a stock is not overvalued. The Price/Sales ratio is

    significant since it is harder to manipulate sales than earnings. The Price/TTM

    Sales ratio for this Industry Group (Oil-Exp. & Prod.) is 6.50.

    Profitability:

    The Operating Cash Flow was Positive in the last three years.

    Growth Potential:

    The prior quarter Earnings Per Share (EPS) growth rate of -94.90% is greater

    than the TTM EPS growth rate of -436.15%.

    Mr. Miller set an acquisition price of $35.00 per share based upon a mean analyst price target of $29.00/share in 2010. See link:

    www.naturalgasstocks.com/Karl_Miller/news/1292.asp

    The Analyst community have raised their mean target price to $35.00 on a stand alone basis, without any acquisition premium, should a buyer emerge.

    Analyst Consensus Forecast:

    The EPS forecast for the next two quarters is greater than the prior quarter EPS.

    FactSet Earnings Estimates

    Analyst Rating OVERWEIGHT

    Number of Ratings 29

    Current Quarter $0.68

    Next Quarter $0.59

    Current Fiscal Year $-0.22

    Next Fiscal Year $2.56

    Surprise % N/A

    Year Ago Earnings $3.55

    Average Target Price $35.00

    Mr. Miller's take away from this summary analysis is that the markets clearly believe CHK is the number one acquisition candidate and have been positioning the natural gas prices and shorting CHK down artificially to capitalize on i) a fundamental positive shift in Natural Gas Consumption; ii) an announced acquisition of CHK by a third party, which would enable short sellers to flip into long positions through purchasing out of the money options above the current stock price (which we have see substantial $30.00 calls purchased); and iii) an attempt to hold CHK (and other natural gas producers) hostage on hedge contract prices.

    Disclaimer:

    This column, Energy Commentary from Karl Miller, is the opinion of Karl Miller. Investors should seek the advice of a qualified investment professional prior to making any investment decisions.

  • Report this Comment On February 02, 2010, at 12:40 PM, karlwmiller wrote:

    Are Hedge Funds and Financial Institutions Holding Natural Gas Producers Hostage

    Jan 30, 2010 11:31 PM | about stocks: CHK, DVN, EOG, APC, APA, OXY, XOM, CVX, MRO, WMB, EP

    For public interest, senior energy executive and institutional investor Karl W. Miller, today issued the following statement through his advisors regarding the U.S. Natural Gas Industry.

    CHK is a unique natural gas company, in that it is rated Outperform by a collection of 29 independent analysts, the number one (1) rated outperform natural gas company by retail investors, yet it is the most heavily shorted natural gas company by hedge funds and financial institutions.

    Mr. Miller has previously opined that based on his over twenty years in the commodity industry and specifically energy, that natural gas futures and swaps prices are being artificially manipulated downward in the current market.

    When you look at CHK as an example of why short sellers might be manipulating prices downward, some high profit reasons become clear. CHK is in essence a proxy for a natural gas futures contract, but with the asset protection of owning its natural gas production.

    CHK utilizes volumetric production payments or what we used to call the gas bank, whereby they finance future production by borrowing against reserves in the ground and then delivering physical gas to the lender who in this case is the financial institutions. This is in addition to having major global partners like Total, BP, Statoil, and others in club arrangements for its production assets, which Mr. Miller has opined is a very good strategy. Major oil companies have a long history of partnering and risk sharing in natural gas and oil production fields (consortium's) globally.

    Mr. Miller has also opined that CHK and other natural gas producers should not be hedging long term at the currently depressed natural gas prices. CHK has abided by that doctrine, believing that better prices are ahead, which Mr. Miller concurs. Therefore, if one takes CHK as a proxy for the entire natural gas producer community, one can easily see why the hedge funds and financial institutions would continue to manipulate natural gas futures contracts and over the counter swaps prices down, to profit substantially if natural gas producers hedge with them to lock in prices, as well as to lock in artificially low volumetric production prices for financing purposes.

    Keep in mind that financial institutions make a majority of their money from proprietary trading, not customer business. Customer business facilitates proprietary trading. Mr. Miller can say this from experience, as he used to trade proprietary capital for a major money center financial institution and has executed billions of dollars worth of structured energy transactions globally over his career.

    If we take a closer look at CHK, they have one of the industry's best

    collections of natural gas assets in the U.S. Chesapeake's future growth prospects are largely driven by its positions in what it refers to as the Big 4 shale plays - the Haynesville, Marcellus, Barnett and Fayetteville Shales. The company is less hedged than normal for 2010, as management believes there will be better opportunities to secure more favorable pricing than are currently available, consistent with Mr. Miller's views and recommendations for the entire natural gas sector.

    Positive Factors on CHK Valuation (per MarketEdge Research):

    The Price/Book Value ratio is 1.39. The average Price/ Book for this Industry

    Group (Oil-Exp. & Prod.) is 13.71.

    The Price/Cash Flow ratio is 20.14. A low ratio shows a strong ability to

    generate cash and reflects well on a company’s stock price and liquidity. The

    average Price/Cash Flow ratio for this Industry Group (Oil-Exp. & Prod.) is

    97.15.

    The Price/TTM (Trailing Twelve Month) Sales ratio is 1.89. A stock with a low

    Price/Sales ratio indicates a stock is not overvalued. The Price/Sales ratio is

    significant since it is harder to manipulate sales than earnings. The Price/TTM

    Sales ratio for this Industry Group (Oil-Exp. & Prod.) is 6.50.

    Profitability:

    The Operating Cash Flow was Positive in the last three years.

    Growth Potential:

    The prior quarter Earnings Per Share (EPS) growth rate of -94.90% is greater

    than the TTM EPS growth rate of -436.15%.

    Mr. Miller set an acquisition price of $35.00 per share based upon a mean analyst price target of $29.00/share in 2010. See link:

    www.naturalgasstocks.com/Karl_Miller/news/1292.asp

    The Analyst community have raised their mean target price to $35.00 on a stand alone basis, without any acquisition premium, should a buyer emerge.

    Analyst Consensus Forecast:

    The EPS forecast for the next two quarters is greater than the prior quarter EPS.

    FactSet Earnings Estimates

    Analyst Rating OVERWEIGHT

    Number of Ratings 29

    Current Quarter $0.68

    Next Quarter $0.59

    Current Fiscal Year $-0.22

    Next Fiscal Year $2.56

    Surprise % N/A

    Year Ago Earnings $3.55

    Average Target Price $35.00

    Mr. Miller's take away from this summary analysis is that the markets clearly believe CHK is the number one acquisition candidate and have been positioning the natural gas prices and shorting CHK down artificially to capitalize on i) a fundamental positive shift in Natural Gas Consumption; ii) an announced acquisition of CHK by a third party, which would enable short sellers to flip into long positions through purchasing out of the money options above the current stock price (which we have see substantial $30.00 calls purchased); and iii) an attempt to hold CHK (and other natural gas producers) hostage on hedge contract prices.

    Disclaimer:

    This column, Energy Commentary from Karl Miller, is the opinion of Karl Miller. Investors should seek the advice of a qualified investment professional prior to making any investment decisions.

  • Report this Comment On June 12, 2010, at 8:39 AM, Northern7 wrote:

    Which pension funds? Article speaks in generalities without giving examples.

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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