Mar 31, 2010

ABP Pension Fund ROI Travesty

What is a 'good' return on investment?

Dutch Pension Fund ABP, the industry-wide pension fund for employers and employees ( 2.8 million participants) in government and educational institutions in the Netherlands and the world’s third largest pension fund, reported a 20.2% return on investment in 2009.

In the 2nd half 2009 Press Release, ABP qualifies it's own performance as a 'Good Rate of Return'.
Now theologists as well as actuaries are familiar with the risk of calling something 'Good' ....

ABP ROI Stress Test
Let's put the ABP investment strategy to the test.

In the same Press Release,  ABP publishes the long-term rate of return from 1993 to 2009. ABP's average annual rate of return over this period of 17 years is 6.7%.

ABP's 'Signs of Hope Strategy'
To achieve this phenomenal return, ABP has developed a spectacular - every three years changing - Investment Strategy Plan (latest plan is confidently called: 'Signs of Hope') with a strong diversified 'winning' (?)  investment mix in combination with zero transparency or accountability information with regard to 'investment costs'.

Alternative T-Bond Strategy
Alternatively, ABP would have been better of if it would have applied a no-risky defensive European (10 years) Treasury Bond Strategy from the start. In this case the yearly average 1993-2009 ROI would have been around 6.9%.

Take a look at the next chart and decide for yourself. What pension fund would you prefer, Red or Blue?

ABP stated in their objectives that, in order to keep pensions affordable in the future, the return on investments must attain an average of 7% per year. It's clear that this objective will never be met on basis of the developed investment strategies in the past.

ABP's Future perspective?
Let's 'hope' that, after the recent step down of Ed Nijpels, ABP's new to be appointed chairman will have enough power, (pension) experience and time available to resist and combat the opportunistic and risky plans of the headstrong APG investment specialists.
Anyhow, the new chairman should be at least someone who knows how to spell the word 'Risk Management' and is experienced in (ac)counting from 1 to 10.... maybe an actuary?

Perhaps the best thing to do is to:
  • turn the ABP scheme into a "pay as you go system",
  • transfer the ABP administration to the efficient Dutch Social Insurance Bank,
  • fire most of the ABP Asset Management Department (APG) (as they are confused about time and cannot tell the difference between Tomorrow and Today anyway) and finally,
  • use the € 208 billion on assets to reduce most of the Dutch National Debt ( € 375 billion)

Good Luck ABP!

- Top 10 largest pension funds in the world
- ABP Press release 2nd half 2009
- APG: Tomorrow is Today 
- Joshua Maggid: Excel ABP (.xls) 

Mar 29, 2010

Actuarial Smurf

Question is whether actuaries are best positioned for the role of Chief Risk Officer (CRO)....

More and more the CRO becomes one of the most important positions at board level to analyze, control and optimize risks in (financial) institutions. Qualified actuaries are pre-eminently positioned to qualify as CRO. After all, managing risk has been their primary task for decades. Rolling out the new Chartered Enterprise Risk Analyst (CERA) credential, actuaries will get better trained and educated than ever before.

CRO Role at Risk
Despite of all this, the CRO role is 'at risk' itself. CRO responsibilities and position are by definition conflicting with certain other stakeholder roles.

This is clearly demonstrated in a graph developed by Professor Emeritus Harry Panjer(Actuarial Science University of Waterloo).

Let's take a look at the slightly adapted graph of Harry Panjer:

  • Regulator
    Regulators’ primary responsibility is to protect customers. Thus avoiding downside risk is their focus.
  • Rating agencies
    Rating agencies focus on both the possibility of large losses as well as the possible gains to shareholders.
  • Investors
    Investors are interested in both gains and losses and are willing to take the risk of the loss of capital as long as there is compensatory opportunity for gains.
  • CEO
    The CEO with big stock options, has huge upside potential but little downside risk. Getting fired is one of the embedded options of the CEO's personal strategy.
  • CFO
    The CFO's first responsibility is to stay 'in control'. The CFO will try to prevent excessive unforeseeable or unexplainable results, whether down- or upward.
  • Clients
    Clients are primarily interested in value for money, service, quality and the continuity of the (financial) institution. Clients will keep satisfied as long as the financial results of the company remain stable and (average) positive within limits.
  • CRO
    The CRO is trying to control the downside risk. The CRO is a kind of 'Risk Management Smurf' who only has a big STOP sign to limit the CEO and shareholders in their (short term return) demands. 

It's clear, acting as a CRO is like:
  • Walking on eggshells
  • Communicating with a silver tongue
  • Listening like a fly on the wall
  • Looking like a policeman
  • Convincing like a missionary
  • Calculating like an actuary

Don't wait any longer, become a professional Actuarial Smurf!

- Panjer: ERM and the Role of Actuaries (2009,pdf)

Mar 23, 2010

Return of a U.S. Debt Dollar

Take a (compressed) look at what author and business owner Nathan Martin calls:

This chart, based on the latest (March 11, 2010) U.S. Treasury Z1 Flow of Funds report, shows the change in GDP divided by the change in Debt. Or in other words: it illustrates how much extra economic productivity is gained by pumping one extra dollar of debt into our debt backed money system.

As is clear, the economic return of one dollar of 'debt infusion' declined from a positive $ 0.70 in the sixties to a negative $ 0.45 return by the end of 2009!

From a macroeconomic point of view the U.S. economy is fully saturated with debt. Flushing more debt in the U.S. economy will no longer help the economy out. Moreover, it will damage the economic growth!

Interested? Read the full blog of Nathan A. Martin

- Source: The Most Important Chart of the Century!
- U.S. Treasury Z1 Flow of Funds report (March 11, 2010)

Mar 21, 2010

Country Default Probability

National debts are growing worldwide. It seems we're drowning in a sea of debt. Who's gonna survive?

By experience we know that whenever our gut-feeling takes us for a ride, help of statistical models is necessary to rebalance and get sight at the real problem.

Sovereign Risk Monitor
In this case of 'national debt', the help of CMA's Sovereign Risk Monitor comes in. The CMA Sovereign Risk Monitor identifies and ranks the world’s most volatile sovereign debt issuers according to percentage changes in their 5 year CDS. CMA also calculates the Cumulative Probability of Default (CPD), the 5 year probability of a country being unable to honour its debt obligations.

Let's take a look at the world's most risky countries in Q4 2009:

Yet, the 'Default Landscape' is rapidly changing as becomes clear in CMA's interesting daily 19 March 2010 report showing Greece 'Cumulative Probability of Default' rising to 24.27%.

On the other hand we've got the world's best Countries, with Norway on top....

More actual information is available at CMA (registration required).

Let's hope for the best....

- CMA Sovereign Risk Report for Q4 2009
- Source: CMA
- Latest CMA Update

Mar 14, 2010

Hedge Fun

Do you recognize the next situation?

You're at a birthday party or having a social evening. Everybody is having fun, talking to each other and - like usual - discussing the latest financial topics, scandals and solutions.

Suddenly someone turns to you and says: Heee.. you're an actuary, you can tell us what a a hedge fund is!

Of course as born or raised actuaries we all know what a hedge fund is. But when it comes down to explaining what a hedge fund is to clients, board members, friends or family, probably not one of us can explain it better than Paddy Hirsch, Senior Editor at Marketplace, can in the next Youtube video:

Now, when a Hedge Fund or a (Lehman)bank 'unexpectedly' gets into trouble, it simply uses the Repo 105 technique to to survive. Paddy Hirsch explains again.....

As professional risk managers we would expect these high risk Hedge Funds to operate under excessively severe capital requirements. Too bad...., this is not the case, as Mr. Timothy Geithner explains in the next video......

From Mr. Geithner's statements it's clear that Hedge Funds are de facto treated as 'Hedge Fun' until the systemic risk shows up.

However, when this risk becomes manifest, it will be to late to take appropriate measures.

Misunderstanding: Risk management
One of the great public misunderstandings of Risk Management is that most people - obviously including Government -think that Risk management is all about 'Managing Damage' after the corresponding loss has occurred.

As we know, Risk Management is about something else:

I. Identify, Analize & Prevent Risk
About 70% of Risk Management is about constantly identifying, analyzing and preventing risks from happening.

II. Emergency Response Plan
Another 20% is about proactively creating and updating Emergency Response Plans (ERP's) on how to deal with loss and how to limit and reduce that loss in case of the unfortunate event that a risk materializes in a loss.

III. Damage Reduction
Only the last 10% is about 'damage reduction' by executing the ERP's and tackling losses in case a risk - notwithstanding the measures taken - has resulted in a loss.

Perhaps we should offer (one volunteer is worth two pressed men) Mr. Geither a free Risk Management Course from the institute of actuaries.....

Read more about (the regulation of) Hegde Funds in an excellent (2006) paper by Dale A. Oesterle called Regulating Hedge Funds.

It's clear: there's nothing funny about fundy hedge funds....

Corresponding Links:
- Derivatives study center : Hedge Fund
- Regulating Hedge Funds (2006)
- Marketplace videos
- Will Lehman Brothers and Repo 105 allegations bring down Ernst & Young?
- Wikipedia: Repurchase agreement, Repo 105

Mar 13, 2010

Magic Banking

Based on an idea as presented in a joshing blog by Henry Blodge, CEO of The Business Insider, here's the slightly changed formula for making thousands of investors happy, becoming a millionaire within months while having a successful career as well.

Become a banker!
All it takes, is to start a new bank. Don't worry, it's simple as will be shown.

This is how it works:
  1. Form a cooperative bank called: Cooperative Magic Bank (CMB).
    A cooperative bank is a financial entity which belongs to its members, who are at the same time the owners (shareholders) and the customers of their bank.
  2. Appoint yourself CFO together with two of your best friends as Board members. Set your yearly Board Bonus at a modest 10% of CMB's profits.
  3. Make a business plan (this blog IS the business plan)
  4. Raise $ 100 million of equity and $ 900 million of deposits, as follows
    • Offer your prospects/clients a guaranteed 4.57% guaranteed return on investment.
    • Offer a 70% yearly profit share. First year return on investment guaranteed 13,35% !
    • Everybody who wants to join the bank becomes a 'Lucky-Customer-Owner' (LCO)
    • Every LCO is obliged to invest 10% of his investment as shareholder capital.
    • The other 90% is invested in the CMB-Investment Fund (CMBIF).
    • CBMIF guarantees the return (and value) on the LCO's account based on a 30 year Treasury Bond
  5. Borrow $3 billion from the Fed at an annual cost (Federal Discount Rate) of x=0.75%.
  6. Buy $4 billion of 30-year Treasury Bonds paying y=4.57%
  7. Ready! Sit back and enjoy high client satisfaction and your Risk Free career and bonuses as a professional banker!

Magic Banking
Wrapped up in a 'Opening Balance Sheet and a first year ''Income Statement', this is how it looks like:

This is how the FED helps you to become a millionaire. but the party is not yet over.....

Pension Funds and Insurance Companies
If your the owner of a pension fund or an insurance company, starting a 'Magic Bank' could help you achieve a total 'risk free' return of 4,57% with an upward potential of 13,35% as well.

So why should you set up a complex investment model that you don't really see through, to achieve a risky 6% or 8% of return on investment, if you can have more than a 'high school comprehensible' 10% return without any substantial downside risk by starting a Magic Bank instead?

Together with the new Basel and Solvency regulation, this 'magic bank principle' will cause banks to sell their investments in more risky assets like insurance companies. On the other hand, insurance companies and pension funds will probably be interested in starting new banks to profit from the FED's 'free credit lunch'.

Criticasters and Risk
Some criticasters will rightfully point out that the magic bank is not completely risk free. Indeed there are some risks (e.g. the treasury bond volatility), but they can be adequately (low cost) managed by means of stripping or derivatives (e.g. swaptions).

Of course there's also the risk that the Fed will raise the short rates (Federal Discount Rate).In this case, instead of using derivatives upfront, one might simply swap or (temporarily) pay off the FED loan. Yes, your return will temporarily shrink to a somewhat lower level. But who cares?

Moreover, keep in mind that as long as we're in this crisis, the Fed's short money will be cheap. Don't ask why, just profit! By the time the crisis is over and Federal discount rates are more in line again with treasury notes, simply change your strategy again.

And if - regrettably - the federal discount rate and the treasury bond rate rise at the same time, simply book a life time trip to a save sunny island to enjoy your 'early pension' of $ 11.1 million (ore more).

For those of you who still doubt and for all of you who like a humorous crash course in investment banking, just click on the next video by Bird & Fortune....

Let's get serious
Although for us actuaries it's clear that because of the Asset Liability Mismatch, the magical bank is a running gag, the principles and consequences of the situation as described above are bad for the economy.

Financial Health Management
Banks and financial institutions in general are discouraged to act in their primary role as risk transfer institutes by performing on bases of professional calculated risk.

Why would they take any additional (credit) risk if they can generate their revenues almost 'risk free' with help of the Fed?

We all know that without risk, there's no economic added value either. Continuing this Fed policy will lead to Bob hopes:

A bank is a place that will lend you money, if you can prove that you don't need it.

Maintaining the current Fed policy keeps the banks alive, but ill.

What's needed is a new Federal Financial Health policy.

Over the last decades the relative equity (equity in % of assets) of Banks deteriorated from a 20% level to a 3-5% level in this last decade.

Banks need to be stimulated to take appropriate healthy risks again, while maintaining a sound individual calculated 'equity to assets ratio', increased with an all over (additional) 5% risk margin.

The Fed should therefore act decisively and:
  • stop the ridicule and seducing leverage risk levels
    Redefine the Capital Adequacy Ratio (CAR). The new Basel III leverage, calculated as 'total adjusted assets divided by Tier 1 capital', won't do. Strip the nuances, limit 'adjusting', add a surplus.
  • Limit and make all new financial products subject to (Fed) approval
  • Limit the proportion of participating in products that only spread risk (e.g. Citi's CLX) instead of neutralizing or matching risk
  • Raise the discount rate as fast as possible,

to prevent moral hazard and economical laziness that eventually undoubtedly ends in a global economic melt down.

However, there's one small problem..... The FED has to keep the discount rate low because otherwise financial institutions that run into trouble aren't able to finance their loss in a cheap way and will activate the nuclear systemic risk bomb (chain reaction).

It seems we're totally stuck in a governmental financial policy paradox. Nevertheless the FED should act now!

- Henry Blodge Video on Modern marketing...
- 30 year treasury bonds
- Historical Federal discount rates
- Can Basel III Work?
- The Economist: Base Camp Basel (2010)
- Citi's Financial Crisis Derivatives Should Be Banished From Earth
- Capital Adequacy Ratio (CAR)
- Treasury yields

Mar 6, 2010

OTC Warning

In a 55 minute Pbs-video it becomes clear what kind of serious derivatives (OTC) problems we still have.

Watching this video will dramatically change your view on risks and players in the financial system. If you want to protect yourself on the short term against the effects of what is going on in the skyscrapers of the financial markets: don't watch this video! Don't blame yourself, because it's not 'just funny' to become aware of risks you can't handle anyway....

However, if you are professionally active in investment risk or if you're a member of a (pension fund) Investment Committee, hiding is no option and this video is a good investment and a 'must see'......

Enjoy, shiver, learn.....

If you like big numbers, please look for 15 seconds at the size of the 'Over The Counter' (OTC) Market (Q2 2009):

(are you still with me?)

There's a dutch proverb that states:

a warned person counts for two.....

- OTC derivatives statistics
- Financial crisis explained