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Monday, August 16, 2010

Bethlehem City Pension Investing in Hedge Funds

Bethlehem Business Administrator Dennis Reichard is currently exploring the idea of buying out some long-time employees. Based on an independent audit showing that the City finished last year $8.5 million in the red, he might want to start with himself. Among many other problems, Bethlehem actually missed its annual $2 million pension contribution last year. A few years before that, Mayor John Callahan had to borrow $34.6 million to make up a shortfall in the police and fire pensions. Now, it appears that City pensions are investing in hedge funds, and enough to bother the City's independent auditor. Let me fill you in.

$34.6 Million Needed to Replenish Pension Fund

Between 2000 and 2002, a combination of bad investments and unforgiving stock market led to a $20 million loss in the Christmas City's fire and police pensions. Ho. Ho. Ho. In 2004, the State ordered Mayor John Callahan to come up with $34.6 million, enough to cover both the loss as well as the amount the City should have earned over those two years.

Conocrd Public Finance, now a faithful Callahan campaign contributor, was only too happy to propose one of those painless bonds. You know, the kind where you make no payments at all the first year. They added this "will not have a negative impact on the City’s credit rating."

Council member Jay Leeson had no interest in the Municipal Novocaine being offered by Callahan's Financial Dentists, but was instead concerned this was probably the worst fiscal crisis in Bethlehem's history. "[T]he origin of the City’s crisis dates really back to a pattern of borrowing from Peter to pay Paul, and draining the surplus funds from municipal authorities, such as the Bethlehem Authority, the Housing Authority, the Parking Authority.”

As we've since learned, things could and would actually get worse.

Leeson argued the only way out of this crisis was Municipal Root Canal, a tax hike. "You don’t borrow money and then invest it in the stock market unless you can afford to lose it. But that is essentially what we are doing is borrowing money to put it in the equity markets. That assumes we can afford to lose it. We cannot afford to lose it, given the circumstances that the City is in. We cannot afford to assume that risk."

This was unthinkable to Mayor John Callahan, who insisted (in 2004) that the City had turned the corner economically, that Leeson is just painting "doomsday scenarios" while he "rolls up his sleeves" a lot and presents "creative solutions." People like Leeson are just "irresponsible."

Callahan's pain-free bond was approved, after which the City's credit score was reduced by S&P. Subsequent years proved Leeson was, if anything, too optimistic.

City Misses $2 Million Pension Payment.

Last year, the Callahan administration demonstrated its creativity and responsibility by missing its annual pension payment, set at $2,047,975. It finally caught up in April, thanks to the casino. Bethlehem was required to pay $139,198 more than if it had paid on time, but the City denies this is any form of late fee or interest penalty. It probably would be irresponsible for me to make that suggestion. City administrators assure Council President Bob Donchez it will never, ever, ever, ever, ever, ever, not ever ... ever happen again. Ever.

I'm sure this will have no impact on the City's next S&P rating.

Despite $20 Million Loss and Missed $2 Million Payment, City Pension Invests in Hedge Funds

At last week's Finance Committee meeting, City Council President Bob Donchez was understandably concerned when auditor Tracey Rash mentioned "unusual investments" in the City pension fund. (You can see their exchange here).

Donchez: "This pension investment. Is this something that you're concerned about? Because if we go back to 2006 ... 2005, we took a bond out for the pension, to fund it. Is this a very high risk or am I completely wrong?"

Rash's answer? "I can't address the risk associated with the investment. What I can say is that it caught my eye because it wasn't a typical investment in a pension fund. ... It was enough to make me look at the pension investment law and make sure you were in compliance with the law and make some inquiries to your Solicitor and Financial Advisor."

Translation. "Are you folks out of your frickin' minds? After borrowing $34.6 million and then missing a pension payment completely, why the hell are you investing in something this stupid?"

The two investments that caught Rash's eye are in Graham Global Investment Fund & Green & Partners, LP. A google search quickly revealed that these are hedge funds.

What Exactly Are Hedge Funds?

According to a Securities and Exchange Commission (SEC) staff report, a Hedge Fund is "an entity that holds a pool of securities and perhaps other assets, whose interests are not sold in a registered public offering and which is not registered as an investment company." It's a $2 trillion industry where managers are not required to report how much money they oversee or how much money they make or lose each month. As explained in an University of Maryland article, hedge funds are unregulated and exempt from SEC disclosure and registration. This enables them to earn much higher returns than your usual mutual fund, but they are more risky. "They are highly secretive investment vehicles." Wall Street reforms have had no impact on them, either.

New York City's three pension funds for police officers, firefighters and civil employees are considering investing in these loosely regulated hedge funds. According to a CFO at one of the Lehigh Valley's leading corporations, they do deliver positive returns, even in a down market. He considers them a legitimate option to diversify a large size pension fund. But this assumes the fund selected has a successful track record, something Bethlehem's pensions funds can't claim.

That University of Maryland article tells us 326 hedge funds went out of business in the first half of 2006. In May 2007, two Bear Stearns hedge funds lost approximately $1.6 billion of capital due to overexposure to bad mortgages. Likewise, the Swiss banking firm UBS AG shut down a hedge fund in May 2007 that lost more than $124 million from similar bad investments. In the UK, public and private pensions alike are wary of hedge funds because of their perceived risk, potential for big losses, and concerns about a lack of liquidity.

In the eyes of their detractors, hedge funds are little more than a Ponzi scheme. “There were accepted practices going on in the industry up until 2008 that in retrospect look like a problem. Funds were using the liquidity of incoming investors to pay out the established investors without testing the investments themselves. It was hard to see this until everyone hit the exit at once and everyone starting asking for their money back at the same time."

Given Bethlehem's troubling history with its pensions, it's no wonder that these investments bother Rash.

Why Don't Hedge Fund Investments Bother Mayor Callahan?

On his Congressional Facebook page, asks, "Where was Congressman Dent when Goldman Sachs sent up to $4.3 billion in taxpayer fund to overseas banks?" He's "glad that the Wall Street reform bill passed last night because it eliminates taxpayer funded bailouts and holds Wall Street CEOs accountable."

Does Callahan realize that money invested in hedge funds could easily go to offshore accounts? Has it dawned on him that there is no accountability at all?

35 comments:

Anonymous said...

You do realize that these practices started under Mayor Cunningham?

Anonymous said...

a hedge fund can be an appropriate part of a balanced pension portfolio. it all depends a) how much, and b) where is the rest of the fund invested,

Anonymous said...

Bernie,
While some of us needed more beauty sleep than others, Sam Bennett at 6:16 a.m. today was interviewed on Fox News.

Anonymous said...

anon 2:04

the smoke and mirrors has been going on for decades. the budgets and all of the projections are lies, have been for years. glad asleep at the wheel donchez is "concerned" WAKE UP

Bernie O'Hare said...

"a hedge fund can be an appropriate part of a balanced pension portfolio. it all depends a) how much, and b) where is the rest of the fund invested,"

I'd add that a public pension that has had its share of recent problems should think twice or three times before making this kind of investment.

Bernie O'Hare said...

"You do realize that these practices started under Mayor Cunningham?"

Hedge funds? You know not whereof you speak, as befits the 3 AM troll.

Anonymous said...

Callahan does not decide what investments to have the pension fund invest in. This is an unfair criticism. The City has experts who manage the pension.

I sure hope the City does take advice from O'hare...apparently his investment strategies don't work...I have seen the vehicle he drives

Bernie O'Hare said...

Actually, as a member of the pension board, he makes precisely thiskind of decision. Moreover, the lead auditor's questions should have set off all kinds of alarms he'd do well to heed. As for my own financial circumstances, you got me.

Anonymous said...

"Bethlehem City Pension Investing in Hedge Funds"

If true, why isn't this in the newspapers?

Anonymous said...

because neither paper is worth a damn and the mc is in callahan's pocket.

you can smell the corruption in the hallways at 10 e church

Bernie O'Hare said...

Actually, I had forgotten about this until an editor I know suggested I should try to find out what made these investments "unusual" to Stacey Rash, and enough to note in her audit.

Anonymous said...

Speaking of retirement, I am interested to know if Dent wants to privatize social security. in 2005 he managed to put out one of the best double-speak statements on the matter but nobody really knows what at it means.

Bernie O'Hare said...

This comment is a poorly disguised attempt to deflect attention away from Callahan's irresponsible handling of the City's pension funds. He borrows $34.6 MM, misses a payment completely, and now we learn he's investing in hedge funds. Do you have anything to say about that or are you going to try to change the subject?

Anonymous said...

And yet the city flourishes and the citizens are content. I guess this sort of attack works in the Slate Belt however.

Bernie O'Hare said...

A City that finishes the year with a 8.5 million negative fund balance is not flourishing. Especially when it's the second year in a row that the City finishes in the red. A City that keep a firetruck in the garage bc it cannot pay for it is not flourishing. It is actually endangering the public safety. A City that misses a $2 million pension contribution is not flourishing.

As for the citizens, theyve been miseld, and the ones I see at council meetings are by no means content.

Anonymous said...

9:01, it appears, is content to eat cake.

Bernie O'Hare said...

... and look down his elitist nose at people from the slate belt.

Anonymous said...

A City that keep a firetruck in the garage bc it cannot pay for it is not flourishing. It is actually endangering the public safety.

Mr. O'Hare,
Tragically, according to local reports, a week ago a little boy died in Philadelphia because the closet fire dept was placed on some type of temporary closure.

Anonymous said...

Bernie,
Are those two city officals responsible for this horrific financial report going to be fired?
Have you had a moment to speak with any city council members.

Anonymous said...

Maybe a financial executive will explain to us in simple terms what are hedge funds, derivatives,
and why each is dangerous.

Anonymous said...

Bernie
Did they pay the phone bill?
Good Grief!

mc-bethlehem-phone-outage-20100816

Bethlehem City Hall was partially without phone service Monday morning, and the phone company was working to fix the problem.

Bethlehem officials said emergency numbers remained in operation. Verizon hoped full service would be restored soon, according to a news release.

Anonymous said...

Whether you agree or disagree, I see two (2) interesting angles here:

1. This blog is generating highly competent and relevent investigative research, that doesn't cost .75 and isn't filled with advertisements.

2. Those who disagree are not presenting plausible expalantions, instead they are lobbing anonymous personal attacks at the writer.

Nice work

Anonymous said...

So BOH makes it perfectly clear he knows very little about investing and hedge funds. Yes, there are hedge funds that take on more risk, just as there are mutual funds that take on more risk. But there are many hedge funds and hedge fund strategies that are extremely conservative in nature.

Global Macro, for example, is a space in the hedge fund world in which a manager can go any where and invest in any asset class, including currencies, futures contracts, stocks on any global exchange, bonds from any entity, and precious metals. They also can go short the market(s). So, if the "market" is going south like it did in 2008, these managers have the ability to hedge their long positions with other asset classes and short positions. Some of the smartest minds invest in this style including Julian Robertson, Seth Klarman, John Paulson, and George Soros.

Other areas like a long/short fund or market neutral fund will have both long and short stock positions, while a merger arb. fund will be investing in the mergers and acquisitions area. The point is, to just say "oh my G@d, they invested in hedge funds, that is just horrible," shows your lack of understanding. There is no single definition of what a hedge fund is.

If you go to the website for Graham Capital it appears that they are what is referred to as a fund-of-funds. This means that they invest an investors money across anywhere from 15-50 different funds and strategies. Kinda like the fund of fund mutual funds you can get in your typical 401k plan today, but the investments are in hedge funds, not mutual funds.

You also state that because hedge funds are not registered they are secretive and, thus, are riskier. This is just not true. Just as a mutual fund needs to disclose what they hold at the end of each fiscal quarter, so do hedge funds (long positions only). Reality is that if you own an actively managed mutual fund you truly have no idea what is owned at any given time.

Finally, by adding alternative investments - hedge funds, private equity, commodities - to a traditional stock and bond portfolio, you actually lower the risk (read: variability of returns) of that portfolio.

Could the investment committee picked a bad fund? Sure. But they could have picked a bad long only stock fund as well.

Bottom line, Bernie, is that your very simplistic analysis - hedge funds bad - is lacking. How did the pension funds do compared to a 60/40 stock/bond split? How did the fund do compared to other, similar pension funds? Maybe you should dig a little deeper and get an understanding before you just start shooting from the hip.

- Someone With an Understanding

Anonymous said...

So BOH makes it perfectly clear he knows very little about investing and hedge funds. Yes, there are hedge funds that take on more risk, just as there are mutual funds that take on more risk. But there are many hedge funds and hedge fund strategies that are extremely conservative in nature.

Global Macro, for example, is a space in the hedge fund world in which a manager can go any where and invest in any asset class, including currencies, futures contracts, stocks on any global exchange, bonds from any entity, and precious metals. They also can go short the market(s). So, if the "market" is going south like it did in 2008, these managers have the ability to hedge their long positions with other asset classes and short positions. Some of the smartest minds invest in this style including Julian Robertson, Seth Klarman, John Paulson, and George Soros.

Other areas like a long/short fund or market neutral fund will have both long and short stock positions, while a merger arb. fund will be investing in the mergers and acquisitions area. The point is, to just say "oh my G@d, they invested in hedge funds, that is just horrible," shows your lack of understanding. There is no single definition of what a hedge fund is.

If you go to the website for Graham Capital it appears that they are what is referred to as a fund-of-funds. This means that they invest an investors money across anywhere from 15-50 different funds and strategies. Kinda like the fund of fund mutual funds you can get in your typical 401k plan today, but the investments are in hedge funds, not mutual funds.

You also state that because hedge funds are not registered they are secretive and, thus, are riskier. This is just not true. Just as a mutual fund needs to disclose what they hold at the end of each fiscal quarter, so do hedge funds (long positions only). Reality is that if you own an actively managed mutual fund you truly have no idea what is owned at any given time.

Finally, by adding alternative investments - hedge funds, private equity, commodities - to a traditional stock and bond portfolio, you actually lower the risk (read: variability of returns) of that portfolio.

Could the investment committee picked a bad fund? Sure. But they could have picked a bad long only stock fund as well.

Bottom line, Bernie, is that your very simplistic analysis - hedge funds bad - is lacking. How did the pension funds do compared to a 60/40 stock/bond split? How did the fund do compared to other, similar pension funds? Maybe you should dig a little deeper and get an understanding before you just start shooting from the hip.

- Someone With an Understanding

Anonymous said...

Prudent man rules have been expanded to include hedge funds. The best example of this is a White House ordered study: Report of the Investors Committee to the President's Working Group on Financial Markets, January 15, 2009 "Principles and Best Practices for Hedge Fund Investors". Pension fund policeman in the Commonwealth is the State Auditor General. If hedge funds are not permitted, the Auditor General would have noted. The legislative act permits pension investments in real estate. So, how hedge funds would be problematic, I don't know.

Anonymous said...

Hedge Fund Risks:

Appetite for risk - hedge funds are more likely than other types of funds to take on underlying investments that carry high degrees of risk, such as high yield bonds, distressed securities, and collateralized debt obligations based on sub-prime mortgages.

Lack of transparency - hedge funds are private entities with few public disclosure requirements. It can therefore be difficult for an investor to assess trading strategies, diversification of the portfolio, and other factors relevant to an investment decision.

Lack of regulation - hedge fund managers are, in some jurisdictions, not subject to as much oversight from financial regulators as regulated funds, and therefore some may carry undisclosed structural risks.

Short volatility - certain hedge fund strategies involve writing out of the money call or put options. If these expire in the money the fund may make large losses.

Bernie O'Hare said...

Someone with an Understanding and Anon 2:52,

You're right, I'm certainly no expert when it comes to high finance. I know a litle about everything and a lot about nothing. But I think you have me confused with a fool, and I learned a lot more today from "others with an understanding."

First, although you try to hedge on this point, hedge funds are largely unregulated. They are highly secretive private offerings, as was noted in the University of Maryland account.

Second, I acknowledged that some hedge funds do add diversification. But that should only be tried with pension funds that have established themselves. Bethlehem missed last year's payment completely, and that speaks poorly both of the pension fund and the city's finances.

Third, and you failed to mention this, so let me point it out. Hedge fund managers usually charge on a 2-20 basis. They charge 2% of the investment upfront and then charge 20% of the profit earned.This gives them an incentive to roll the dice with pension funds and try to win big. If there's a big ptrofit, they walk awy rich. If not, it's not their money. If you're in the know, why did you fail to point that out? Mutual fund managers do not take a cut of the profit.

Fourth, although legal, only a handful of counties - four at most - have hedge funds in their pensions. Northampton County is among the vast majority of pension funds to reject the idea.

Anonymous said...

ANON 4:00PM

Those are risks involved with hedge funds in general, but, like any other investment (mutual funds included), one needs to do his/her due dilligence. Just like any other investment, you cannot invest in just any fund. And being short the market can lessen the risk (read: volatility) of a long-only portfolio.

Any seperately managed long-only account or mutual fund can still be extremely/overly aggressive. Bill Miller's Legg Mason Value Trust was down 60%+ in 2008 because he was buying shares of Countrywide, AIG, Fannie Mae, Bear Sterns, Citigroup, etc. all the way down.

Any good hedge fund manager can/will tell you their strategy. They will not tell you the specifics of what they are doing, nor should they. That is where they get their advantage.

Take a look at the returns of funds like Baupost (Seth Klarman), Tiger Asset Management (Julian Robertson), T2 Partners (Whitney Tilson & Glenn Tongue), Greenlight Capital (Davis Einhorn), etc. All of these funds made very good after fee returns for their clients between 2000 and 2009 while your Vanguard S&P 500 fund lost 2% per year.

Einhorn, by the way , is the fund manager who said that Lehman Brothers (LEH) was a broken company that was worth nothing. And he started saying that in 2006.

ANON 2:18

Bernie O'Hare said...

Somoeone with an understanding,

I disagree about the signifigance of the missed payment. If the pension fund were doing well, there would be no need for any contribtion at all. The pension wuld instead be financing the general fund.

I also disagree with your point about the practices of other counties. Those reflect the views of many others who are suspicious of these alternative investments.

To your point about diversification, I hace already stated that I could see some of that if the fund were large enough and its track record is good.

Today, I learned what percentage of the pension is made up of hedge funds. I also learned about one of the goofy investments. While you and I may disagree about the relative merits of hedge funds, I am sure you'll agree that Bethlehem has invested too much and in a ridiculous investment.

I am writing uo the post now, and will have it online around midnight. I'll be very interest how someone who does have an understanding feels after reading the specifics.

Bernie O'Hare said...

Anon 2:18, Like I just told Someone, please tune in tomorrow to see the %age of money invested in hedge funds and specifically the nature of that investment. Then tell me what you think.

Anonymous said...

I don't believe that one can address this issue in black and white terms. The White House paper stated the following elements of a HEDGE FUND INVESTMENT POLICY need to be considered

Fiduciaries considering hedge fund investments should develop explicit policies that define the
key features and objectives of the hedge fund investment program. At a minimum, these policies
should address the following considerations:
• What is the strategic purpose of investing in hedge funds? What role will hedge
funds play in the total investment portfolio?
• Is the hedge fund program consistent with the applicable investment beliefs,
objectives, and desired risk profile of the investment program?
• What are the performance and risk objectives of the hedge fund investment
program?
• Who will manage the hedge fund investment program and what responsibilities
will they have?
• What investment guidelines will apply to the range of funds and strategies that
can be utilized, the number of funds to be targeted, and the risk and return targets
for those funds?

If Bethlehem cannot answer those questions then the investment was wrong. The fact that other municipalities reject this type of investment may have more to do with the lack of investment sophistication within their staffs and less to do with the actual investment. That choice is perfectly alright. If you don't understand something, you should never take the risk.

Anon 2:52

Bernie O'Hare said...

I'll agree there is a lack of sophistication in just about all but the largest of municipalities. Clearly, the only reason is to have something that does not depend on the stock market. While that might be a laudable goal, it means nothing if the persons making decisions are themselves somewhat unsophisticated.

Tune in tomorrow and I suspect you'll agree Bethlehem's decision is folly.

Anonymous said...

So you loved Callahan as a Mayor and wished he would have not run against Dent. Bernie, do you still think Mr. Callahan is a great Mayor or has your opinion changed?

Bernie O'Hare said...

No. He should get a job in the private sector, selling hedge funds.

Anonymous said...

No, Callahan's next job should be a dealer at the Sands. He's used to throwing money away to gamblers.