Meltdown in the global financial markets has hit local government pension schemes hard. Not only are they all badly affected by the vicious fall in share prices, but some held direct investments in institutions and securities that collapsed in value.
Perhaps surprisingly, the failure of the giant US investment bank Lehman Brothers has brought some of the heaviest losses. Even before Lehman’s entered bankruptcy protection, two UK local government pension schemes had initiated legal action over sub-prime related losses.
The Lothian Pension Fund and the Northern Ireland Local Government Officers Superannuation Committee began class action lawsuits against Lehman Brothers in the US courts – probably uniquely. Both bought shares in Lehman Brothers, with the Northern Ireland pension fund buying nearly 200,000 shares between September 2006 and March this year. Lothian invested $11.5m (£6.23m) in Lehman shares, which it held between November 2007 and July this year – in which time they lost $3.4m (£1.84m) in value. The Northern Ireland is scheme is believed to have lost £8m – though no one was available at the fund to confirm this.
The law suits claim that Lehman failed to properly and fully disclose their exposure to collateralised debt obligations (CDOs) and other securities that collapsed in value as it became clear they were secured on sub-prime lending, much of which went into default. As a result, the pension funds argue, they could not have correctly understood the exposure they entered into through buying Lehman shares.
Geik Drever, head of investment and pensions at Lothian Pension Fund, says: “The basis of the case being developed by our lawyers is that Lehman Brothers concealed the true extent of the company’s exposure to sub-prime related assets and financial positions, and materially misled the investing public. Our lawyers will seek to prove that this was a policy approved and implemented by high ranking officers and directors. As lead plaintiff we represent all shareholders in the class and will try to maximise compensation for all of them, including all the stakeholders in Lothian.”
With the collapse of Lehman’s, the class action against the bank is ‘stayed’. But the funds are continuing to pursue company officers. “If the case is won, the settlement would be paid from the officers and directors insurance cover and / or the officers personally,” says Drever.
Other local government pension schemes in the UK have also been exposed to Lehman’s, including that of Northumberland County Council. A council spokesman says: “The Northumberland Pension Fund has an investment, valued at £7.3m, in the Lehman Crossroads Fund XVIII, a private equity investment. The county council is a limited partner in this arrangement, which is the normal situation for a private equity investment of this type. The funds allocated to this investment are a separate legal entity from Lehman Brothers Holdings Inc and, as such, they are not part of the bankruptcy filing. These funds are therefore safe. The county council continues to monitor the situation in respect of all its invested assets.”
As recently as June, according to minutes of the meeting, Northumberland’s then fund advisor Watson Wyatt was reassuring Northumberland that “there was nothing in the recent announcements to make Watson Wyatt revise its view of Lehman Brothers, but that the main concern in this situation is that the rumours may overtake the fundamentals”. Watson Wyatt is currently in the process of withdrawing from the market advising local government pension schemes. Paul Deane-Williams of the firm stressed that the collapse of the bank should not affect Northumberland’s holding. “It is not Lehman Brothers the bank, it is the asset management and that is quite an important point,” he said. “That is different from the bank. They are ring-fenced assets.”
But questions are also being asked about whether local government pension funds have damaged their own interests through their involvement in short-selling. Short-selling is the now widely criticised practice of ‘borrowing’ shares (for which the shareholder is paid a price) in order to sell them and later buy them back at what the short-seller hopes is a lower price. The practice is currently suspended in both the UK and the US in named financial institutions, amidst allegations that market rumours helped bring down prices and generate profits for the short-sellers.
It is believed that local government funds have participated by ‘lending’ shares to short-sellers – with the effect that the value of their own holdings in UK banks have fallen significantly. Ian Bailey of specialist local government pension fund advisors Hewitt Associates says: “I am sure some local government pension schemes will have been lending-out stock which some hedge funds have used for short-selling. But in normal market condititions, short-selling does not have much impact. I think a number of people will be reviewing this.” He urges caution, though. “If everyone stopped stock lending then it could have a very bad impact on market liquidity.”
But Bailey makes the point that things could easily have been worse for local government funds. Some of the biggest market losses have been recorded in the handling of swaps and other complex derivatives. Thanks to the court judgement some years ago which concluded that Hammersmith & Fulham council did not have the power to enter into swaps, local government pension funds have been wary about entering into swap agreements, so have been largely protected from these losses.
Where local government has lost most heavily – as have all pension funds – is in the collapse in the value of equities. According to John Hastings of fund advisors Hyman Robertson, UK local government funds will typically have about 65% in equities, of which half will be in UK equities. Banks will probably represent about 20% of those UK shares, and perhaps 12% to 14% of global equities.
That suggests that UK banks represent typically about 6.5% of a local government fund’s total value. With some bank shares losing half their value or much more – as with Halifax Bank of Scotland – funds may have lost 3% or more of their total value, just through the reduction in the share prices of banks.
And, as Hastings points out, even before the current crisis, share values were still around their values of a decade ago. With the latest falls, share valuations are substantially below those of the high water marks of 10 years ago. The FTSE 100 is currently hovering around the 5100 to 5200 mark, compared with 5900 at the end of 1998. Since then, funds have only benefited from dividends, not growth.
All of which emphasises the fact that pension funds have to take a very long-term perspective indeed – what Hastings calls the ’50 year view’. Trying to adapt to short-term problems can be a big mistake, he suggests. “There are always periods when the stock market has problems,” he explains. What councils should not do, he advises, is to make cut backs on services in order to increase contributions in reaction to a situation that may correct itself in years to come.
Bailey agrees. “This is a very scary time and there is a lot of uncertainty. These are unchartered waters.” But he adds: “It’s a long-term game.” Which means that councils should not rush into raising contributions – even though they may fairly soon have to think about doing so.
“Short term volatility does have an impact,” says Bailey. “What is different for local government [from many private sector schemes] is that contribution rates could have to go up. That would have to be met either by raising the council tax – which not all councils can do – and if they can’t then they have to cut services. And that is a real cost, because redundancies cost money. It is better to wait for a little while to see how things settle down before taking a decision on contribution rates. Some schemes will have to increase contributions. This isn’t going to go away in the next five minutes.”
Box – infrastructure
It seemed as if the rise of infrastructure funds was inexorable. Their growth in size and number was driven not just by the need for infrastructure, but also by the demand from pension funds for long-term, strong and reliable incomes that match pension funds’ liabilities. Infrastructure funds looked the perfect investment.
Local government pensions have found infrastructure investments particularly attractive and have been a core part of the diversification strategy of many, reducing their dependence on equities and property. Infrastructure funds typically invest in major transport projects, water companies, energy schemes and also in the provision of public sector infrastructure, through Private Finance Initiative and Public Private Partnership projects.
Leading infrastructure funds such as those of Innisfree and Barclays have invested heavily in a range of public sector projects, including schools, hospitals and primary health care facilities. One of the Barclays infrastructure funds – Bridges Ventures – is backed by the West Midlands and South Yorkshire local government pension funds and provides public sector infrastructure, including homes for key workers.
But there have been fears in recent weeks that infrastructure funds may be a bubble that is bursting. Concerns have focused in particular on two funds based in Australia, run by leading infrastructure fund specialists, the Macquarie Group and Babcock & Brown. Earlier this year, a report by consultants RiskMetrics suggested that infrastructure funds’ business model may no longer be viable.
However, what marks out those infrastructure funds that have hit trouble is that they are highly leveraged – they have borrowed several times over against the value of their assets. As borrowing costs rise and the availability of lending reduces, so the profitability and even the viability of such funds is undermined.
But John Hastings of Hyman Robertson is convinced that infrastructure funds’ that are conservatively managed and rely on equity investments rather than high levels of borrowing should be perfectly sustainable. Hastings believes that local government and other pension funds should, though, concentrate their investments on infrastructure funds that do not over-borrow. “It’s always a question of what you are buying – are you buying infrastructure, or are you buying leverage?,” argues Hastings.
In any case, says Hastings, even if the whole infrastructure fund hit crisis, it would not devastate local government pension funds. While they hold a reasonably large proportion of total infrastructure fund investments, this does not represent a large proportion of their pension funds’ total assets. The value of asset diversity is that there is no need to panic when one asset class hits problems.
Ultimately, the global crisis in financial markets may, in fact, spell excellent news for the infrastructure funds. With governments committed to bailing-out failing banks, their expenditure and liabilities are rising, just at the time when their tax income is falling. If they are to continue to provide public infrastructure they may see little alternative to actually increasing their reliance on infrastructure funds.
Swaps
A swap is a means of hedging risk. An example is an interest rate swap, where two parties might exchange parts of their fixed and floating interest rate exposure. In this way, both parties are partially protected from interest rate volatility. Swaps can also be based on the price of commodities – which may protect one party from price volatility, while increasing the exposure of the other party.
CDOs
CDOs are collateralised debt obligations. They are packages of debts that can be sold and resold as assets that are backed by securities. Some CDOs contain high levels of exposure to sub-prime mortgages and defaulting borrowers and were secured against properties that significantly declined in value.