Illinois pension fund uses OTC derivatives to recoup returns, jeopardizes pensions

[one...two...tree 2,762]

by Alexandra Harris

Dale Rosenthal, a former strategist for Long Term Capital Management, the hedge fund known for its epic collapse in 1998, and a proprietary trader for Morgan Stanley, has seen his share of financial complexities. But when shown a seven-page list of derivatives positions held by the Illinois Teachers Retirement System as of March 31, obtained by Medill News Service through a Freedom of Information Act request, the University of Illinois-Chicago assistant professor of finance expressed disbelief."If you were to have faxed me this balance sheet and asked me to guess who it belonged to, I would have guessed, Citadel, Magnetar or even a proprietary trading desk at a bank," Rosenthal said.

The fact that the sheet doesn't belong to one of those high-flying hedge funds, but to the $33.72 billion pension fund that serves more than 355,000 full-time, part-time and substitute public school teachers and administrators working outside the city of Chicago, is perplexing to those interviewed for this story.

How bad is it? After losing $4.4 billion on investments in fiscal year 2009, and 5 percent on investments in fiscal 2008, the teachers' pension is now underfunded by $44.5 billion, or 60.9 percent, according to the Commission on Government Forecasting and Accountability's March 2010 report. By comparison, only 20.3 percent of the Chicago Teachers' Pension Fund is unfunded.

For the quarter ended March 31, according to derivatives experts who studied TRS' financial documents, the fund lost some $515 million on its derivatives portfolio. Since then, the fund's derivatives positions have likely soured further, the experts said, due to worsening financial conditions in Europe.

Frank Partnoy, a law and finance professor at the University of San Diego who worked on Wall Street as a derivatives structurer in the mid-1990s, said TRS's portfolio is an indication that investing is not about what is smart but what will generate the highest returns.

"It's an epic illustration of how we've really gotten lost in financial complexities," he said, after studying the Illinois Auditor General's 2009 audit of TRS and the fund's March 31 derivatives positions.

more....

[Mr. Big Dog 10,747]

IL is not alone - FL is doing the same thing.

[one...two...tree 2,762]

IL is not alone - FL is doing the same thing.

Brooksley Born warns that we are going to have many more financial crisis in the future until we learn from our mistakes and close the gap on regulations.

Edited October 18, 2010 by El Buscador

[scandal 951]

Very good article, Steve.

I thought that perhaps the article was referring to positions that the pension plan had taken on before the CDS market imploded in 2008 but is unable to sell off now due to illiquidity. There were plenty of funds that invested < 2008 in supposedly safe AAA-rated CDO, or synthetic CDS as 'investment grade' products that had juiced returns. We all know now (and some warned then) that there is no such thing as risk-free but premium-reward: something had to be cooked, and indeed it was.

However, in reading the article in full, I see this is NOT the case: It's not just that they still hold positions acquired in 2006 that they are holding on their balance sheet. They are, apparently, continuing to take active speculative views on interest rate swaps in emerging markets. Reckless and foolhardy, and especially in the light of 2008 they should certainly know better. But, of course, we know who's liable when it blows up, don't we.

The bottom line, experts say, is that there is no language in the Illinois pension code that prohibits pension funds and retirement systems from buying or selling OTC derivatives as an investment method. In the event of catastrophic losses, lawsuits would be filed against the fiduciaries, but ultimately taxpayers would be left holding the bag.

[one...two...tree 2,762]

Reckless and foolhardy, and especially in the light of 2008 they should certainly know better. But, of course, we know who's liable when it blows up, don't we.

Yep. There's got to be a story behind this story, as to who is making these decisions and why. I'm wondering if it's the ol' fox guarding the hen house routine?

[Wayne and Claudia 40]

Why should any of these union funds worry about how risky things are? They can lose everything (which means someone is going to score large) and then go crying to Washington for a bailout.

[one...two...tree 2,762]

Why should any of these union funds worry about how risky things are? They can lose everything (which means someone is going to score large) and then go crying to Washington for a bailout.

Yeah, who got the bailout money when Lehman Bros. and Goldman Sachs had accumulated billions in toxic assets? It was your laissez-faire buddies on Wall Street that got us into this mess in the first place. When you have Alan Greenspan, the true disciple of Ayn Rand and her free market ideology, admitting that he was in error in believing that the market could regulate itself, you'd think the rest of the free market fanatics would listen....but instead, they threw him under the bus. We're going to see more of these financial crisis until all you free market fanatics accept that regulations are necessary to protect our economy and our national interests.

[Wayne and Claudia 40]

Yeah, who got the bailout money when Lehman Bros. and Goldman Sachs had accumulated billions in toxic assets? It was your laissez-faire buddies on Wall Street that got us into this mess in the first place. When you have Alan Greenspan, the true disciple of Ayn Rand and her free market ideology, admitting that he was in error in believing that the market could regulate itself, you'd think the rest of the free market fanatics would listen....but instead, they threw him under the bus. We're going to see more of these financial crisis until all you free market fanatics accept that regulations are necessary to protect our economy and our national interests.

Capitalism...it's great.

[scandal 951]

Yeah, who got the bailout money when Lehman Bros. and Goldman Sachs had accumulated billions in toxic assets? It was your laissez-faire buddies on Wall Street that got us into this mess in the first place. When you have Alan Greenspan, the true disciple of Ayn Rand and her free market ideology, admitting that he was in error in believing that the market could regulate itself, you'd think the rest of the free market fanatics would listen....but instead, they threw him under the bus. We're going to see more of these financial crisis until all you free market fanatics accept that regulations are necessary to protect our economy and our national interests.

Steve, we'll see more financial crises in the future because it's in the way of the world for economies to have boom and bust cycles. There have been breathtaking market rises and collapses from the South Sea Bubble to Tulip mania to the 19th century railroads and canals to the 1907 crash and the 1929 crash and the dotcom crash. 2008 will surely join that list, and it won't be the last one on the list. In a decade or two, some new asset class will be "discovered", some new reason postulated for why "this time it's different" and the market can rise inexorably without fail, taxi drivers and hairdressers will be gossiping about the killing they're making in the market and..... it will collapse. Because it always inevitably does when the last buyers are in and there's no one left to buy. That's when the selling must begin and does begin. That's the closest thing to a sure bet that there is.

Also, I question your use of the term "fanatics" as in "free market fanatics". Like most Americans, I believe in the power of the free market as the best way to raise our standards of living. I also believe that we need regulation to ensure balance and a level playing field. There's nothing "fanatic" about that. Capitalism and enlightened regulation are not irreconcilable, despite what the extreme left or right will have you believe.

[one...two...tree 2,762]

Steve, we'll see more financial crises in the future because it's in the way of the world for economies to have boom and bust cycles. There have been breathtaking market rises and collapses from the South Sea Bubble to Tulip mania to the 19th century railroads and canals to the 1907 crash and the 1929 crash and the dotcom crash. 2008 will surely join that list, and it won't be the last one on the list. In a decade or two, some new asset class will be "discovered", some new reason postulated for why "this time it's different" and the market can rise inexorably without fail, taxi drivers and hairdressers will be gossiping about the killing they're making in the market and..... it will collapse. Because it always inevitably does when the last buyers are in and there's no one left to buy. That's when the selling must begin and does begin. That's the closest thing to a sure bet that there is.

Also, I question your use of the term "fanatics" as in "free market fanatics". Like most Americans, I believe in the power of the free market as the best way to raise our standards of living. I also believe that we need regulation to ensure balance and a level playing field. There's nothing "fanatic" about that. Capitalism and enlightened regulation are not irreconcilable, despite what the extreme left or right will have you believe.

What I meant by free market fanatics - the ones who believe that regulations are by default, bad or harmful to the market. I won't even pretend to fully understand all these exotic financial schemes, but I believe that Brooksley Born is a very intelligent person and quite capable of understanding the dangers from the gap in regulations from OTC derivatives. She was right over decade ago and she is right about it now. Even Greenspan, Summers and Geitner have now become believers in regulating these markets.

As for the boom and bust of cycles, people like Elizabeth Warren believe that they don't have to be as catastrophic as they have become, with the right amount of regulations. She sites the nullification of the Glass-Steagall by the Gramm-Leach-Bliley Act as one of the key components that allowed the most recent financial crisis to put us into a deep Recession.

[Ban Hammer 13,355]

We're going to see more of these financial crisis until all you free market fanatics accept that regulations are necessary to protect our economy and our national interests.

i smell a government program lurking around here.

[one...two...tree 2,762]

i smell a government program lurking around here.

Nah, that's just your flatulence. Wall Street all but owns Washington now thanks to the Supreme Court.

[Ban Hammer 13,355]

Nah, that's just your flatulence. Wall Street all but owns Washington now thanks to the Supreme Court.

[one...two...tree 2,762]

Eat yogurt or take some probiotics....before you kill us all.

[Ban Hammer 13,355]

Eat yogurt or take some probiotics....before you kill us all.

why do you think i'm so against cap and trade?