Have the last few months of negative headlines scared you yet? If not, don’t be too complacent. According to a recent survey conducted by Greenwich Associates, institutional investors have grown weary of structured financial products and fixed income securities. According to a summary provided by CFO.com writer Stephen Taub, a worldwide credit crisis "has caused a nearly complete disruption in the trading and use of many fixed-income products." Even trading in ordinarily liquid corporate bond markets has reportedly been difficult, leaving many scratching their heads as to whether the credit crisis is a short-term blip or a long-lived problem. Taub adds that the survey predates the Fed’s recent rate cut. (Click here to read "Liquidity Crunch: How Long Will it Last?")
In his September 20, 2007 testimony before the House Committe on Financial Services, U.S. Treasury Secretary Henry Paulson describes the "interconnectedness" of global capital markets and the fallout from concerns over sub-prime mortgages – reduced investor confidence, reassessment of risk, and temporary diminution of liquidity. Describing self-correction tendencies of financial markets, Paulson’s more sanguine take can be accessed by clicking here.
After a recent bridge game, I had a chance to ask my friend, Dr. Lucjan Orlowski, for his view of the world around us. As Senior Fellow at the Center for European Integration Studies (ZEI) at the University of Bonn; a Senior Fellow at the Center for Economic and Social Research (CASE) in Warsaw; a Research Fellow at the William Davidson Institute (WDI) at the University of Michigan School of Business, and a Research Professor at the German Institute for Economic Research (DIW) in Berlin, Orlowski’s opinion counts in more ways than one. His prognosis? Not very good – In fact, he was downright gloomy with respect to jobs growth and continued ill-effects of this summer’s incorrect pricing of default risk. Click here to read Lucjan’s impressive bio.
So what does all of this mean for pension funds? Let us count the ways.
1. Diminished liquidity could imperil a plan’s ability to meet its short-term obligations. This is especially serious for mature plans or in situations where labor contracts offer few opportunties to revise cash outflows. How should strategic asset allocations change to reflect a sustained credit crunch (if you accept that premise)?
2. Fewer companies are making their way to capital markets. Will a reduction in fixed income security issuance and/or a widening bid-ask spread make it more difficult for pensions to execute any type of liability-driven investing tactic that involves bonds or bond derivatives?
3. Will a weakening U.S. dollar, likely to experience even more downward pressure as oil producers switch to Euro invoicing, compel plans to seek out international assets? Will plan sponsors need to ask external asset managers more questions about risk controls, notably currency hedging techniques, as a result?
4. Could lower U.S. interest rates push some plans over the edge in terms of funding status and inevitable financial consequences?
5. Will changing correlation patterns, and the related reduction of diversification potential, leave defined benefit plan sponsors in a position of having to take on more risk? In the event that FASB requires additional pension investment risk disclosure, will corporate plan sponsors begin to feel pressure from shareholders as market volatility is more explicitly embedded in financial statements?
These are but a few possibilities for those who see the glass half empty and draining fast.