CFA Society Chicago Book Club:

No Ordinary Disruption: The Four Global Forces Breaking All the Trends by Richard Dobbs, James Manyika, Jonathan Woetzel

No ordinary disruptionEverything can be measured, and what gets measured gets managed.” So reads the motto of one of the world’s most pre-eminent consultancies, McKinsey & Co. This month’s CFA Society Chicago Book Club Selection, No Ordinary Disruption: The Four Global Forces Breaking All of the Trends, is written by three men from McKinsey and they truly take this tagline to heart. The “four global forces” in the title include: urbanization, the challenges of changing demography, technological advance and acceleration, and growing interconnectedness of the global economy. Major news outlets have focused on these forces in some form or another for many years (or perhaps decades), but the main value that this book brings is its focus on anecdotes and “measurements.”

The first half of the book focuses on the forces themselves and where we find evidence of their existence. The center of global economic growth has been moving east for some time and many Chinese and Indians (among others) find themselves commanding a larger standard of living. Meanwhile, “The West” has been fraught with stagnation and labor’s replacement with capital in many industries due to technological advances. Furthermore, the demography of many developed nations has produced more retirees per working person. Each of these facets is well laid out with stories of real life examples in the development of smarter and less expensive robots, the crises affecting aging developed economies, and the rise of emerging markets.

The second half of the book begins to falter a bit with the prescription on what to do about the changes coming. Almost every single course of action recommended would be common in MBA programs or even undergraduate studies of business. Employers and companies are encouraged to adapt to this new environment we find ourselves on the brink of.  Which skills will be necessary aren’t named specifically, but the emphasis is really on the ability to change. This reflects the true challenge going forward in managing that which is measured.

Overall, the book provided for a great discussion on what the future will look like and how it affects the investment profession. Even though its prescriptions weren’t always insightful or groundbreaking, the idea of a different economy and investment environment can be both frightening and exciting. We will continue to watch these factors to see where they take us going forward.

 

Upcoming Schedule:

January 19, 2016: The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

February 16, 2016: TBD

March 15, 2016: Pension Finance: Putting the Risks and Costs of Defined Benefit Plans Back Under Your Control by Barton Waring

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

29TH ANNUAL DINNER

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Financial speakers don’t come with a higher profile than billionaire Mohamed El-Erian, whose resume lists a staggering body of achievement: Chair of President Obama’s Global Development Council, Chief Economic Advisor at Allianz, former Co-CIO and CEO at PIMCO and Bloomberg columnist and author.

As attendees milled around the large meeting hall of the Streeterville Sheraton, our annual Society dinner began with soft jazz in the background and steak and salmon slowly finding their way to tables. Experienced investment executives and new Charterholders alike shook hands and networked while dining, excited about the prospect of hearing from one of the preeminent minds in the investment world.

Kerry Jordan, CFA, current Chairman of the CFA Society Chicago, opened the proceedings with a video message from Paul Smith, President and CEO of the CFA Institute, who explained the genesis of the CFA Society Chicago to commemorate our 90th anniversary as an organization. This was no ordinary annual dinner; it was a milestone for our organization and an occasion to celebrate our past and look towards our future.DSC_2216

Each attendee also received a book published by the CFA Society Chicago titled “Celebrating 90 Years” to take home with them. The book, which the Society’s Communications Committee spent over a year preparing, shares biographies of our pioneers, financial news articles from years past and photographs of important places and people who helped shape our organization’s history. As Co-Chairman of the CFA Society Chicago Communications Committee, I’d like to extend my gratitude to everyone who worked on the history project and helped make it happen: many thanks to all of you who spent long weekends in various libraries researching and crafting this excellent book.

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New Charterholders being recognized at the 29th Annual Dinner

 

Kerry Jordan, CFA thanked Paul Smith for his remarks and switched gears to honor the four individuals marking their 50th year as Charterholders. The new class of 177 recently-minted Charterholders was also toasted, with Jordan reminding the audience just how difficult it is to pass all three exams and the massive amount of time and effort expended to earn a CFA Charter. Jordan reiterated the benefits and reach of the CFA Charter, stating that there are now local societies in 71 countries, with over 300 universities globally incorporating the CFA curriculum into their programs.

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Priscilla Perry – Hortense Friedman, CFA, Award for Excellence

The Hortense Friedman, CFA, Award for Excellence was presented to longtime Harris Bank analyst Priscilla Perry. Perry’s biography mentioned that she needed to pass all 3 exams, not just 2, as some Charterholders were given the CFA designation with only two passing exams earlier in the program.

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Priscilla Perry & CFA Chicago Past Chairmen

Jordan then discussed her own personal journey towards becoming Chairman of the CFA Society Chicago. She quipped, in reference to former Chair Heather Brilliant, who had been recently promoted to CEO of Australasia at Morningstar, that she liked the trend of recent CFA Chicago Chairs receiving a ‘Chief’ in front of their job title.

“We’re getting to you Mohamed, just a couple more things,” Jordan said to laughs in the audience as she listed off the event sponsors and graciously thanked them for their kind support.

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Left to Right: Chris Vincent, CFA, Kerry Jordan, CFA, Mohamed El-Erian

Immediate past Chairman Christopher Vincent, CFA was asked to introduce Mohamed El-Erian. In his introduction, Vincent mentioned the parlor game that he likes to play with other company leaders of “who has the most CFA Charterholders” but that he usually prefers a per capita measurement, which favors William Blair.

Dressed in a dark suit and a blue tie, El-Erian made his way to the stage amidst thunderous applause, pausing to take a few pictures with Christopher Vincent, CFA and Kerry Jordan, CFA.  The format for the presentation was a one-on-one chat, a la a Charlie Rose interview. Questions from CFA Society Chicago members were solicited ahead of time, with Jordan to act as the interviewer while she and El-Erian sat in armchairs on the Sheraton ballroom stage. Jordan mentioned a few of the questions that had been tossed out, including “How crazy is Bill Gross…really?”, to which El-Erian stared straight ahead with the slightest smirk on his face, wisely declining to offer any thoughts around his old boss at PIMCO.

Given El-Erian’s vast array of job, media and government responsibilities, how does he spend a typical day, a CFA charterholder wanted to know?

While at PIMCO, he would rise at 2:45 AM to compensate for the 3 hour time difference between California and New York, but now El-Erian sleeps in…until 3:30. The audience audibly gasped upon hearing this, realizing that building a net worth of $2.3 billion doesn’t always come with a lot of sleep.

After an early wakeup, El-Erian does some of the same things we all do. He looks to find out what is going on in the world, takes his dog out and makes his daughter breakfast. Sometimes when he lies down at 9 pm to sleep (he aims for about 6.5 hours of sleep a night), he starts tossing and turning and obsessing about how many hours of sleep he’ll get if he can’t fall asleep promptly at 9 pm. Then, El-Erian said, he might begin calculating his 3 day sleep moving average and his 5 day sleep moving average, to chuckles in the financially-oriented audience.

El-Erian has been a fan of the Mets since 1968 and said he was a bit worried about presenting in front of a room full of Cubs fans shortly after his team knocked the North Siders off in the NLCS. “Well, about 20% of you are on my side,” he said, referencing the much smaller Chicago White Sox fan base.

The nature of the conversation shifted as Jordan moved the conversation to the Fed’s decision on whether to raise rates in December. “What are the odds?” Jordan asked.

“High,” El-Erian responded. “But why are we obsessing with 25 basis points?”

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Keynote Mohamed El-Erian

El-Erian had three observations on the current Fed watch:

  • We’ve been living in a non-normal world and we are addicted to the Fed’s help. The Fed has had some missteps in communicating with the market about its plans, and this will likely be the most gradual tightening in Fed history.
  • The Federal Reserve probably won’t raise rates during every meeting and will stop raising rates well below the historical average seen in previous tightening cycles.
  • The world has become a very asymmetrical place, with the ECB moving in a different direction than the Fed and many central banks are out of alignment with respect to their monetary policy. This will likely lead to more foreign exchange and equity market volatility and higher interest rate differentials going forward.

“The Fed is dying to get off of 0%,” said El-Erian, “and the longer they are unconventional with monetary policy, the lower the benefits and the higher the costs.”

Over the past 10 years, society has bet on a growth model with finance, seeing it as an engine of prosperity for the economy. Countries like Iceland greatly expanded the size of banking within their economies with the belief that you can grow a lot with an expanding financial center. “Finance,” said El-Erian, “just got too big.”

Another observation El-Erian made was that the global political system was not stepping up to its economic governance responsibilities. In his mind we need a political system that steps up and a financial system that serves society as a whole to counter the effects of volatile markets and uncertainty around interest rate increases.

He talked about a recent investment he made in a firm that provides credit for very low income individuals, stating that “credit card debt can ruin you.” Technology is changing everything we do, and behavioral finance is now being used to help improve access to credit. The new generation of millennials expects “interaction anytime, anywhere” and companies need to build their strategy around this fact. In 10 to 15 years, Millennials will comprise the main customer base for most firms. El-Erian mentioned peer-to-peer lending, seen on platforms such as Lending Club, as part of the disruptive force currently taking place within finance, enabling individuals to interact in ways that would previously require an intermediary such as a bank. Technology has given rise to a broader trend of individual empowerment, and firms that ignore this change will find themselves rapidly disrupted. El-Erian used the example of the Hilton hotel chain taking a century to build 700,000 rooms while Airbnb accomplished this in a few years. “Starwood is being disrupted by people who never built a hotel in their life,” he said.

Jordan then turned the conversation towards the topic of student loan debt. Over $1.4 trillion is owed by students and this amount has tripled in just a few years, making many consider the student loan market to be the next subprime-like domino waiting to fall. As El-Erian explained, the return on higher education has gone down as the costs have increased, with an increasing household concentration of educational debt. Some options to fix this situation include broader use of community college, an earlier start for financial literacy programs and increasing the transparency around the student loan market, which El-Erian described as very low. “When you have a debt overhang, it impacts everyone,” El-Erian stated, saying that the options of bailing out delinquent borrowers or having an entire segment of society of being crushed by student loan debt are both highly unpalatable.

In El-Erian’s mind, one of the best ways new charterholders can prepare for a successful career would be by learning the languages of emerging economies, particularly Mandarin and Cantonese. The emergence of a much larger global middle class also points to an increased need for financial advice. Another less positive trend El-Erian highlighted was the “hollowing out” of the middle class in the West, resulting in a barbell-style society of poor and rich with few in the middle.

In terms of the investment landscape, El-Erian said it is no longer about products, it’s about solutions. You can’t expect to lob an array of diverse products at consumers and hope for them to construct a solution, the investment industry needs to build solutions for them.

One attendee wanted to know El-Erian’s views on the topic of active versus passive investment. In El-Erian’s mind, there shouldn’t be a debate because there is room for both approaches. Passive investment can be problematic in some asset classes, which El-Erian detailed in an example from earlier in his career while working as an emerging markets bond portfolio manager. At the time, Argentina represented 20% of an emerging markets index, but PIMCO made the decision that the country wasn’t a good credit risk and decided not to allocate any of its capital to Argentine bonds. Some commentators characterized this decision as irresponsible because it was such a large holding in the index and its exclusion would inject a huge tracking error into the PIMCO emerging market fund. Over time, PIMCO’s decision not to invest in Argentina turned out to be a huge success as the country defaulted in 2001-2002, and the exclusion of its bonds in PIMCO’s fund led to strong benchmark outperformance. For this reason, when default and liquidity risk is high, active management is very important. But in some asset classes, active management doesn’t really add much value, El-Erian opined.

Liquidity drives many investment decisions in fixed income and this risk factor has grown in importance as the buy side has increased market participation as sell side participation has declined, resulting in what El-Erian termed “the delusion of liquidity” currently going on in markets.

El-Erian listed three items he would expect economists to name as top initiatives needed to drive economic growth, including structural reform, the fundamental imbalance between the will to spend and the size of the wallet (“Germany has the wallet but not the will, Greece has the will but not the wallet”), and reducing what he sees as excessive levels of debt in the financial system. Publicly-traded markets are especially prone to manipulation by Fed policy, and El-Erian continues to move assets from public markets to cash and private markets as new index highs are reached.

Lastly, Jordan asked El-Erian about what he thinks of the future of finance. El-Erian laughed and said “They always say be afraid of the last question”, stating that he had recently created a Twitter account and was amazed by that platform, and that the future is generally very hard to predict.

To view 29th Annual Dinner pictures online please visit: http://edwardfox.pixieset.com/guestlogin/cfachicago/

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The Retirement Lifeguard

The Retirement Lifeguard

After reading one of my recent posts, a good friend paradoxically asked “What’s a pension anyway?” And his point is well taken – millions of Americans don’t have a traditional defined benefit pension plan or even a defined contribution plan. So how are they going to accumulate enough assets to retire and just how much money will they need to save for retirement?

It seems to me that the average worker is in need of a “Retirement Lifeguard”to help them develop and plan their retirement savings program. Fortunately, Stephen C. Sexauer and Laurence B. Siegel commendably address this issue in their article entitled “A Pension Promise to Oneself” which appeared in theFinancial Analysts Journal, Volume 69 · Number 6 ©2013 CFA Institute: 13-32.

Sexauer and Siegal assuage numerous concerns by saying, Don’t have a pension? Don’t worry. Most people don’t. They will get to retire, and so will you(13). And then the authors go on to provide a clear, simple framework for thinking about retirement planning issues and offer a basic “toolkit” to help you get started.

What is “A Pension Promise to Oneself?”

The basic function of any pension or savings plan is to shift consumption over time. In other words, how do you save enough during 45 working years (e.g. ages 20 to 65) to make it last for another 20 to 40 years of retirement? Simply put, one must first accumulate assets by forgoing consumption during the working years and then decumulate the assets, enabling consumption, in retirement. And you may consume what you saved plus (or minus) investment returns (14). Sexauer and Siegal contend that, “with or without your employer’s assistance, you have the ability to make “A Pension Promise to Oneself” and deliver on that promise by making pension payments to yourself from the moment you retire until the end of your life or your spouses life, whichever comes later” (13).

The Personal Pension Plan

In order to create your own Personal Pension Plan the authors outline three basic steps and include examples for a typical high school teacher and sanitation worker given the assumption of “minimum risk investing” which we will discuss later. Here are the 3 basic steps:

(1) Estimate how much annual income you will need during retirement.

For starters, Sexauer and Siegal indicate that this step can be as easy as using a simple rule of thumb like 70% of your pre-retirement income (16). However, I also like to use a “bottoms up” approach by developing an estimated budget of expected future expenses. In this regard, I’d recommend using the U.S. Department of Labor, Employee Benefits Security Administration (EBSA), booklet entitled “Taking the Mystery out of Retirement Planning” which provides a set of easy-to-complete templates.

Then, the authors subtract expected Social Security payments to determine the yearly amount the investor will need to generate from personal savings in retirement. By the way, you can get an estimate of your Social Security benefits by using the Retirement Estimator on the official Social Security website (http://www.ssa.gov/retire2/estimator.htm).

(2) Calculate the “retirement multiple” or total amount of savings to accumulate.

Now the fun part. Sexauer and Siegel reduce the retirement calculation down to a multiplication problem that even a fifth grader can solve (18)! The retirement multiple (RM) is the number of years of income you need to save in order to retire while investing risklessly (or as close to risklessly as markets allow), where “income” is not your current pay but the cash flow you need to generate, over and above Social Security benefits, in retirement. (17) For example, at current market rates, the authors conclude that the retirement multiple RM is 21.47x. So if you need to generate $50,000 per year in retirement then you need to have 21.47 times that amount in assets or $1,073,000 ($50,000 X 21.47 = $1,073,000). (17) {Technical note: The RM is the reciprocal of the DCDB yield: 1 / 4.657% = 21.47 and you can find the DCDB yield at www.dcdbbenchmark.com (18)}

Here’s where the authors’ examples really help to illustrate the methodology.

As shown in Table 1, Sexauer and Siegel (19) project the final (40th year) salary of a Columbus High School Teacher as $79,904 as highlighted in yellow below.

 

Then, using the 70% retirement income rule-of-thumb discussed earlier, the authors’ determine that the teacher will need $55,933 per year of income in retirement (Line A). Next, deduct expected Social Security Payments of $24,912 per year and we can see that the teacher will need $31,021 (Line C) per year from his/her “Personal Pension Plan.” Finally, by applying the retirement multiple (RM) of 21.47 to this amount we see that the teacher will need to accumulate $666,111 in order to retire (Line E) (19).

(3) Determine the savings rates necessary to accumulate the assets.

The final step is to determine the annual savings rates, and dollar amounts of annual income, that should be saved and invested in minimum-risk investments in order to accumulate $666,419 by the retirement date. In this regard, the authors present a spreadsheet of data for the Columbus High School teacher example that illustrates the assumed growth rates in earnings and annual savings levels necessary to achieve the goal. I’ve illustrated this data in graphical form below. Graph 1, shows that the teacher’s asset accumulation plan successfully achieves $666,419 in accumulated savings after 40 years.

Graph 1: Asset Accumulation Plan

 

Graph 2, below, provides a closer look at the projected annual income levels and the percentage of income that needs to be saved each year (Annual Savings Rate %) over forty years. Does the percentage of annual income that needs to be saved surprise you? (10% in year 1, 28% in year 20 and 32% in year 40)?

Spoiler Alert: Saving for retirement requires saving a large proportion of your income! “Like dieting, it’s simple to understand but not easy to do (16).”

Graph 2: Annual Income and Annual Savings Rates (%)


In this example, Sexauer and Siegel are conservative in using today’s real risk free rate of return of zero on Treasury Inflation-Protected Securities (TIPS). However, the point is to develop a base case where the investor can guarantee the results and that’s why the “risk minimizing investment” approach is used. In practice, many investors try to reduce the savings burden by taking on “shortfall risk” (the risk of not achieving the asset accumulation goal) by investing in riskier assets like equities with the promise of higher returns. But remember this warning, if the increased risk does not pay off then the investor will ultimately increase the savings burden rather than reduce it (21). And remember, investing in risky assets does not change the retirement multiple or the savings goal one needs to achieve (23).

Sounds simple. Are we done yet?

Not so fast. The truth is that real life is much more complicated than a few simple tables or graphs can depict. As Yogi Berra once said, “It’s tough to make predictions, especially about the future.”

Importantly, Sexauer and Siegel include a thorough discussion about the “adaptive behavior” that’s also required to keep your “Personal Pension Plan” on track. The authors explain that it’s important to make “Personal Fiscal Adjustments” (PFAs) when favorable or unfavorable surprises occur on either side of your balance sheet. These adjustments include increasing or decreasing consumption levels or the production of income. This is really a natural process and people make these types of adaptive changes all the time. For example, parents might move in with their children for a time if necessary. Others might find an opportunity to work full time for a portion of their retirement. The important point is that people can and do make the required adjustments to match needs and resources (15).

Live for Today – Plan for Tomorrow

I really enjoyed Sexauer and Siegel’s pragmatic approach to demystifying the retirement savings problem. They did an outstanding job of simplifying complexity for the average investor and showed that saving for retirement can be done, with limited risk, if you make a simple plan, monitor it and adapt to life’s changing conditions.

I think it’s important to be good stewards of the resources we have and to make sound financial plans for tomorrow. And let’s not forget the bigger picture. Don’t forget to live for today rather than for “retirement.” We aren’t guaranteed tomorrow so live with honesty and integrity, caring for the needs of others and treating others with dignity and respect. It’s much more rewarding to be generous with your time and resources than to build a retirement planning spreadsheet!

Stephen C. Sexauer is the chief investment officer, US multi-asset, at Allianz Global Investors, New York City. Lawrence B. Siegel is the Gary P. Brinson Director of Research at the Research Foundation of CFA Institute, Charlottesville, Virginia.

CFA Society Chicago Book Club:

The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies by Erik Brynjolfsson and Andrew McAfee

Second Machine AgeThe CFA Society Chicago book club met on Oct 20th, 2015 to discuss The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies written by MIT professors Erik Brynjolfsson and Andrew McAfee.  The book discusses the digital age and how it will impact our global economy.  To start off, the first machine age was attributable to the evolution and invention of the steam engine.  If you viewed an economic graph of human history, you would find relatively stagnant economic growth going back thousands of years until the chart vertically takes off around the late 18th century.  Technology is clearly what has shaped recent human history starting with the steam engine which led to the industrial revolution, internal combustion engine, electricity, and supernormal growth.  Like today, there was significant concern new technologies such as the steam engine would displace millions of workers.  While there were certainly many people that were impacted, people eventually evolved and adapted to the new opportunities that were presented by the invention of the steam engine.  There was a lag, but then a significant rise in employment and growth.  Looking back in history, new technologies have destroyed jobs but have also created new jobs albeit on a lag as people adjust and educate themselves to the newer times.  While it took a couple of decades for the invention of the steam engine to turn into the industrial revolution, the authors see the same evolution happening in the digital age.  While there are many similarities between the industrial revolution and the digital age, the former was about automating physical labor while the later is focusing more on cognitive tasks.

The next major inflection point is upon us due to the major breakthroughs in robotics, artificial intelligence, 3D printing, and the expanding computing power of the smart phone.  Google announced in 2010 that they had successfully created the autonomous car that can navigate on major freeways with the help of sensors, algorithms, and meticulously preprogrammed street mapping technology.  Long after the computer beat the world’s best chess player, Watson came along in 2011 and beat our best Jeopardy players.  More recently in 2014, Microsoft announced that not only could we communicate with anyone in the world for free via Skype, we could also communicate with anyone speaking any language via a real time translation service.  The computing purchasing power has been doubling almost every 18 months and while it is always dangerous to extrapolate, the authors don’t see this trend slowing down any time soon.  As always, there are economic challenges as technology races ahead.  Education and flexibility will continue to be important as new technologies emerge and robotic use continues to advance the global economy.

 

Upcoming Schedule:

November 17, 2015: No Ordinary Disruption: The Four Global Forces Breaking All the Trends by Richard Dobbs, James Manyika, Jonathan Woetzel

December 15, 2015: Rise of the Robots: Technology and the Threat of a Jobless Future by Martin Ford

January 19, 2016: The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

February 16, 2015: TBD

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

CFA Society Chicago Book Club:

The New Cold War? Religious Nationalism Confronts the Secular State by Mark Juergensmeyer

The New Cold WarThe United States won the Cold War when the Soviet Union collapsed in 1991.  Liberal democracy and capitalism reigned supreme; the primary ideological alternative, communism, had proved to be economically and politically unviable.  In 1992, Francis Fukuyama published The End of History and the Last Man, in which he argued that, with the collapse of communism, humanity may have reached the endpoint of its cultural and political evolution.  But history didn’t end, and according to Paul Berman, the euphoria of the moment “led so many people – in the United States, nearly everyone – to underestimate the dangers of the moment.”

The dangers came from an ideology far older and more intractable than communism, and if most scholars underestimated it, Mark Juergensmeyer definitively did not.  In his book The New Cold War? Religious Nationalism Confronts the Secular State, published in 1993, Juergensmeyer identifies the continued dominance of religion in many parts of the world, and how many of these religious worldviews conflict with the secular values of liberal democracy.

Juergensmeyer starts in the Middle East, with the Iranian Revolution of 1979 as his first recent example of religion overthrowing a secular government.  Religion has had influence in many other Middle Eastern countries as well, including Egypt.  Even Israel, essentially a secular state, has constituencies that have called for an explicitly religious state.  For example, the Kach Party has stated that non-Jews have no place in Israel, and have called for the country to be run according to Jewish law.  Some of the Kach Party’s statements about Arabs were eerily similar to Hitler’s statements about Jews.

Juergensmeyer also traces the strength of religion in politics in South and Central Asia, including Sri Lanka, Mongolia, Uzbekistan, and most notably India.  Running a secular government has been a challenge in India given the competing religious factions, including Hindu nationalists (such as the BJP) and Sikh nationalists.  In some instances, this competition has resulted in violence, perhaps reaching is apex in 1984 with Operation Blue Star and its aftermath, in which thousands were killed, including Indira Gandhi, the first female Prime Minister of the country.  Although Sikh and Hindu nationalists strongly disagree about many things, they are united in their opposition to secularism; according to Juergensmeyer, “the Sikh rhetoric is strikingly similar to the language of Hindu nationalists”.

The key question that Juergensmeyer asks at the end of the book is if secular western democracy can be compatible with religious nationalism.  He spotted many challenges in 1993, and the last 22 years have only highlighted the challenges in reconciling these two ideologies.  Perhaps surprisingly, religious nationalism can be very compatible with democracy in many countries, simply because many countries have a homogenous religious population.  If 95% of Iranians are Shi’a Muslims, democracy and theocracy may look very similar in that country.  Indeed, Fareed Zakaria, in his book The Future of Freedom, stressed that often Americans focus too much of promoting democracy, and not enough on promoting liberalism, and then are surprised when liberal values don’t automatically follow from democracy.

And thus the main tension between liberal democracy and religious nationalism comes from the tension between liberalism and theocracy.  Questions about human rights, protection of minorities, and freedom of expression may be answered very differently depending on how societies are structured.  This tension was much discussed in the aftermath of the recent Charlie Hebdo shooting, and highlighted that, however optimistic Juergensmeyer was about reconciling liberal democracy and religious nationalism, there may be intractable differences that continue to cause major problems in our world.

 

Upcoming Schedule:

October 20, 2015: The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies by Erik Brynjolfsson and Andrew McAfee

November 17, 2015: No Ordinary Disruption: The Four Global Forces Breaking All the Trends by Richard Dobbs, James Manyika, Jonathan Woetzel

December 15, 2015: Rise of the Robots: Technology and the Threat of a Jobless Future by Martin Ford

January 19, 2016: The Entrepreneurial State: Debunking Public Vs. Private Sector Myths by Mariana Mazzucato

 

To sign up for a future book club event, please click here:

http://www.cfachicago.org/apps/eve_events.asp

New Risks for Municipal Bond Investors

New Risks for Municipal Bond Investors

Hey! Mom-and-pop retail investors still own about 75% of the municipal bond market (directly or indirectly). They want a stable asset class with relatively few defaults, high credit ratings and interest income that’s tax free at the federal, state and local levels, if possible. In short, they want their father’s Oldsmobile.

Yet, today we’re seeing more stressed municipal credits than ever. Detroit, Michigan, filed for Chapter 9 bankruptcy protection in 2013 and is now the largest municipal bankruptcy filing in U.S. history at $18 billion. In this environment, there are new risks for municipal bond investors to evaluate. So investors should think again and remember the old advertising slogan: This is notyour father’s Oldsmobile—or his municipal bond either!

Public Finance: Key Issues and Red Flags 

To address this timely topic, the CFA Society of Chicago brought a panel of experts together for a program entitled: Uncovering Value and Risks in Stressed Municipal Credits. The panel was moderated by Arlene Bohner, Senior Director U.S. Public Finance, at Fitch Ratings and provided forward-looking insights on how to navigate these uncharted waters.

Bohner opened with a big picture overview of key state credit issues. She noted that U.S. states have broad economies and tax bases with substantial control over spending and raising revenue and this, in turn, generally supports their higher credit ratings. However, most governments made heavy cuts during the ’08-’09 recession and are still challenged by higher labor costs, pension funding deficits and huge infrastructure needs.

Longer-term, Bohner feels states remain significantly exposed to the possibility of federal funding cuts (e.g. Medicaid), although Bohner says, “Fitch believes states would have time to adjust to any significant federal actions.” Even still, Fitch has Connecticut, Illinois, Mississippi, and New Jersey currently on a negative outlook yet feels most state ratings will remain stable. In addition, she notes that steep cuts to vulnerable discretionary programs and/or federal tax code changes could have significant effects on state budgets and economies over time.

At the municipal level, Bohner looks for a number of red flags including:

  • Declining revenue base
  • Declining population and/or school enrollment
  • Increasing unemployment rate, coupled with a declining labor force
  • Relatively high tax burden
  • High and rising fixed cost burden
  • Declining assessed property valuations
  • Large debt issuances for controversial / non-essential projects
  • High levels of variable rate debt or swap obligations (> 15% of total debt)
  • Unusually contentious relationships among officials and/or with the State (including poor relationships between management, labor and taxpayers)
  • Inability to resolve labor disputes
  • Long-term labor contracts with inflexible terms
  • Low pension funding ratios with payments below actuarial required contributions (ARC)
  • Agressive budgeting and/or economic assumptions
  • Weak disclosure practices

Bohner now expects to see increased debt issuance at the municipal level to address deferred maintenance and capital needs. She notes that “pay-go” capital spending, which uses savings or current cash flow to finance projects, was reduced or eliminated by most governments well into the recovery. She also cautions investors about the increasing use of direct bank loans (private placements) for municipal financing due to their lack of transparency.

Forward-looking Municipal Metrics

Richard Ciccarone, President and CEO, Merritt Research Services LLC, reported that most cities experienced net general fund deficits from 2008 through 2010 and this was a reflection of the economic downturn. During this period, as many as 62% of big cities (over 500,000 population) and 58% of all cities reported deficits. But Ciccarone points out that Meredith Whitney’s prediction of billions being lost in the muni bond market didn’t come true and that general fund deficits returned to the 23% to 41% range between 2011 through 2014 (see graph below).

Percent of Cities with a Net General Fund Deficit                                    

 All Cities vs. Biggest Cities (Over 500,000 Population) FY 2006-2014

Source: Merritt Research Services, LLC

But that’s ex post information and investors need effective ex ante tools to guide future investment decisions. Ciccarone says, “in almost all distressed situations the unrestricted net asset ratio is negative.” Ciccarone started using this ratio around 2000 and says it has key predictive capability. As shown below, the ratio compares unrestricted net assets, which are resources considered usable for any purpose (numerator), to governmental activities expenditures, which are outflows of resources recorded on the government-wide financial statements per GASB Statement No. 34 (denominator).

Source: Merritt Research Services, LLC

Like a coverage ratio, this metric illustrates the availability of funds relative to expenditures—so the higher the ratio the better. As shown below, the largest cities (a with population over 500,000) have fallen into negative territory since 2009. Meanwhile, for all of the 2,000 cities in Ciccarone’s study, unrestricted net assets were between 20% to 23% of governmental activities expenditures from 2011 to 2014.

Importantly, we need to look at the government-wide balance sheet rather than the fund accounting statements that ignore long-term liabilities. Remember that governmental fund accounting focuses on the short run. But the government-wide balance sheet will reveal pension obligations, OPEB, debt and contra assets with deficit financing and no assets or revenue supporting them.

In regards to significantly underfunded pension obligations, Ciccarone’s big concern is that they may restrict a municipality’s ability to provide essential services (police, fire, garbage, etc.). He emphasized that Chicago’s actuarially required pension contribution (ARC) was as high as 55% of its general fund expenditures in 2014. That’s more than three times the level of other big cities (with a population over 500,000) as shown below. However, like many big cities, Chicago actually paid in far less to its pension plans than its actuarially required contribution levels.

Pension Requirements for Chicago and Big Cities:                          

Annual (Actuarial) Pension Cost as a % of General Fund                                                             Single Employer Plans only (2007-2014)

 Source: Merritt Research Services, LLC

Watch the Early to Mid-Career Numbers

Ciccarone’s final piece of forward-looking advice is to watch the early (25-29 years) to mid-career (30-34 years, 35-39 years) population numbers. These numbers tend to fall in distressed areas and Ciccarone says we need to watch them closely for Chicago. The charts below illustrate the decline for fallen angelslike Detroit and Puerto Rico. Fortunately, Chicago appears to be holding its own on these metrics and/or increasing in some areas.

Detroit Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, LLC & Government Census Data

Puerto Rico Early to Mid-Career Population Groups                            

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Chicago Early to Mid-Career Population Groups                                      

(25-29 Years, 30-34 Years and 35-39 Years)

Source: Merritt Research Services, Inc. & Government Census Data

Bankruptcy – Is the stigma is gone?

 Shawn O’Leary, Senior Vice President, Senior Research Analyst at Nuveen Investments is concerned that the stigma associated with default is gone. O’Leary noted that historically there’s been a significant fear of losing access to credit markets during bankruptcy. Yet he points out that  Detroit, Michigan, Jefferson County, Alabama and Stockton, California all refinanced and gained market access after bankruptcy. These cities are among the top five municipal bankruptcies in US history (below).

The 5 Biggest Municipal Bankruptcies in US History 

  1. Detroit, Michigan (2013)                                          $18 billion
  2. Jefferson County, Alabama (2011)                           $4 billion
  3. Orange County, California (1994)                            $2 billion
  4. Stockton, California (2012)                                        $1 billion
  5. San Bernardino County, California (2012)       $500 million

 Source: Forbes/Capital Economics

Ciccarone agrees with O’Leary and feels that in this environment the potential for more bankruptcies is definitely there—especially if policymakers approve additional bankruptcy statues like the one Governor Rauner proposed in Illinois. Today, approximately 24 states have been granted bankruptcy rights by their State legislatures but U.S. Territories, like Peurto Rico, cannot.

Lessons from Detroit

Bill Grady, CFA, Senior Portfolio Manager, Allstate Investments says that the problems in Detroit were brewing for decades. Grady says, “if you didn’t see them coming—shame on you.” After all, Detroit lost 50% of its population over the last 11 years. And looking even further back, it had been consistently losing population since the 1950s. Today, Grady hears even more municipalities talking about using bankruptcy as a negotiating tool.

O’Leary quickly added that people assume “special revenue bonds” will always pay principal and interest. In the case of Detroit, O’Leary was stunned by a federal judge who wanted to transfer his investors’ collateral (on water and sewer lines) out for ten years in order to redirect payments to unsecured creditors ahead of him. Even some attorneys suggested that he really wasn’t a secured creditor because Detroit had billions in unfunded capital expenditures. Ultimately, he says it took the ratings agencies to help force a tender offer by insisting that paying less than what’s due is recognized as a default.

Puerto Rico – Neither Fish nor Fowl

According to Bloomberg’s Michelle Kaske and Martin Braun, at $72 billion, The Commonwealth of Puerto Rico has more debt than any U.S. state government except California and New York and had been borrowing to pay its debts when they came due, until it defaulted on its payments in August 2015 (see Puerto Rico’s Slide, Bloomberg Quick Take 10/22/15). Notably, Puerto Rico’s bonds are exempt from local, state and federal taxes everywhere in the US—which made it easy for the US territory to double its debt in ten years.

O’Leary explains, “the problem with Puerto Rico is that it’s neither fish nor fowl.” O’Leary says it’s not a true sovereign nation (so they can’t go to the International Monetary Fund) and, unlike municipalities, it doesn’t have collective action clauses which would enable bondholders to implement a debt restructuring plan as long as the majority agrees. Rather, it’s like U.S. states that can’t file for bankruptcy. Hence, Puerto Rico can only ask for a settlement and that encourages creditors to holdout during negotiations. Ultimately, O’Leary feels the federal government needs to step in and make a deal happen.

To that end, on October 21st the Obama Administration announced its support for legislation that would grant Puerto Rico Chapter 9 bankruptcy protection, and a legal framework for U.S. Territories to conduct debt restructuring. Only time will tell if Congress will approve such a measure.

Bill Grady wraps up by saying, “hedge funds are controlling billions of dollars in bonds in Puerto Rico so it’s nearly impossible to take a position there without exceptional research capabilities.” In the end, Ciccarone thinks bondholders will probably recover between 40% to 70% of their investment—at typical sovereign default rates—while noting that the Puerto Rico’s 8% bonds have recently been trading in that range.

A Crisis in Illinois?

Illinois currently has an underfunded pension system of over $100 billion and the lowest credit rating of any state. Notably, Fitch lowered its rating on Illinois’ general obligation bonds to BBB- (just three steps above junk status) on October 19th and Moody’s downgraded the GO bonds to Baa1 on Oct 28th. And we shouldn’t forget that the state of Illinois has been operating without a budget since July 1, 2015. Bill Grady says, “Illinois and Chicago have been penalized but haven’t hit money yet.” So he wouldn’t handicap either as buying opportunities at this point saying, “you would need a cast iron stomach.”

Finally, Ciccarone thinks there will probably be a crisis at the Chicago Public Schools (CPS) first, then there’s the potential for a happy ending. Chicago has a $20 billion unfunded pension liability and has serious structural budget gaps. On the bright side, Ciccarone points out that Chicago’s school, city and county taxes are still only half that of New York on a per capita basis. And on October 28th, the Chicago City Council passed a $543 million property tax increase to be phased in over four years which will help maintain police, fire and other city services. But he still thinks there will be a lot more paper sold and people losing money before it gets better.

In closing, I’d simply add that these risks do not mean that we should avoid the municipal bond market. Rather, we should consider the relevant factors and metrics described above to carefully select the right municipal bond issues for our portfolios. When given a choice, choose well!

Distinguished Speaker Series: Kurt Summers

KS Photo (new)On October 1, 2015, Chicago City Treasurer Kurt Summers took time out of his busy schedule to present the latest on city finances to a packed room in Hotel Allegro.  Summers became Chicago’s Treasurer less than a year ago. In this role, he acts as Chicago’s investor, banker, and advocate.  During his presentation Summers discussed financial challenges and opportunities that Chicago faces and outlined plans to make his office more efficient and cost-effective for taxpayers.  He recently presented his first budget for the Office of the City Treasurer, with a goal of reducing taxpayer expense by 30% while doubling revenue.

One source of savings is at the Department of Aviation at O’Hare airport.  The Treasurer’s Office currently manages the Department’s $1.8 billion portfolio and only charges O’Hare $76,000 a year in investment fees.  This low rate effectively means Chicago taxpayers are subsidizing O’Hare’s investment management fees to the tune of approximately $1 million per year.  Summers plans to better align costs by charging O’Hare directly instead of having this cost subsidized by taxpayers.  By implementing similar measures the Treasurer’s Office can be fully funded without incurring taxpayer expense. Summers also aims to eliminate subsides and generate more revenue across the board.

Another recent initiative that Summers undertook was revising the official benchmark for Chicago’s investment portfolio.  Previously, the benchmark was the 90 day Treasury bill, which Summers felt set the bar too low.  His office decided to changed this to a bespoke benchmark to better reflect the risk-return profile of the city’s investments.  His office also instituted minimum credit quality standards for its entire portfolio.  Previously, credit quality standards were only applied to individual securities.  Finally, his office saw that Chicago had been holding an excess of working capital in the operations portfolio; enough capital to last for 2 months, even though GFAO standards only call for holding enough capital to last for 45 days.  Summers’ office responded by creating an operations reserve portfolio with slightly longer duration, which should generate an extra $30 million in revenue per year for the city.

Summers identified pension reform as the biggest financial problem facing the city of Chicago, and he bemoaned the fact that politics and egos can often get in the way of progress.  Even when proposals for pension reform get agreement from all relevant parties, there are still legal challenges, as some of these proposals have been struck down by the courts.  Large pension liabilities pose many problems for the city including reduced funding for schools and potentially higher taxes, which could drive residents away.

Finally, Summers talked about Chicago’s financial education program.  Initially, there were 130 different organizations in Chicago providing financial education with little coordination and no common set of curriculum.  Summers’ office created a financial education network, and the U.S. Secretary of Education Arne Duncan has referred to Chicago a “model city” for its approach.  Summers encouraged CFA members to volunteer their time and energy to assist in the program.