Jack Gray Wants to See People in Handcuffs
“Shortly after Lehman Brothers fell, I was at a global conference of pension funds in Tacoma, Washington. I got up in front of the group and gave a call to arms. ‘This is our time to assert some power,’ I said. ‘We are the managers of assets. Dislocations like this are dislocations of power.’ I proposed that we write a manifesto on how we thought finance should be. And as you can imagine—much to my disappointment—you could have heard crickets or a pin drop. Eisenhower warned in 1961 of the growing military–industrial complex. Now, it’s the growing finance–industrial complex that’s truly dangerous to Western democracy. The crisis was our opportunity for restructuring—to totally restructure the financial sector. And we missed it. The consequences from these crashes are borne by the poor and middle class, while the bankers and Wall Street types profited. Finance is by and large a rent-seeker. The one thing that Karl Marx understood better than anyone was the nature of power: The powerful work through networks—they are members of the same clubs. We’ve seen Timothy Geithner’s phone records. The people he mixed with and played golf with were the Wall Street players. As for Dick Fuld—a prince of darkness straight out of Hollywood Central Casting—he’s sitting in Florida, and nothing seems to have happened to him. You need a couple of people in handcuffs going to the slammer to keep the Wall Street types in line.”
Mr. Gray is the director of the Centre for Capital Market Dysfunctionality at Australia’s University of Technology.
Chris Verhaegen Remembers the Shock
“I was in Brussels when I found out, at a meeting with MPs. There was someone there representing AIG who told us they’d had to write off I $5 billion of their toxic products. That came as a huge shock. Nobody talked afterwards. Nobody expected during that first month that this would take years to sort out. Everyone thought we should try to keep out of the heat and it would pass by in a year or so. Nobody talked about a monetary crisis. People started realizing this wasn’t just a small blip in 2009. But even then, no one thought about the euro currency crisis. Some people are still denying its existence because the Eurozone seems to have coped and got past the worst of it, but the markets are still speculating against the euro. I think that pension funds are better prepared today for another 2008-type scenario. The risk-consciousness has increased a lot. There’s European legislation coming up to bring more transparency to costs in mutual and investment funds, and that has contributed to more competition and efficiency in asset management. Nobody would have talked about banking resolutions before the crisis. Now there will be regulation to force banks to make a living will and a resolution mechanism for banks to wind up within the Eurozone. These things were unthinkable before. The most important lesson we should have learned was that before the crisis nobody bothered to think about the intertwining of the financial system globally. Nobody knew where all the toxic assets were. This is still a problem; there is not enough centralized data on assets and liabilities across the financial system.”
Ms. Verhaegen is the chair of the Occupational Pensions Stakeholders Group at the European Insurance and Occupational Pensions Authority.
Andrew Lo Sees Problems (and They Keep Him up at Night)
“John Maynard Keynes said, ‘In the long run, we are all dead.’ But we have to make sure the short term doesn’t kill us first. Investors don’t have to be day traders to be managing risk actively. Where we are today is a kind of purgatory. Equity markets have obviously done well, but we still have these common drivers of market dislocation and a flight to quality. There are several nightmare scenarios that keep me up at night. One: The debt ceiling and sequester. If anything, Congress seems more dysfunctional than last year. If we end up defaulting on our government debt, that would be a tremendous shock—and you can’t rule it out, given the Congress we have. Two: Continuing problems with sovereign debt in Europe. Greece narrowly passed a bill that let them continue with the bailout. Had it gone another way, you would have seen more protests in the streets. People have gotten tired of the Euro situation, and as a result they’ve forgotten about it. But the problems haven’t gone away. There are still banks teetering on the brink. Markets worldwide are balanced on a knife’s edge right now. Pension funds have to put their money to work, so they’re pulling it out of bond markets and putting it into equities. Obviously, the Lehman meltdown brought a lot of sleepless nights for everybody. From a historical and intellectual perspective, it was a horrifying and fascinating period.”
Mr. Lo is the Charles E. and Susan T. Harris professor of finance at MIT’s Sloan School of Management.
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Jim Dunn Thinks We Need Better Leadership and Regulation
"J. Paul Getty said, ‘If you owe the bank $100, that’s your problem. If you owe the bank $100 million, that’s the bank’s problem.’ But if the bank owes $76 billion, that becomes the central bank’s problem. We’ve learned that banks can’t loan any more money than they can afford to, yet Lehman Brothers owed more money than Enron and WorldCom combined. That’s a lot of money. We’ve also seen the true egos of Lehman Brothers executives—their arrogance, hubris, and paranoia hindering the transparency, respect, and modesty needed to run banks. The collapse helped redefine the importance of ISDA fine print and of learning about exactly who owns what and where the derivatives were. Banks are bigger than they’ve ever been, the SEC [Securities and Exchange Commission] is a revolving door, and we lack good regulation. There needs to be stronger leadership at the SEC and on the federal level, with actual regulations from Congress implemented to prevent 2008 from happening again. Americans need loans to open businesses and put their kids through college, and, for that to happen, we need to have government accounting back on track. Hank Paulson showed intestinal fortitude in dealing with the crisis in 2008, something we want from the leadership today. We need good debt to offset bad debt, which means the economy has to improve. The crisis can continue as long as banks focus more on profits and liquidity and less on making loans. As an endowment CIO, I’ve found ways to work around banks such as Goldman Sachs and Bank of America the last few years. We don’t want to compete with them, and we haven’t seen the level of trust in them that we’d like. We wanted to be a partner, not a transaction, so mostly we’ve allocated our assets to independent asset managers, hedge funds, private equity, and other liquid funds. More endowment CIOs need to have a stronger voice, a clear input, and a risk-aware stance—not a ‘where do we rank in NACUBO’ mentality. Our mission is simple: We invest in the lives of students. It’s not about making the most money, highest returns, or profits. And, as more of our partners share and understand that, we can better serve our students. Too many large banks are focused on earnings and not furthering our missions.”
Mr. Dunn is the CIO at Wake Forest University.
Bob Rädecker Knows What He Has—and How to Replace It
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“It was the first day of my holiday, but I returned to the office on Sunday evening and started to execute the plan we had prepared in the preceding weeks. We had exposure to Lehman in the derivatives market, so we had double-checked the amount and quality of collateral against the contracts. We had planned which exposure we would try to replace first and who would be responsible for doing it. We had to make the decision on whether the Lehman entity we traded with in Europe was going to file—if it didn’t, we would end up with double exposure.We decided it would file, so we started ending the trades. Now, in general, investors are more aware of counterparty risk. People have realized they have to work on a collateralized basis, but some remain unaware of ‘replacement risk.’ If you have to replace trades in markets that have become very chaotic, that’s a big risk. And liquidity tends to dry up on you, too. At PGGM we centralized functions and built internal models that run daily analysis. Prior to Lehman Brothers, many models just focused on credit ratings, but the mere probability of a counterparty failing is just one risk element, so we have to look at many others. We have to know how quickly and at what cost we could unwind and replace the trade. The megabanks have gotten bigger since the crisis, and the wall of money in financial markets creates bubbles. There are factors that are problematic, but there are some things you cannot change. We are better prepared, but I still wouldn’t go on holiday if it happened again.”
Mr. Rädecker is CIO for Public Markets at PGGM.
Mark Gull Thinks Failure Should Be Allowed
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“We didn’t know Lehman was going to collapse that day, but we had 75% of our portfolio in cash and gilts and the other 25% in investment-grade corporate bonds. We had a strong view for a long time that what was happening was not a regular recession but actually a deleveraging trend. The industry’s probably positioned a bit better today, but it’s hard to know. Sometimes people accept there is risk, do the calculations, and then they believe them too much. If your risk model doesn’t work in stressed times, it’s not going to work. If you look at the products that really went wrong, they had a lot of leverage and depended on a huge amount of liquidity. Liquidity is transient in markets—it’s not always there. CDOs are back on the market again. A CDO [collateralized debt obligation] isn’t necessarily a bad product. They can make sense and diversify risk. What’s silly is if you don’t understand the risk or it becomes a CDO squared or cubed and has too much leverage in it. But policymakers putting rates as low as they are encourages investors to do that. If you regulate people incredibly tightly and tell them to buy the same assets, you increase systemic risk. Regulators are terrified of more problems happening. One of the things that will show when we really are recovering is when regulators are happy to let businesses and systems fail. You need failure to pay for risks. I’m not encouraging people to fail, but if things go wrong, they’ve got to be allowed to fail. The regulators need to judge that a system can do that, and then people would price risk better.”
Mr. Gull is co-head of asset and liability management at Pension Insurance Corporation.
Erik Valtonen Wants More Than Diversification on a Stormy Day
“I saw things coming, but I never thought Lehman Brothers would collapse. There had been increased nervousness, and in the summer of 2008 we had extra meetings with the board. Everyone was connected in a huge web, and we had a systemic collapse. The hedge funds were connected to banks, to investors, and to others. All the moving parts of this web ended up colliding. In the internet bubble, equity markets had two years of red figures, but it was quite isolated, and investors could put their money elsewhere. This time, it took people by surprise. They had built diversified portfolios, but there were many misconceptions about what this actually meant. For example, hedge funds don’t hedge; their exposures are often the same as everyone else’s. Diversification isn’t insurance. It works on a normal rainy day but not if things get really bad. At AP3, we discussed the role of the long-term investor and our objectives. We recognized we shouldn’t focus on the short term, but we had to decide what our temporary pain threshold was. We knew the short term has an impact on the long term so we had to think about insurance—and whether it was cost-effective. Dynamic asset allocation was the new panacea. We thought:“Well, we screwed it up this time, so we’ll avoid it with this.” The AP funds generally understood risk factors, but 95% of our risk was equity risk—due to restrictions on investments, tradition, and fees—so when the crisis hit, we were sitting on equities. We now have a better understanding of risk, but we have to also understand that equities are a proxy for growth, and that’s missing at the moment.”
Mr. Valtonen is CEO of Blue Diamond Asset Management and former CIO of Swedish pension fund AP3.
Penny Green Thinks It Might Be About to Happen Again—in a Different Way
“Lehman Brothers collapsing was a core part of what happened, but it was a culmination of events that started in 2007. Through the whole period there was a sense of impending crisis, and Lehman Brothers was the exemplifier of it. I’m not 100% convinced that pension funds have learned the lessons of the crisis. Credit was too cheap—some were saying there was a credit crisis coming and it would be nasty. Yet, it started to happen and no one was prepared. The pension fund sector is really bad at being forward-looking. They are very good at reacting but not very good at being proactive. We should have all learned to use better risk management, protect against downside risks, and become less about the bond/equities split. Maybe it’s too difficult to look at a world, think about what might be happening, and ask whether our allocation is appropriate and defensive enough. There will be another crisis, which is a massive worry. 2013 feels like 2007. We have a low interest rate environment, and everyone is looking for yield. Junk bonds are returning what investment grade should be, and people are talking about ‘covenant-lite’ again. We haven’t learned anything. Credit is only good if you get your money back. The housing boom feels like 2007, and there has been a re-rating of equities without the fundamentals being there to support it; it’s just people using excess liquidity in the system. Something has got to give, but it will be a different crisis this time.”
Ms. Green is CEO of the Superannuation Arrangements of the University of London.
Joanne Segars Believes in Capital Preservation
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“For UK pension funds, the subprime crisis really started a year before Lehman Brothers was brought to its knees, with the collapse and eventual nationalization of Northern Rock. The unravelling of Lehman Brothers brought home the fragility of financial markets and the huge embedded credit risk in the derivatives market. On the day of the crisis, there was a sense of incredulity that the most powerful government and central bank in the world could not force a stay of execution to allow Barclays’ shareholders to vote on the acquisition of Lehman. That has cost global economies dearly. The fall of Lehman Brothers has highlighted the capacity of governments and central bankers to engineer and steer financial markets for a prolonged period of time through the unprecedented use of quantitative easing and rock-bottom interest rates. This, of course, brought in its wake burgeoning pension deficits, de-risking strategies, and the prospect of low investment returns in the future for pension schemes. The crisis was a wake-up call, which taught investors that they should have a thorough understanding of all the moving parts in their portfolios. What lessons have we still not learned? The investment world has become even more complex with investors continually bombarded with new asset classes and strategies. Getting the right balance of regulation in the future is key to ensuring sustainable economic growth and for instilling renewed confidence in financial markets.Investors are better prepared today for a 2008-style crisis. Greater scrutiny of portfolio holdings combined with new regulation provides a ‘belt and braces’ approach to managing risk in the future. The advice given to investors now, which wouldn’t have even crossed their minds before 2008, is that capital preservation during volatile times is more important than investment returns.”
Ms. Segars is the CEO of the United Kingdom’s National Association of Pension Funds.