Back in the early-to-mid 2000's large pensions and insurance companies made a very large bet on a "sure thing". They sold trillions in notional value of credit default swaps (CDS) on mortgage backed securities. The bet was a "no brainer" as the insurance companies could collect a solid coupon payment for insuring risk on "investment grade" credits backed by U.S. housing, an asset class that had basically never declined in value. Well, as we all know, in the end, that bet didn't work out that well resulting in a government bailout of many financials, including AIG, which received over $180BN.
Well, turns out, some of the "smart money" in this country either didn't learn much from that event or doesn't remember it. As the Wall Street Journal pointed out over the weekend, pension funds in Hawaii and South Carolina have adopted a new strategy, in their thirst for yield, that involves selling puts. While the insanity of the domestic equity markets, which seem to indiscriminately soar to new highs every day, might convince some that, like housing circa 2006, equity values never actually decline, Nathan Faber of Newfound Research says:
“There comes a point where you might be picking up pennies in front of a steamroller.”
Well, we tend to agree with you, Nathan, but what do we know? As the WSJ points out, selling puts can provide great "current income" which is "especially attractive" with government bond yields at records lows. That said, the WSJ does hedge saying that if protection is "cheap" and the market "takes a big fall" that strategy may not work out so well.
For some, the approach offers a way to generate income, which can be especially attractive with government-bond yields at record lows. The upside for the pension funds, which are writing options on the S&P 500 index, is that they earn regular income. But if protection is cheap and the market takes a big fall, the pension fund can end up with losses.
So, they're implying that selling puts at all-time market highs and all-time volatility lows might result in "losses." We're shocked.
But employees in Hawaii shouldn't worry too much as the Hawaii Employee's Retirement System CIO pointed out that this put writing strategy will help "mitigate" risk. Per fund CIO, Vijoy Chattergy:
“After the great financial crisis, we recognized that there was a lot of risk in our portfolio. We’ve been in an ongoing effort to address those concerns and understand them.”
Might we suggest you seek to "understand" the risk BEFORE you dedicate assets to it? The Nancy Pelosi "we have to pass it to see what's in it" policy didn't work that well with respect to Obamacare and it certainly doesn't work in the financial industry.
At least someone at the South Carolina Retirement System questioned the level of risk inherent in a "put-writing" strategy. Treasurer, Curtis Loftis, who is a member of the pension investment committee says he remains "cautious" about the level of risk inherent in the strategy but ultimately ended up voting for it anyway. Way to cave to that political pressure, Curtis, in the event this all goes horribly wrong, again, can't have any dissenters smearing egg in that face of the rest of the investment committee.
“l think it’s difficult to assess the true risk of these strategies. One of the great untold stories of the pension world is how we have underestimated risk.”
Actually, we don't think the story went untold at all...taxpayers remember that one quite well.
But there has to be some silver lining in this story, right? Like maybe they're just committing a small portion of overall assets to this risky strategy. Wrong. The Hawaii pension is dedicating over 10% of overall assets to put writing in an effort to "mitigate risk."
Risk mitigation was behind a decision by the Hawaii Employees’ Retirement System to invest $1.6 billion of its $15 billion portfolio in a put-writing strategy, which it expects to be fully invested by October. Based on how the options would have been priced last week, Hawaii could generate about $19 million a month in income if it wrote puts on the full amount and the options weren’t exercised, according to Neil Rue, a managing director at Pension Consulting Alliance, an independent firm that works with the pension fund.
Yes, because housing prices never decline and put options never actually get exercised, right?