The blind leading the blind

Editor's Letter


The US state of New Jersey sits next to New York like a dowdy younger sibling, awed and shabby in the presence of its glamorous, cosmopolitan big sister. The glittering Manhattan skyline, home of so many global financial giants, has little in common with the peeling, grimy infrastructure that stretches southwest from the Hudson river.

But every so often, the financial giants stumble. The sub-prime crisis has inflicted body blows on the likes of Citigroup, Merrill Lynch, UBS and Morgan Stanley, blows so grievous that their capital adequacy has been threatened. A bevy of exotic investors, sovereign funds from places like Abu Dhabi, Kuwait and China have queued up to buy stakes in these tottering giants, offering infusions of desperately needed capital. And joining the exotic investors parading their wealth down Wall Street is the dowdy sister from across the Hudson, in the form of the New Jersey Division of Investment, an $80 billion fund that is supposed to back the state's pension liabilities. Once upon a time, this fund would have been lucky to get good terms on a block trade from the banks it has just invested in, Merrill Lynch and Citi.

Now it has managed to invest in a $6.6 billion mandatory convertible bond issue from Merrill that pays a guaranteed 9% coupon for two-and-three quarter years. The New Jersey fund's deal from Citi is even better - a $12.5 billion perpetual preference share issue paying a coupon of 7% and 20% conversion premium.

At first sight, this action by New Jersey to exploit the credit crunch and make opportunistic high return protected investments resembles a recent trend among European insurers and pension funds that have fished for opportunities in dislocated credit markets. But appearances could be deceptive. The European firms that we have spoken to have chosen to invest selectively, in collateralised structures backed by loans with good fundamentals, such as emerging markets. The New Jersey investment is in two banks that, notwithstanding some eye-popping write-downs, remain heavily exposed to further losses in sub-prime mortgages, and other deteriorating sectors of the US economy such as credit cards.

As the 2001-02 downturn showed, it is never clear where defaults will eventually strike. But there are perhaps some more fundamental differences between what European insurers and pension funds are doing and the example of New Jersey. In Europe, the trend has been towards economic valuation of liabilities, and risk models that test potential investments against their marginal impact on capital.

Meanwhile, the US local government pension sector is at the opposite end of the transparency scale. As shown by the lonely example of New York City, attempts to introduce market-consistent valuation are treated with suspicion. In particular, New Jersey has a long track record in exploiting opaque public sector accounting in order to avoid funding its liabilities, which some estimate to be higher than $175 billion.

Maybe there is some undisclosed risk model that shows how the $80 billion controlled by the state's Division of Investment will catch up with the outstanding pension liability. Maybe the investments in Merrill and Citi are part of the plan, rather than being connected with the fact that the two banks employ significant numbers of New Jersey residents. Or perhaps it is simply an unintended irony that a pension sponsor with no clue about its liabilities has invested in two banks that were clueless about valuing sub-prime structured credit assets.

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