Fed Policies Lead Pension Funds To Take On More Risk In Direct Lending

The Federal Reserve (and other central banks) have been hyperactive in pushing interest rates to near zero (and negative in Europe and Japan). Here is the Fed’s activity.

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One of the by-products of low rate policies is that pension funds cannot meet their projected payouts to retirees. As a result, pension funds are seeking to take-on more risk in their hunt for higher yields.

(Bloomberg) — Arizona’s $41 billion State Retirement System is looking to dedicate one out of every six dollars it manages to direct lending — more than five times the industry average — in a move some see as a harbinger of what’s to come for the booming asset class.

Investors have plowed hundreds of billions of dollars into private-credit funds in recent years, lured by premiums that are more than five percentage points higher than competing public debt. Yet less than 3% of pension portfolios were dedicated to the sector as of December, according to London-based research firm Preqin. That may be about to change.

In a recent survey of firms managing nearly $400 billion in private-credit strategies, nearly 90% said they expect pension funds to up their allocations over the next three years. The Ohio Police & Fire Pension Fund said this month that it was cutting its high-yield exposure as it moves toward a 5% target for private debt. And in its most recent financial statement, the Teachers’ Retirement System of the State of Illinois said it “continues increasing exposures to private debt opportunities,” even as it retreats from fixed income broadly.

“We’ve been invested in private debt since early 2013,” said Al Alaimo, who oversees the Arizona fund’s credit investments and aims to boost direct lending, one of the most popular private-credit strategies, to 17% of the portfolio, from about 13.6% previously. “We were very conscious that we were an early adopter and we tried to lock up as much capacity as we could with managers we perceived as being the best.”

Asset class returns outpace gains from leveraged loans, junk bonds

Now others funds are catching on, too.

The number of U.S. public pensions active in private credit climbed to 281 this year, with a median allocation of 2.9%, up from 186 and 2.1% in 2015, according to Preqin.

That may not seem like much, but with $4.57 trillion in assets, even incremental increases in exposure can mean billions of dollars in inflows for alternative credit managers.

The Arizona State Retirement System invests with some of the biggest players in the business, including Ares Management, HPS Investment Partners, Cerberus Capital Management, GSO Capital Partners, Oaktree Capital Management and Monroe Capital, according to fund documents.

Of course, other problems plague pension funds, such as in the State of Illinois where people are fleeing due to higher taxes … to pay for their underfunded pension plans.

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Illinois’ pension problems are helping Illinois to have a credit rating one notch above junk. The City of Chicago is already rated as junk along with Chicago Public Schools.

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How long before Illinois jumps on the direct lending bandwagon? After all, it is easier to take on more risk than trying to fix the problem.


The Big Short In One Chart! The Case of Phoenix AZ (The Fed’s And Federal Government’s Forgotten Role In The Mortgage Crisis)

I don’t mean to be a Debbie Downer, but it is important to understand what happened to the US economy and housing market in the US back in 2000s that culminated in such destruction to American households.

The book/movie “The Big Short” laid the blame on subprime adjustable-rate mortgages (ARMs) which is partially true. It also blamed Collateralized Debt Obligations (CDOs). But “The Big Short” ignored the Federal government and Federal Reserve’s role in the financial disaster.

It all started in 1995 under President Bill Clinton when HUD issued its now infamous National Homeowership Strategy  in order to increase homeownership rates, particularly among minorities. The NHS included Action 44: Flexible Mortgage Underwriting Criteria. Flexible? Like ALT-A (no or limited documentation) loans? Yes, the mortgage product that had less that 5% serious delinquencies (60+ days) as of late 2007, but exploded after 2007.


Using Phoenix AZ was an example, notice that Phoenix’s home price index soared post-1995 as mortgage underwriting became looser coupled with The Fed lowering its target rate as a result of the 2001 recession. But The Fed overdid it, resulting in a massive house price bubble that exploded. The Fed then lowered their target rate to near zero percent but the damage had been done.


At the national level, adjustable-rate mortgages (ARMs) were higher than post crisis.


As housing construction collapsed, unemployment skyrocketed as did subprime mortgage delinquencies.

Phoenix was rocked by unemployment in the wake (not John Wake) of the construction boom and collapse. Pre-foreclosure filing rose with the unemployment rate, then subsided.


So, The Big Short failed to mention the role of the Federal government and The Federal Reserve in the crisis, a dance that was a fantasy with a bad ending.

That is, The Fed and the Federal government were hoping for Heineken but got Pabst Blue Ribbon instead.




US Average Hourly Earnings (3 Mo Avg) Highest Since President GWBush, Home Price Growth Lowest Since 2012 (Housing Bubble Redux?)

Unlike the housing bubble and “The Big Short” years of 2005-2007, when home price growth was greater than average hourly earnings growth, we are now in the opposite situation: slowing 2% YoY home price growth and the highest average hourly earnings growth rate since 2008 and President George W. Bush.

Home price growth is slowing …

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As average hourly earnings growth rises to its highest level since 2008 and George “Dubya” Bush.


Using a different home price growth index (FHFA Purchase Only) and an average hourly earnings for the majority of Americans, you can see where home price growth exceeds average hourly earnings growth starting in 1998 and ending in 2006 (the “Big Short” bubble) and the QE3-induced home price bubble starting in 2012 to today.

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Between HUD’s National Homeownership Strategy of 1995 and The Fed’s quantitative easing (particularly QE3). the US Federal government is doing the “housing bubble dance.”


Mortgage Purchase Applications Back To 1998 Levels As Mortgage Refi Applications Slow A Bit From Refi Wave

If you have recently applied for a mortgage refinancing given plunging mortgage rates, you may have noticed a delay in the underwriting. Why? US lenders are in the midst of a “refi wave” and some lenders are swamped with work, particularly underwriters.

Mortgage applications decreased 6.2 percent from one week earlier, according to data from the Mortgage Bankers Association’s (MBA) Weekly Mortgage Applications Survey for the week ending August 23, 2019.

The Refinance Index decreased 8 percent from the previous week and was 167 percent higher than the same week one year ago. The seasonally adjusted Purchase Index decreased 4 percent from one week earlier. The unadjusted Purchase Index decreased 6 percent compared with the previous week and was 2 percent higher than the same week one year ago.


The 30 year mortgage rate has been generally falling since November 2018 as European (Brexit) and Asian (China trade) pressures have increased. As a consequence, we have seen a “refi wave” in 2019.


Mortgage purchase applications have risen gradually since 2014, but litigation against lenders and rules created under the Consumer Financial Protection Bureau (CFPB) resulted in mortgage purchase applications at 1998 levels.


A refi wave can feel like surfing at Nazare in Portugal.


US Home Price Growth Weakest In 7 Years (Phoenix Now Fastest Growing Home Prices, Seattle Home Prices Declining)

US national home price growth has slowed to its lowest level in 7 years, according to  June’s Case-Shiller report.

The decline in national home price growth coincides with The Fed’s decision to let its balance sheet self-unwind.


Phoenix, my former residence, is now the fastest growing metropolitan area in the US, even faster than Las Vegas. Seattle is now the slowest growing metro area in terms of home prices and is actually declining. San Francisco is barely above 0% at 0.7% YoY.

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The FHFA purchase-only home price index YoY has fallen to 1.0.


Time for some more “Fed Fresh” spray?