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In addition to writing swaptions, TRS is also selling credit default swaps on corporations like MetLife Inc. and Ford Motor Co., as well as the debt of Brazil, Germany, China and Panama.

Illinois pension fund uses OTC derivatives to recoup returns, jeopardizes pensions

by Alexandra Harris
June 10, 2010


Data from The Pew Center on the States

The Illinois TRS lost 22 percent on its investments in fiscal year 2009, the fifth-largest loss in the U.S.


Data from Standard & Poor's and TRS

Substantial losses in fiscal year 2009 crippled the Illinois TRS, while the S&P 500 index's total annual return was 26 percent. 


Data from TRS

According to TRS, its over-the-counter derivatives are scattered throughout various asset classes. 

Related Links

Illinois Teachers' Retirement System audit for fiscal year 2009Illinois Teachers' Retirement System OTC derivatives positionsState lawmaker seeks change in Illinois pension lawOklahoma TRS sheds OTC derivativesFor teachers, focus is on political pension problems

What to know about OTC derivatives

Credit default swaps may have entered the American lexicon as a result of the 2008 financial crisis. But here are some other terms to know:

Derivative- a financial instrument whose value is derived from an underlying asset.

Over-the-counter (OTC)- a financial instrument that is privately traded between parties, instead of on a centralized exchange like CME Group Inc. or NYSE.

Swap- a derivative in which two parties agree to exchange one stream of cash flow against another.

Interest rate swap- an exchange between two parties of a fixed interest rate payment for a floating interest rate payment that is linked to an interest rate, usually the LIBOR. Companies use interest rate swaps to manage exposure to changes in interest rates.

Credit default swap- a swap where the buyer receives credit protection and the seller guarantees the creditworthiness of the debt.

Swaption (swap option)- anoption to enter into an interest rate swap. The buyer has the right but not the obligation to enter into a specified swap agreement.

LIBOR (London Interbank Offered Rate)- the interest rate at which banks can borrow funds from other banks in the London interbank market.

Euribor (Euro Interbank Offered Rate)- the interest rate at which banks can borrow from other banks in the European Union interbank market. 

Definitions from Investopedia

Dale Rosenthal, a former strategist for Long Term Capital Management, the hedge fund known for its epic collapse in 1998, and a proprietary trader for Morgan Stanley, has seen his share of financial complexities.
But when shown a seven-page list of derivatives positions held by the Illinois Teachers Retirement System as of March 31, obtained by Medill News Service through a Freedom of Information Act request, the University of Illinois-Chicago assistant professor of finance expressed disbelief.

“If you were to have faxed me this balance sheet and asked me to guess who it belonged to, I would have guessed, Citadel, Magnetar or even a proprietary trading desk at a bank,” Rosenthal said.

The fact that the sheet doesn’t belong to one of those high-flying hedge funds, but to the $33.72 billion pension fund that serves more than 355,000 full-time, part-time and substitute public school teachers and administrators working outside the city of Chicago, is perplexing to those interviewed for this story.

How bad is it? After losing $4.4 billion on investments in fiscal year 2009, and 5 percent on investments in fiscal 2008, the teachers’ pension is now underfunded by $44.5 billion, or 60.9 percent, according to the Commission on Government Forecasting and Accountability’s March 2010 report. By comparison, only 20.3 percent of the Chicago Teachers’ Pension Fund is unfunded.

For the quarter ended March 31, according to derivatives experts who studied TRS’ financial documents, the fund lost some $515 million on its derivatives portfolio. Since then, the fund’s derivatives positions have likely soured further, the experts said, due to worsening financial conditions in Europe.

Frank Partnoy, a law and finance professor at the University of San Diego who worked on Wall Street as a derivatives structurer in the mid-1990s, said TRS’s portfolio is an indication that investing is not about what is smart but what will generate the highest returns.

“It’s an epic illustration of how we’ve really gotten lost in financial complexities,” he said, after studying the Illinois Auditor General's 2009 audit of TRS and the fund's March 31 derivatives positions.

The teachers’ fund denies it’s currently losing money on its derivatives, and in a statement said its investment strategy, which has included OTC derivatives for the past 27 years, is up 9.7 percent during that same time period. That’s better than the fund’s 8.5 percent target return rate.Further, a TRS spokesman said derivatives represented just 2 percent of the $4.4 billion fiscal 2009 loss.

Still, TRS has the fourth-riskiest investment portfolio for a pension fund in the U.S., with fully 81.5 percent of its investments considered risky, according to a Pensions & Investments study based on 2008 data.(The Commonwealth of Pennsylvania State Employees’ Retirement System was considered the riskiest with 86.1 percent of its investments considered risky.)

Collecting nickels ahead of the bulldozer

TRS said it uses over-the-counter, or privately negotiated, derivatives to maximize the performance of its portfolio and only allows money managers to invest in derivatives if they “have the appropriate expertise and knowledge and employ sophisticated risk management systems,” said David Urbanek, public information officer, in an e-mail.

The fact that TRS trustees and investment advisors approved the use of OTC derivatives isn’t, in itself, alarming. The financial instruments are not explicitly prohibited in the Illinois pension code, and many derivatives contracts provide protection against losses on other investments.

But right now, TRS is largely on the risky side of the contracts, selling and writing OTC derivatives, including credit default swaps, insurance-like contracts that guarantee payment in the event of a default, that were blamed in part for the 2008 collapse of Lehman Bros. and bailout of insurance giant American International Group Inc., or AIG.

In the balance sheet provided to Medill News Service, TRS’s OTC derivatives portfolio showed that in addition to writing CDSs, the pension fund was selling swaptions and shorting international-based interest rate swaps. For each contract written or sold, TRS received a premium.

Joshua Rauh, an associate professor at Northwestern University’s Kellogg School of Management, said TRS is taking a calculated risk.

“If its annual return is lower than 8 percent, TRS will have to admit that it’s in even worse shape than it is,” Rauh said. “They’re under incredible pressure to meet return targets and that’s when more exotic instruments start to looking appealing.”

TRS is selling OTC derivatives because, Rauh said, it needs the money today and hopes economic events don’t occur that would force the fund to pay out to the buyers on the other side of the contracts, a strategy one derivatives trader dubbed “collecting nickels ahead of the bulldozer.”

“If you’re a pension fund, you might put on crazy bets because you think you have to earn outsized returns to meet the liabilities they’re going to have to pay out when people start retiring,” Rosenthal said.

It’s clear the portfolio is primed for speculation, he added, because if Illinois TRS were hedging, or seeking to mitigate other risky investments, it would be on the buy side of swaptions and CDSs, rather than selling one set of maturities while buying another.

“TRS basically sold insurance and now it has an enormous short volatility position,” said one trader in the tightly knit OTC derivatives industry, who asked that his name not be used in this story.

Unfortunately for TRS, its OTC positions soured in late April when Greece’s debt woes worsened, Standard & Poor’s downgraded Spain’s debt to AA and the euro dropped to its lowest levels since the currency’s inception. The International Monetary Fund and European Central Bank orchestrated a $1 trillion bailout to ensure that Greece and the other PIIGS—Portugal, Ireland, Italy and Spain—would not default on their debts.

“As the European debt crisis worsens, TRS’ positions are going to bleed money,” the trader said.

Operating in the dark

Over-the-counter derivatives refers to securities traded between two parties rather than on a centralized exchange. As a result, the custom contracts are opaque, meaning their market values are largely hidden.

But the Illinois Teachers’ Retirement System said if it unwound the OTC trades held in its pension fund today, the positions would have a market value of $5 million and a notional value of $1.1 billion. Notional value is the total value of a leveraged financial instrument’s assets.

It isn’t clear how TRS is valuing its OTC derivatives and market experts, among them Rosenthal, who estimated a loss of $515 million as of March 31, were skeptical the OTC positions could have been showing a net positive notional value.

TRS projects it will have logged a $158 million gain from its derivatives portfolio by the June 30 end of fiscal 2010— with $5 million derived from its swaptions, CDS and interest rate swaps positions—and just a fraction of its projected $627 million total return.

A significant portion of TRS’s OTC derivatives are linked to interest rate swaps and those are tied to either the London Interbank Offering Rate or Euro Interbank Offering Rate. Interest rate swaps stipulate for every basis point tick upward in the LIBOR or EURIBOR, the fund is forced to pay out an interest rate that is two basis points higher. This is why the notional value of TRS’s U.S. dollar- and international-based interest rate swaps were in the red by $361.4 million at the end of March.

TRS’ portfolio also includes a large number of swaptions—or the right at a future time to enter into a swap position—which showed a loss of $14 million as of March 31. In addition, the fund sold approximately $154 million worth of CDSs guaranteeing the debt of dozens of companies, countries and states, among them American International Group Inc., GMAC, Panama, Mexico and California. (See graphic). 

A large part of TRS’s international-based interest rate swaps positions are linked to the Brazilian Interbank Deposit Rate and Euribor in a bet that inflation would stay low in Europe but rise in emerging markets.

Rosenthal, who said TRS appears to be betting that long-term Treasury yields will greatly increase, is incredulous that the fund even has this view. “Their job is not to play the [Treasury] yield curve,” Rosenthal said. “It’s not their job to have that view.”

Fiduciary duty

Section 1-109.1. of the Illinois Pension Code states it is the duty of the board of trustees of a retirement system or pension fund to appoint fiduciaries to manage its assets—including the power to acquire and dispose of any assets—as well as assign others as fiduciaries to oversee activities other than asset management.

“Trustees would have fiduciary duties and they have to be careful because it’s not their money,” said Eden Martin, president of the Civic Committee of the Commercial Club of Chicago. “They have to be looking out for the beneficiaries.”

TRS said it makes day-to-day operational decisions concerning strategic asset allocation, portfolio structure and manager selection, but cedes all of its investment decisions, within TRS parameters, to professional money managers, a list some 60 names long that includes Goldman Sachs Asset Management, JPMorgan Investment Management, Northern Trust Co. and State Street Global Advisors.

When asked which managers were responsible for the pension fund’s derivatives portfolio, Urbanek, the Illinois TRS spokesman, said OTC derivatives positions are scattered across each asset class because they are “complementary positions” within each portfolio.

According to its investment policy, TRS encourages diversification of assets and “prudent” risk taking because these strategies align with its long-term investing goals. “Increasing risk is rewarded with compensating returns over time.”

“They’re not maintaining effective internal controls,” Partnoy said. “Is it prudent risk-taking to write CDSs on Brazil?”

The Illinois TRS investment committee includes internal investment managers and the retirement system’s board of trustees, comprised of six governor appointees; four elected by active TRS members; two elected by TRS retirees; and the state superintendent of education, who serves as president of the board of trustees.

Besides teaching experience, the trustees’ employment experience ranges from executives at manufacturing and human resources companies to lawyers and high school finance administrators. Each must undergo 32 hours—four eight-hour modules–of training that includes fiduciary, investment, actuarial and legal and administrative issues.

Efforts to reach trustees for comment were not successful.

Historically, the Illinois TRS and other pension funds did not engage in excessive risk-taking. During the 1970s, pension fund investments were conservative and aimed for low but consistent rates of return.

In the 1990s, pension fund investment standards loosened and funds began investing more heavily in equities, real estate and private equity. The growth of such investments exploded, helped by major bull markets in equity and real estate assets.

Approximately 38 percent of a pension fund’s assets were in equities in the 1990s—in 2007, 70 percent of state pension plan assets were in equities, according to the Pew Center on the States report, “The Trillion Dollar Gap: Underfunded state retirement systems and the roads to reform.”

In addition, David Swenson’s Yale Endowment Model created a dangerous precedent for investing. Swenson, who has been managing Yale’s endowment since 1987, along with deputy investment office Dean Takahashi, created a model that promoted asset diversification and avoiding liquid markets because they yielded lower returns.

The new attitude toward portfolio management can be seen in some of the out-sized returns by the Illinois TRS and other pension funds during market boom times. For example, TRS’s returns shot up by 16.5 percent in 2004 and by 19 percent in 2007, before the fall of Lehman Brothers in 2008 drastically changed the investment landscape.

The bottom line, experts say, is that there is no language in the Illinois pension code that prohibits pension funds and retirement systems from buying or selling OTC derivatives as an investment method. In the event of catastrophic losses, lawsuits would be filed against the fiduciaries, but ultimately taxpayers would be left holding the bag.  

“When it comes to interpreting the legal language of regulation, there’s always a gray area,” Rauh said.