Heads bankers and fund managers win, tails taxpayers lose

Christopher Joye

Coolabah Capital

In the Australian Financial Review I write, what do you get when politicians hire bankers to run their treasury and fund managers to lead their debt issuance agency? Why a public balance-sheet that starts resembling a leveraged equity hedge fund: the pollies are persuaded to divert tens of billions of dollars of taxpayer revenue into shares and other high risk strategies, which is funded by a huge increase in debt.

The winners are the former fundies paid handsomely to run the money at the debt issuance agency, and the managers they farm the cash out to, collectively reaping over $150 million annually in fees on the billions of dollars of taxpayer capital they oversee. The bankers also make out like bandits as advisers on all the debt issues.

The losers are taxpayers who bear the downside of having their balance-sheet leveraged-up to the gills with stocks and other high-risk strategies that can blow-up in any recession or external shock, dramatically increasing the fiscal hazards they face. Pity the poor future generations that have to pick-up the tab when interest rates normalise, crushing the value of all asset-classes as discount rates climb.

The AFR's John Kehoe observed that this is similar to the “moral hazard” Macquarie Bank succumbed to during the global financial crisis (GFC) when it borrowed $13 billion of government-guaranteed money and embarked on a huge “carry trade” by gambling this cash on foreign junk bonds. The premium yields on these securities came with the risk that they defaulted, which could have blown up the bank, leaving taxpayers to foot the bill.

That is precisely the problem NSW Treasurer Dominic Perrottet confronts. Back in 2018, the widely admired Perrottet had an inspired idea: the NSW budget was running a circa $4 billion surplus and its balance sheet reported negative net debt.

To his immense credit, Perrottet announced that he was creating a rainy-day fiscal buffer called the NSW Generations Fund (NGF), which would have two subsidiary funds. The first, known as the Debt Retirement Fund (DRF), has the sole legislated purpose of “reducing the debt of the State”.

The Debt Retirement Fund has to be run in a way that maintains NSW’s AAA credit rating and lowers the cost of taxpayer debt. It also has to be fair to future generations, or “intergenerationally equitable”.

There was no reference at all to growing the Debt Retirement Fund’s assets forever to act as an offset against gross debt (or to reduce net debt). There was certainly never a plan to materially increase taxpayer debt to allow Perrottet to funnel even more money into the NGF in the hope that by punting this on risky strategies that earn more than 4.5 per cent above inflation (over 7 per cent annually), the NGF could outperform the cost of NSW’s debt.

As former treasurer and Future Fund boss Peter Costello has argued, that’s a crazy idea. The Future Fund was seeded by budget surpluses and privatisations: inflows halted once the budget plunged into deficit during the GFC.

Costello anticipated Perrottet’s problems, writing that because governments can borrow more cheaply than anyone else, “on a long-term basis it should not be difficult to exceed the long-term bond rate” by gambling on riskier assets.

“Taken to its logical extreme, this process could enable the government to become an investment business. But a government is not an investment business, and we were not doing this as a money-making scheme.”

Where would you stop? Why not issue infinite amounts of debt and buy all the equities in the world?

The purpose of the Debt Retirement Fund

Perrottet clarified this week that the only purpose of the Debt Retirement Fund is “is to help retire debt and guard against intergenerational budgetary pressures”.

When launching the fund in 2018, Perrottet said governments have an obligation to leave finances in a better position for future generations – the new NGF would secure the State’s finances. “We owe it to our children to prepare for the challenges they will face in the decades to come, not saddle them with debt,” Perrottet exclaimed.

Yet his advisers had other ideas in mind, as we will see shortly.

The NGF has a second subsidiary fund, called the Community Services and Facilities Fund, which Perrottet promised would pay for local infrastructure under a “My Community Dividend Program”. More specifically, Perrottet said that “up to half of the investment returns will enable the new My Community Dividend program”.

Under its legislation, this second fund’s sole purpose is to “provide funding for cost-effective facilities and services throughout NSW”.

In practice, Perrottet’s advisers have spent virtually nothing on infrastructure, with almost all the NGF’s returns kept inside the DRF.

In seeding the NGF, Perrottet initially put $3 billion of budget surpluses into it combined with $7 billion from the sale of the first half of WestConnex. The second half will be sold next month, reaping NSW taxpayers as much as $13 billion. All this money is going into the NGF.

Perrottet explained that “proceeds from any potential transaction will be invested into the NGF and allow us to continue to build world-class infrastructure such as the Metro West train line from Sydney to Parramatta”. He repeated that promise this week.

Speaking to the Sydney Morning Herald, Perrottet said that “our priority is providing the schools, hospitals, roads and rail NSW needs”. “The Government’s asset recycling strategy has enabled us to do that and create tens of thousands of jobs in the process.”

Anyone reading that would believe the WestConnex money is going to fund new infrastructure construction. But it’s not clear it will pay for one cent.

To date, Perrottet’s promises have not been met. And experts like former NSW parliamentary budget officer Dr Stephen Bartos believe the NGF’s Debt Retirement Fund (DRF) and Community Services and Facilities Fund (CSFF) have been used in a manner that conflicts with both Perrottet’s and the legislation’s intent.

The DRF has not retired a single cent of taxpayer debt despite the fact the budget has been punching out record deficits and debt has exploded from $35 billion in 2018 when the DRF was created to a new record $120 billion this financial year.

Even more remarkably, Perrottet’s advisers want to direct over $10 billion of taxpayer revenue to the DRF, and $20 billion in total to a range of TCorp investment funds, which has to be replaced with taxpayer debt because NSW is in deep deficit. They have already done this, shifting $2 billion of revenue into the DRF in October 2020, which was debt-funded due to the record deficit.

So the DRF is perversely contributing to significantly increasing NSW taxpayer debt, not reducing it, because of the revenue it is hijacking at a time when NSW’s budget is in the red.

This is exacerbated by the fact that NSW has yet to use any of the DRF’s $15 billion, which will rise to more than $27 billion once the second half of Westconnex is sold, to pay for the unprecedented $108.5 billion of infrastructure Perrottet has committed to build. Because the former fundies and bankers running NSW want to keep all this money in TCorp's funds, NSW has to raise more debt to replace it.

Since 2018, the NGF’s CSFF has funded a grand total of $19.7 million of community infrastructure. Perrottet this week boasted that the NGF had made $2.8 billion of returns since 2018 (it actually lost money in 2020), and yet his previous promise that up to half of this, or $1.4 billion, would flow into local infrastructure remains missing-in-action.

So why has the NGF run off the rails? What is Perrottet going to do about it? And why do I care?

Since 2018, the only people profiting from the NGF appear to have been the fund managers running it. NSW’s debt issuance agency is a private, for-profit entity, TCorp, which made a $75 million profit in 2020, and is led by former fund managers.

TCorp is paid by NSW to run the NGF’s $15 billion-going-to-$27 billion, which represents a material share of both TCorp’s funds and the asset management fees that are used to pay TCorp’s executives.

TCorp has a theoretical interest in keeping all the money in the NGF, and not paying-back NSW debt, which would result in TCorp losing substantial fees, or the NGF funding new infrastructure, which would also see the money walk out TCorp’s doors.

TCorp's 184 executives were paid a chunky $53 million in 2020, and can earn significant bonuses, which are influenced by TCorp’s profitability. The more money TCorp manages, the more revenue it captures, and the more salaries and bonuses TCorp can afford to pay its staff and its (many) high-flying board members.

TCorp is paid to both manage NGF money-in-house and to choose the global fund managers that it farms the remaining cash to. There are many hands in the till capturing what would be total fees of more than $150 million per year on the NGF’s $15 billion, going to over $270 million per year once the $13 billion from WestConnex is put into TCorp’s kitty.

TCorp also runs NSW’s debt issuance. That means TCorp issues NSW government bonds, and, alongside the bankers leading NSW Treasury, are key advisers to Perrottet on his debt strategy.

At the official lunch outlining NSW’s 2022 budget, TCorp’s CEO, a former funds management executive, advised his surprised audience that NSW could issue as much debt as it wanted to as long as the returns on the NGF’s portfolio beat the cost of this funding. It sounded like Peter Costello’s worst nightmare.

NSW had shocked markets with its proposal to issue $35.5 billion of debt in 2022, 50 per cent more than it did in the COVID-induced recession in 2021, and a similar burden to the total debt issuance of the other Australian states combined.

About $7.2 billion of that money was for funding investments in TCorp funds, with another $12 billion slated over the next three years. That’s almost $200 million in asset management fees.

The tripling of NSW government gross debt since 2018, partly driven by the refusal to use the DRF’s savings to retire debt and expectations of explosive debt increases, resulted in NSW losing its prized AAA credit rating in December in conflict with the NGF’s legislated goals.

And the interest spreads on NSW government debt have soared, and are now for the first time higher than all the other major States because of NSW’s debt funding shock, notably prior to the lockdown, undermining another key NGF objective.

NSW’s use of the NGF directly increases fiscal risks in all downside scenarios, and only reduces risk if we assume equities always go up. In a recession when equities and other risky assets are clobbered 30 per cent to 60 per cent, NSW’s net debt will spike by many billions, increasing its debt servicing costs, and threatening its credit rating.

It’s preposterous that NSW taxpayers should load-up on equities when valuations are at 100 plus year highs precisely because interest rates are at record lows. As Dr Bartos has shown, it is also intergenerationally inequitable to leave future taxpayers with the risk of servicing all this debt when interest rates inevitably normalise and equities valuations correspondingly decline as discount rates rise.

The encouraging news is that Perrottet has signalled he will course-correct NSW Treasury and TCorp following criticisms from Standard & Poor’s, banks like CBA and NAB, former treasurer secretaries, sovereign wealth fund bosses, current and former state government debt agency heads, the bond market, and NSW’s impressive shadow Treasurer, Daniel Mookhey.

This week Perrottet said he was diverting the $13 billion in WestConnex sale proceeds to the NGF to “allow us to continue to build world-class infrastructure”. Let’s hope that means the DRF will buy a $13 billion bond issued by TCorp, which it is permitted to do, to allow NSW to use that money to pay for new infrastructure and COVID-19 spending, reducing NSW’s external debt issuance by the same amount.

Perrottet further revealed that “in light of the mounting challenges faced by the NSW economy and budget, we’ll continue to review our NGF strategy”, particularly in respect of its “optimal fund size and debt clearance” to ensure it is “working to the benefit of current and future generations”. This extends his comments earlier in the week that the NGF’s strategy could “adapt” to allow NSW to “choose to pay down debt in some years”.

Perrottet will likely dump the $7.2 billion of debt funding his advisers proposed this year for TCorp’s funds, and the additional $12 billion over coming years. And it is equally easy for Perrottet to have the DRF retire debt and/or buy new NSW bond issues to fund his COVID spending needs. After all, his rainy-day fund’s hurricane has arrived. In fact, if he committed all the DRF's $27 billion to replace past and future debt issuance, he would be a good chance of recovering his lost AAA rating.

Perrottet did retort that diverting taxpayer revenues into TCorp funds, and replacing that cash with extra NSW debt, is not borrowing to gamble on stocks. While the likes of S&P and CBA disagree, Perrottet claimed that “by that logic, anyone who borrows money to buy a house while topping up their super is also “effectively” borrowing to invest in the stock market”.

The correct analogy would be a person with expenses greater than their income, running negative cash-flows (or a deficit). While no bank would lend to this person, if they did borrow to buy a house, and further topped-up their super, they would be replicating the current NGF strategy. No financially literate person would actually do this, and in the real world they’d be lodging a hardship application with their super fund to withdraw money, as Perrottet should be doing with the DRF.

My interest in this matter is that we lend billions to governments, including the Commonwealth and the States, companies, and banks, and require them to behave in a manner that meets our strict environment, social and governance (ESG) expectations.

The proposal to voluntarily boost NSW’s debt burden by some $20 billion to $47 billion to punt on stocks etc via a “pay-fund-managers-forever-fund” is a serious ESG concern, specifically around potential governance dysfunctions. We cannot have the “heads fund managers and bankers win, tails taxpayers lose” moral hazard in play.

While the market has rationally priced in NSW’s reckless behaviour via much higher interest rate spreads on its debt, which we and other investors are happily capturing after wearing a price adjustment in June, our governance expectations are not-negotiable.

This is not easy to publicly advocate. TCorp manages over $100 billion in assets and is one of the five largest feeders of fund managers in the land. I’ve been warned by my investors that speaking-out will mean we never have a chance of winning TCorp mandates. I’ve also been warned by many banks that TCorp will discriminate against us in future bond issues. But activism is never easy.

Perrottet knows what he needs to do: deliver on his brilliant, original vision of building a rainy-day fund to reduce future debt and fiscal risk, and seriously question the dodgy advice he has been rendered in the past.

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Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 40 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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