Peter Costello and Joe Aston on NSW becoming a massive levered hedge fund...

Christopher Joye

Coolabah Capital

The scandal around NSW using tens of billions of dollars of taxpayer debt to turn itself into a gigantic leveraged hedge fund (reaping substantial fees for the for-profit TCorp and the fund managers it uses) continues to erupt, care of withering new columns from the Australian Financial Review's economics editor, John Kehoe, and Rear Window's editor, Joe Aston, today.

Kehoe starts by highlighting that NSW using enormous amounts of taxpayer debt to punt on global equities, hedge funds, private equity, junk bonds, and other illiquid, equity-like asset-classes is no different (arguably worse) than Macquarie Bank's mercenary efforts to raise $13 billion of government-guaranteed debt during the GFC, which it then gambled on global junk bond markets (this initiative drove up to 30% of Macquarie's profits at one time). You can read the AFR's story on how Macquarie became a huge junk bond player here.

In the same way that the Commonwealth's guarantees of Macquarie's bond issues were based on the clear expectation that Macquarie would use this money to lend to Australian households and businesses during the GFC---of course, they sent most of it overseas---NSW taxpayers would very reasonably assume that when Dominic Perrottet saddles them with $19 billion to $47 billion of extra gross debt (see an explanation of those numbers here), this money would only be used to support NSW's fiscal stimulus, COVID-19 payments, and infrastructure spending, and not be diverted offshore to punt on stocks and global markets, etc. Over to Kehoe:

The circumstances have dramatically changed since NSW Treasurer Dominic Perrottet set up a $10 billion state sovereign wealth fund in 2018 for future citizens to share the spoils of the privatisation of public assets and windfall revenue.
NSW’s net debt was below zero, with excess cash from budget surpluses and asset sales.
Today, gross debt is on track to exceed $120 billion due to necessary government stimulus spending and falling tax revenue during the COVID-19 recession and lockdowns.
Yet Perrottet plans to keep topping up the NSW Generations Fund by borrowing tens of billion of dollars cheaply under the state government’s AA+ credit rating. The $15 billion fund is projected to reach $90 billion by 2030-31, based on expected growth and inflows.
NSW Treasury will pass borrowed money to NSW Treasury Corp to invest in domestic and international equities, hedge funds, private equity and unlisted infrastructure and property.
NSW is margin lending on the government account, as the Reserve Bank of Australia buys NSW bonds to contain government borrowing costs under the RBA’s $200 billion quantitative easing program.
There is a parallel to Macquarie Bank in 2008 exploiting the federal government’s AAA-rated bank guarantee to make a $33 billion-plus bet on distressed global debt, a trade Macquarie profited handsomely on.
The NSW Generations Fund made sense when there were excess savings. But when the budget plunged into deficit last year, it was a turning point.
After consulting Treasury and Treasury Corp officials, including former Perpetual and Macquarie executive David Deverall, Perrottet decided to hypothecate revenue from mining royalties, State Owned Corporation dividends, tax “windfalls” and future asset privatisations to add new inflows to the fund.
The budget was deep in deficit, so in effect debt would fund the inflows.

Kehoe moves on to quote Nick Birrell, who was an asset-liability management specialist and NSW TCorp external advisory committee member in the 1990s. Birrell has a PhD in mathematical physics from King’s College London and was Credit Suisse Asset Management Australia’s founding chief executive:

Birrell says when NSW had zero net debt and billions of dollars from asset sales, a fund for future generations made sense.
“They had the right idea originally, but now it’s an adventure that doesn’t make sense,” he says.
“When you’re running budget deficits and issuing more debt to put into the equity markets and hedge funds with gearing, it makes no sense at all.
“Raising debt to invest in Exxon or Amazon equities doesn’t have much of a rationale.
“This would require a very high-risk tolerance of the state.”

The hammer, however, is Kehoe's references to the founder of the Future Fund, and its current chairman, former Federal Treasurer Peter Costello. Note that Costello is also chair of Nine, which owns the AFR. 

Costello appears to have anticipated the possibility of governments being persuaded by ex-bankers and fund managers to get into precisely this sort of caper: that is, using the government's low cost of capital to transform itself into a massive punting machine. Furthermore, Costello was very careful to ensure that the Commonwealth stopped funding the Future Fund once it went into deficit. As Kehoe explains: 

As federal treasurer in 2006, Peter Costello set up the Future Fund to prevent the Howard government spending too much and to cover future public servant pension liabilities. The Howard government had a $15 billion budget surplus and zero net debt.
Costello considered issuing no gross debt, but ultimately bond investors pressured the government to retain an operating bond market.
The Future Fund, now chaired by Costello, has grown to $180 billion, about halfway to covering unfunded superannuation liabilities of $270 billion and $428 billion by 2050.
Future Fund chairman as treasurer set up the fund with budget surpluses and no debt. 
Costello was aware of calls for governments to use cheap debt to make money by investing in financial assets. But he rejected using debt for the Future Fund and inflows have stopped since the budget plunged into deficit in the 2008 financial crisis.
The Costello Memoirs explain in theory how any government with a high credit rating could earn a higher return on financial assets.
“On a long-term basis it should not be difficult to exceed the long-term bond rate,” Costello wrote.
“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.”

This brings Kehoe to his essential question: "At the core of the issue in NSW is the philosophical question: what is the business of government?" Governments should certainly not be in the business of becoming levered hedge funds and crowding out private investors from financial markets. In Kehoe's words:

A state government’s core business is to provide services such as health and education to the community, to invest in infrastructure and microeconomic reform to increase prosperity.
Financial services veterans with long memories remember when state governments in Victoria and South Australia used leverage from government balance sheets to operate banks. The banks went bankrupt and almost took down the states.
Funds management may be safer than banking, but the introduction of leverage makes it not such a risk-less bet.
Moreover, if a state did get into financial trouble from financial asset investments, unlike a national government with a central bank, a state cannot print its own currency as a bailout.
States don’t have income tax bases and instead rely on terrible taxes such as stamp duty and payroll tax.

In the same newspaper, the inimitable Joe Aston wades into this furore in his typically withering and insightful style. Aston picks up on a potential concern: The NSW Treasury is run by a bunch of ex-bankers from Westpac and Goldman Sachs while its debt-issuance agency, the for-profit TCorp, is now run by former fund managers. 

So what happens when a bunch of bankers and ex fund managers control a government's money printing machine? Well, there can be many possible outcomes. What we see right now is the emergence of a huge levered hedge fund strategy that immediately benefits the folks running the money: namely, TCorp, which is paid fees to manage the NGF's $15 billion-going-to-$27-billion Debt Retirement Fund, and the network of asset managers and hedge funds that TCorp farms most of the Debt Retirement Fund's money out to.

I have never revealed this before, but I was repeatedly warned not to get involved in this debate because it would mean that I would never be able to win a mandate off TCorp to manage money for it as a fund manager across its $100 billion-plus funds under management. 

I was also repeatedly warned that if I criticised TCorp, the firm would prejudice against me in future NSW government bond issues (in other words, give us smaller allocations). 

I even spoke to one of TCorp's fund managers, who was keen to get involved in highlighting these problems, which they were not aware of, until they realised that TCorp was a client, which made it difficult for them to speak out.

Yet I am happy to make these sacrifices if it means we can fulfil our responsibility as an activist ESG (environmental, social and governance) investor that works maniacally to ensure that our borrowers behave properly. In this case, the potential ESG problem is governance.

As a lender to all the State governments, we have one simple requirement: don't behave recklessly and irresponsibly when you are using our clients' money. The fact that NSW now pays the highest interest rates on its debt of all the State governments --- a totally unprecedented event --- is superficially terrific news for fixed-income investors: we get much more attractive future yields. 

And we have confidence that NSW Treasurer Dominic Perrottet will do the right thing, and execute on his original vision of using the NGF's Debt Retirement Fund to: 

  • build new infrastructure, 
  • repay debt to avoid saddling future generations with additional debt, 
  • win back NSW's AAA credit rating and reduce its cost of debt. 

These are commitments he has repeatedly made in public, and which he is also legislatively obliged to comply with.

In the AFR today, Joe Aston calls out Perrottet on his promise to spend the $20 billion of WestConnex asset sale proceeds on building new infrastructure:

This newspaper’s economics editor, John Kehoe, confirmed the bracing news on Monday that the NSW government is debt-funding more than $10 billion of investments in equities and other financial assets over the forward estimates, to be gleefully deployed by NSW Treasury Corporation.
Treasurer Dominic Perrottet has broken his March 2020 commitment (restated in November 2020) that “proceeds from any future transaction would be used to extend the government’s unprecedented infrastructure program”. Instead, WestConnex proceeds are, as we speak, being punted on the stock market.  

Just as significantly, Aston highlights the fact that NSW Treasury is now led by a bunch of ex-bankers while TCorp is being run by former funds management executives, which is rather unusual. Ordinarily, Federal and State treasuries are run by professional public finance experts and economists. And the Federal and State debt issuance agencies are normally led by debt finance and balance-sheet experts. As Aston explains:

TCorp is headed by David Deverall, the former CEO of Perpetual and Hunter Hall. Mere months since S&P downgraded the state’s AAA credit rating, he appears to be writing his own ticket.
Treasury itself is run by Mike Pratt, an alumnus of Westpac and former deputy chairman of icare (alongside former Macquarie banker Michael Carapiet and NAB director Peeyush Gupta). The astonishing cronyism of the government’s workers’ compensation scheme, and then Pratt’s shock assignment auditing it, was immortalised last year by our colleague, Adele Ferguson.
The icare fiasco is yet another instance of Perrottet’s apparent capture by emigrants of private sector finance who’ve effortlessly colonised state government enterprises. It has arguably become serial capture. Does it never occur to these politicians that – with a few exceptions, to be sure – ex-bankers in the public service are ex-bankers for a reason?

One of the biggest beneficiaries of the decision not to use the $15 billion-going-to-$27 billion in the NGF's Debt Retirement Fund to repay debt or fund new infrastructure is of course TCorp itself, and the fund managers it uses. 

As long as this money stays in the NGF, TCorp gets paid asset management fees for running it, as do its fund managers. But if the money is used to payback debt or fund new infrastructure, this money walks out TCorp's doors...

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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 26 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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