Playing the pension game
Two national stories yesterday shed light on the foolishness that’s taking place on the fringes of the public pension world. The first story, from the Los Angeles Times, is about pension obligation bonds – a classic tale of fancy, Wall Street-devised products that promised more than they could deliver. The second story, from the New York Times, is about a scheme, dreamed up in an ivory tower, of having state government pension plans take over responsibility for the pensions of corporate retirees. The mind reels at the complexity and difficulty of this idea.
Nathaniel Popper of the LA Times does an excellent job of describing the speculative risks that state and local governments take by borrowing in the bond markets to fund their contributions to their pension plans. Pension obligation bonds are a form of interest-rate arbitrage: a municipal issuer borrows at, say, 4 percent and invests these funds in its actively managed pension plan. The hope is that the funds will earn higher rates of return, usually from investments in the stock markets. It’s basically a way of borrowing to speculate, but since Congress won’t allow municipalities to do that using tax-exempt bonds, a new approach was developed. The LA Times says:
Congress made it illegal in 1986 to issue normal tax-exempt municipal bonds for this type of speculation, but municipalities and their outside advisors realized they could get around this by issuing taxable bonds, like corporations. These bonds come with higher interest rates, but many local government officials have believed they could earn enough from investments to come out on top.
So pension obligation bonds lose the advantage of having a municipal tax exemption and instead pay higher, taxable rates. Is the strategy good enough for state and local governments to overcome the costs? The LA Times recounts the horrifying experience of the state of Illinois:
In Illinois, the state has struggled even to make the ongoing payments to the [pension] fund, much less make up the shortfall. For the last two years the state has issued billions of dollars of pension bonds just to pay the immediate contribution to the pension fund.
The state will shell out $1.6 billion – or 5% of the state’s entire annual budget – just to pay off the interest on its pension bonds issued over the last decade, according to the Illinois Civic Federation. The bonds were issued with the hope of increasing the funding level of the pension fund, but that level has actually dropped.
The whole basis of the vast fixed-income market is to borrow short and lend long, so POBs make sense – at least, on the surface. But public pension funds move slowly. They aren’t managed aggressively and are often dependent on the whims of the governor and legislature. There is no magic formula for state and local governments to ease their pension woes. Pension obligation bonds just look like fancy speculation with public funds.
MuniLand Snaps: March 27, 2012
Michigan Governor Rick Snyder speaks about working for the residents of Detroit to stabilize the fiscal situation and help the city start growing. It seems likely that the city and state will agree to a deficit elimination plan; some enhancements will allow that plan to qualify as a “consent agreement.” Video from the Detroit News.
Good Links
Forbes: The Media Map: Who’s reading what and where
Bond Buyer: Treasury promotes new round of BABs; Republicans likely to reject
OCC: Notional amount of derivatives exposure for U.S. commercial banks
Stateline: Doing union work on the government clock?
MuniLand Snaps: March 26, 2012
While the sharks circle Harrisburg, the French press reports on the fiscally battered city. National Public Radio weighs in on Harrisburg too.
Good Links
Bloomberg: China’s central bank may grade local governments’ creditworthiness
CBO: Federal budget outlook and aid to states
Hightower Lowdown: Post Office is not broke — and it hasn’t taken any tax money since 1971
Bloomberg: Jonathan Weil dissects the new state integrity index and finds it wanting
It’s Michigan versus Wall Street in the battle over Detroit’s future
It’s hard to follow the news from Detroit without getting a sense of impending doom. Detroit’s fiscal problems are enormous, and Michigan’s governor, Rick Snyder, has been fighting to gain control of the city’s books through his treasurer while he’s off in Europe on a trade mission. Thirty public-worker unions have agreed to concessions requested by Detroit Mayor Dave Bing to help balance the budget. Meanwhile a state appeals court is weighing whether to overturn a lower court order that would bar the governor’s review team from signing an agreement with Detroit because the team violated open meeting laws.
Every level and branch of Michigan government has a dog in this fight. It’s good theater, but the real war over Detroit’s future will be fought among its bondholders, interest-rate swaps counterparties and bond insurers.
In short, Detroit needs about $140 million in cash to make it through the end of its fiscal year. This will allow the city to pay workers and keep current on its debt service while continuing to downsize the government and make it more efficient. Rather than lending the cash to the city, the governor wants control. Detroit has been making its bond and derivatives payments, and a good portion of the bonds are insured by either MBIA or Assured Guaranty, but it’s the nasty derivatives counterparties that wield outsize power over the city’s future.
Detroit has about $3.8 billion in interest-rate swaps outstanding, according to its most recent public filing (CAFR of June 30, 2011, page 113). These Wall Street weapons of mass destruction were sold to the city in a series of transactions since 1997, allegedly to hedge interest-rate risk. The interest-rate swaps were necessary because Wall Street dealers sold variable interest-rate bonds for the city that needed to be hedged. Of course, Wall Street could have sold fixed-interest bonds from the beginning, negating the need for the swaps, but complexity means that Wall Street earns more in fees. Guiding less-informed public officials to the most profitable products seems to be an art form, and it often allows the public officials to push the fiscal reckoning out into the future, long after they have completed their terms.
Detroit’s derivatives could blow up the city because many contain “termination” clauses that require accelerated payments to the dealer on the other side of the transaction. The terms vary by contract, and public documents don’t give us much detail. But if the credit rating of Detroit or its bond insurers (MBIA and Assured) falls below a certain level, then an accelerated lump-sum payment must be made to the dealer. For some of the swaps, if the governor appoints an emergency manager to oversee the city’s derivatives, payments could turbocharged, too. It’s a dangerous standoff, and we don’t know how to decipher the situation, since the information is not publicly disclosed.
On the other side of Detroit’s derivatives sit Citigroup, JPMorgan, Loop Capital, Morgan Stanley, SBS and UBS. If any or all force their termination agreements, then the city, which lacks the cash to pay them, could be forced to default on its bonds and possibly be put into bankruptcy. This would leave the bond insurers, MBIA and Assured, two firms that are not financially strong themselves, to make principal and interest payments on the bonds they insured.
I argued earlier in the week that Bing should not be forced out of control of the city. I still believe this and know he can be a strong partner with Snyder and State Treasurer Andy Dillon. The media have described this battle as the city against the state, but it is really Michiganders against Wall Street. Unless someone takes up the leadership mantle and rallies all the branches of government to get the city and state through this, then Wall Street will declare victory.
MuniLand Snaps: March 23, 2012
Daniel Berger of Thomson Reuters MMD created this interesting chart comparing municipal bond fund flow data from Lipper and the level of the municipal bond ETF “MUB“. I’m not exactly sure what it’s telling us, but if you have thoughts, please put them in the comments or tweet me @cate_long.
Good Links
Council of State Governments: American lawmakers ride the rails in Japan
Rolling Stone: Matt Taibbi: Gangster banks keep winning public business
Reuters: Flows into US muni bond funds drop by 87 percent this week
Bond Buyer: State and local tax revenues mark ninth quarter of growth
Governor Cuomo has the privatization flu
The governor of New York has announced his intent to ask the state legislature for a new law allowing him to auction off the cash flows of the state’s public assets. Bloomberg reports:
Governor Andrew Cuomo is seeking legislation that would allow private-equity firms to help finance construction of public-works projects, including a new $5.2 billion Tappan Zee Bridge.
The bill would authorize the state to lease bridges, roads and state buildings to help pay for construction, maintenance and operations of infrastructure, said Thomas Madison, executive director of the New York State Thruway Authority. Cuomo doesn’t want to sell state assets, said Karen Rae, deputy secretary of transportation. Carlyle Group LP (CG) and Macquarie Group Ltd. (MQG) are among companies expressing interest in the Tappan Zee.
The Debt Reform Act of 2000 limits the amount of money the state can borrow, and New York is right up against that borrowing ceiling. The Debt Reform Act says the state may only borrow 4 percent of the personal income of the state’s residents, which was $37.8 billion for 2011 (the law only counts debt issued since its enactment in 2000). Currently the state has $32 billion outstanding using the law’s counting method, so remaining capacity is around $5 billion.
I think the governor looked over the state’s books with his staff and got a little spooked thinking about where the Tappan Zee Bridge funding would come from. Maybe the governor’s counselors whispered in his ear that they have been getting calls from the helpful people at Carlyle and Macquarie, who would love to finance some infrastructure. What a relief, the governor might have thought. He could fund this mega-project and not have to fight the legislature to change the law. Instead, he could craft a new law that opens up the state’s public assets to Wall Street and other wealthy investors. They’ve been clamoring to get in, and here is a chance.
Now I can understand the governor’s enthusiasm to offload the cost of infrastructure onto private investors, but the funds to construct a new Tappan Zee Bridge would more likely come from the New York State Thruway Authority than the general financing of the state. The Authority is a public corporation of the state but has no taxing powers. Its debt is not a liability of the state (page 41) and would not count against the state’s debt ceiling. Bonds issued by the Thruway Authority are repaid through fuel taxes and other sources. The Thruway Authority has a debt service limit of $16.5 billion. Total debt service (principal and interest) for the Thruway Authority currently equals $10.7 billion. This consists of bonds that come due through 2032; the payments peak in 2015 and then fall dramatically.
The federal government will lend the state about $2 billion to construct the new bridge, leaving the state to issue toll-backed bonds to fund the balance. There is debt capacity in the Thruway Authority and massive demand among the wealthy of the state for tax-exempt municipal bonds. There is no reason for the governor to create legislation privatizing the public assets of New York State. Although there is not a lot of fiscal space within the current law, there is enough. The governor would serve his citizens more prudently by working with the legislature to boost the Thruway Authority’s borrowing capacity. That would be a bridge to a strong public future for the state instead of pledging the public’s cash flows to multinational corporations.
Muniland’s bad boys
Last week I called Puerto Rico “America’s Greece” partly because of its financial statistics and partly because of its inclusion in the muniland bad-boy list maintained by Thomson Reuters Municipal Market Data. What the bad-boy list tells us is how much the bonds of the weakest issuers trade over the AAA benchmark. To put it another way, that difference is the premium the market charges for the risk of owning these bonds; it also reflects the premium the bad-boy issuers would have to pay to bring new bonds to market. For example, Puerto Rico, currently the weakest borrower on the list, would have to pay 225 basis points more than a AAA 10-year bond to borrow. Given that MMD AAA benchmark closed on Tuesday at 2.33 percent, that would mean an investor would demand a yield of 4.58 percent to buy a 10-year Puerto Rico general obligation bond. Also using Tuesday’s numbers, investors would demand a yield of 3.88 percent to own a 10-year California GO bond. This is how the market works — it punishes the weak.
Studying the chart above and table below you get a sense of the relationship between credit quality and the interest surcharge. The weaker the credit quality — that is, the lower the number or rating — the higher the interest paid. There are other factors that affect the premium, including the tax rates in the state (higher-taxed and wealthier states have lots of demand from their citizens for tax-exempt municipal bonds) and the recent supply of new bonds in the state. But the fundamental bond market truism remains: The riskier you are, the higher the interest rate you pay. In muniland these are the bad boys.
Source: Municipal MarketData, Moody’s Investors Service, Standard & Poor’s Ratings Services, local government budget reports, official statements.
MuniLand Snaps: March 22, 2012
Detroit Mayor Dave Bing talks to Bloomberg’s Mark Crumpton about his efforts to get the city’s fiscal crisis under control. He says that Detroit needs help, not a takeover by the state. Meanwhile, the governor of Michigan, Rick Snyder, has spent the week in Europe on a trade mission and left the negotiations for control of Detroit to his staff.
Good Links
Federal Reserve Bank of Dallas: Why we must end too-big-to-fail — now
Governing: The variation among U.S. state and cities is a mile wide
Cal Watchdog: Special series: Bondholders seek governmental transparency
MSRB: SEC approves display of interdealer yield data on the EMMA website starting Apr. 30
Bloomberg op-ed swings and misses on Detroit
I was a little shocked to read a recent Bloomberg op-ed that eviscerated Detroit Mayor Dave Bing for his failure to agree to any real reforms, even as he petitioned Lansing for funds to avoid bankruptcy for the city. Written by Detroit resident Shikha Dalmia, a senior policy analyst at Reason Foundation, the op-ed basically implies that Mayor Bing doesn’t have the necessary skills or personality to engineer a soft landing for the city.
As I wrote last week, Detroit’s fiscal problems have been well chronicled in the media, but little attention has been paid to the underlying financial issues at stake. Dalmia fell straight into that trap and went for hyperbole rather than reason-based criticism. Her piece is full of errors and smells of condescension.
While you couldn’t tell it from Dalmia’s lede, which said that Bing and city leaders would rather drown than share fiscal oversight of their city, the mayor and city council have been hard at work trying to negotiate a way to share power with the state in a way that does not exclude local officials. Meanwhile, Michigan Governor Rick Snyder has been working to wrest full fiscal control away from Detroit (as reported in the Detroit News):
Snyder last week proposed an agreement that turns control of the city over to a nine-member financial advisory board. Bing has proposed a plan that allows the city more control over its own finances, with the financial board acting in a mostly advisory capacity. Bing and the City Council are negotiating a joint counterproposal to offer Snyder.
At the same time, Bing, as he said in the opening of his State of the City address earlier this month (video above), has been aggressive in slashing city jobs as well as salaries and benefits to close Detroit’s big budget deficit:
My primary obligation is to bring financial stability to our city. I came into office confronted by a deficit of over $330 million created over decades … You have seen the tentative union agreements that my administration has made, which include structural changes for work requirements, benefit concessions and paycuts.
MuniLand Snaps: March 21, 2012
NASA reports: “A huge, lingering ridge of high pressure over the eastern half of the United States brought summer-like temperatures to North America in March 2012. The warm weather shattered records across the central and eastern United States and much of Canada.”
Good Links
Stateline: Republican legislatures move to preempt local government
Bond Buyer: Indigestion hits muniland as supply still too much to handle
Reuters: Weak bond insurers thrashed by muni defaults
Bloomberg: After massive debacle in Jefferson County, JPMorgan uses balance sheet to gain top spot in muniland
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Resident Muniland expert
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Just get the FED to print us all retirement checks instead of only benefiting the banks and their money losing management…They are printing anyway and they are benefiting a select few………