Archive for the ‘pensions’ Category

The Grand Jury of San Diego issued a report of this title yesterday.  Also, at yesterday’s GFOA (Government Finance Officers Association) business meeting, the group voted  that the Government Accounting Standards Board should stay away from the topic of sustainability.  The only conclusion one can draw from the Grand Jury report is: the city of San Diego’s current trajectory is UNSUSTAINABLE.  Here, are a few choice passages (please read as if these too, were fully capitalized):

The City has yet to articulate structural solution to close the multi-million dollar budget deficit in fiscal year 2010.  More than 50% of this gap in financing was filled by using one-time solutions, such as skipping reserve payments and deferring projects.

In summary, this investigation is presented to the City and its citizens because the status quo is not going to resolve the crisis of financial instability, unbalanced budgets and reduction of the city’s obligations, liabilities and debts.

One of the underlying causes of the current structural budget imbalance is the underfunding of the City’s pension obligation by previous City administrations.

Ok, we know this.  This is true among states and municipalities across the country.  But what to do?  In some (not all) places the pitch of the problem has reached a scream – CONTINUING GOVERNMENT OPERATIONS ARE UNSUSTAINABLE.  Amazingly, the choice to cut critical services has become the lesser of two evils – the other being pension and benefit reform.  Elected officials, charged with managing cities like San Diego would rather have fewer cops, less trash pick-up, deteriorating infrastructure and higher taxes, than deal with runaway benefit spending.  Even if you believe that the benefits are deserved, earned and righteous, the city simply does not have the resources to pay these costs and also maintain a livable city.  So what’s the decision?  Give up the livable city?  The City’s Independent Budget Analyst stated:

Structural deficits require structural solutions.

The report suggests using the federal bankruptcy courts to determine what can and cannot be restructured.  Investors, along with public employee unions (strange bedfellows) hate this solution and prefer to stay in one-shot-land, or stand by while the deterioration mounts (see stories on Vallejo’s increasing crime.)  The courts could also decide to trim back debt obligations in the same restructuring process.  This has happened in Vallejo, where there is a moratorium on debt service payments (at least with the current intent of re-paying in full at the end of the moratorium period).  Vallejo’s bankruptcy tackled the city’s ability to reject union contracts, a key step, but they did not touch the pension issue.  The San Diego Grand Jury suggests a bankruptcy court could help sort out this benefits conundrum.

Finding 26: A proactive dialogue as to the efficacy of a Chapter 9 reorganization cannot be removed from any discourse as to the City’s financial health

Finding 27:  A Chapter 9 filing would result in a federal determination of which fringe benefits and collective bargaining agreements could be restructured.  The fringe benefit total is $423.7 million, according to the FY 2011 Proposed Budget.


The 2009/2010 San Diego County Grand Jury recommends that the Mayor of the City of San Diego and the San Diego City Council:Convene a panel of bankruptcy experts to discuss the legal and financial ramifications of a Chapter 9 declaration of bankruptcy, in the context of a publicly noticed City Council or Council Committee meeting. 

In this context, the municipal credit analyst, the investor and the taxpayer, need a new tack on fiscal review.  Unfunded pension liabilities must be included as a long term debt in debt ratios.  The rating agencies discuss these burdens but they are not included in the numbers. Medians that include all long term and contractually obligated costs should be developed to correctly compare cities and identify outliers like San Diego Vallejo.  The long term cost of these obligations should clearly be disclosed so that ratios may be calculated.  For example, red flags of fiscal trouble are waving fervently in San Diego’s case and the Grand Jury mentions Vallejo as well:

In 1994, the city’s budget for pension expense was 6% of payroll cost.  Today, sixteen years later, the cost is 28% of payroll, and growing.

For FY2009, the City’s fringe benefits rate was 52.5% of budgeted salaries of $728 million (IBA Report #09-10 issued February 24, 2009, p.2).  On average, privately operated companies spend 35% of budgeted salaries on fringe benefits. 

Some 76% of Vallejo’s operating budget went to salaries and benefits.  The norm is 50%.  Pensions were not an immediate issue since Vallejo had funded its pension obligation.  Vallejo’s most significant liability was $135 million of unfunded health care.  Vallejo officials brought the unions back to the bargaining table after the federal bankruptcy judge ruled collective bargaining agreements can be voided. 

A few other red flags that can be identified with a bit of extra work:

Is the municipality/state postponing annually required benefit contributions?  Is the government making its “annually required contribution” or ARC?  If not, this will catch up quickly as evidenced in San Diego (see separate post on the state of Illinois)

Are judgments and claims high and increasing?  This points to the government’s poor risk management practices and sloppiness.  This is a low-hanging fruit that cities should tackle with gusto.  The Grand Jury found in San Diego’s case:

Funding of the City’s (self-insured) public liability fund against lawsuits that could drain the General Fund for years to come.  As of June 30, 2009, the City faces $129 million in claims.

Funding the city (self-insured) worker’s compensation fund against outstanding claims, currently estimated at $161 million.

As the press and blogosphere keep telling us, there will be more municipal defaults and bankruptcies.  But there is a difference between painting all securities with the same brush and rigorous analysis.  We believe the flags are identifiable. 

We are coming out of a period when investors bought municipal bonds with their eyes closed.  The mantra that municipals don’t default and the once widespread presence of bond insurance convinced the investing community that analysis was irrelevant.  No more.  On the other hand, Congress has pressured newly contrite rating agencies to upgrade municipals at perhaps the worst time in history. 

San Diego’s GO ratings?  Moody’s: Aa3; Fitch: AA- and Standard and Poor’s: A 

There is a table at the end of the Grand Jury report with a September 6, 2010 deadline for city officials to respond to the specific recommendations.  The Mayor, the City Council, the Retirement System’s administration, the Audit Committee and Independent Auditor are required under the state of California Penal Code to do so. Looks like a busy summer.

See highlighted article about the struggle among a group promoting an initiative to curb costs: covering pensions for new employees’, raising the new employee retirement age and capping the pension formula. The initiative also would prevent the city council from passing retroactive increases (which is what Detroit did in the middle of its fiscal mess).  Looks like the local legislators are letting the taxpayer groups fight the fight with the unions; how convenient.

We have two opposing camps in the muni-market at the moment: those who say it is the next systemic shoe to drop and the rating agencies that are systemically raising ratings.

Which is right?

We have moved from a market that has had heavy intermediation from the bond insurance companies to one where investors are on their own. Bond insurers historically performed heavy analysis and monitoring of the credits they insure and actively affect the legal protections embedded in a security. Bank credit enhancers have done the same, although in some cases their agreements allow them out of the risk under certain circumstances. Rating agencies assign their rating on sale and their business model has never been designed to provide robust monitoring of issuers in the secondary market. The Moodys and other agency default studies covered this time period – a relatively prosperous period from 1970 – 2007 when pending defaults on the investment grade level were mostly managed by bond insurers. Further, the default studies did not include insured bonds.

Municipal bonds do default and have throughout this period –not at all in large numbers by any comparison to the corporate world. Knowledgeable high yield investors are aware the risks in hospital, senior care, land development, and corporate-style tax exempts such as industrial revenue bonds. Project finance, such as the Harrisburg incinerator, Las Vegas monorail and Connector 2000 also carry high risk. (I should add WPPSS and other nuclear power projects to this list.)  These should not be lumped together with the other 30,000 or so municipal bond issuers. Like the stock market, there are many, many nuances among borrowers. Only now the investor is left to grapple with his own resources – and the loss of granularity among this diverse and deep market from ratings “re-calibration”.

(Concerning re-calibration of ratings:  As I have said before, lowering corporate ratings to their appropriate probability of default relative to municipals – would achieve the same effect, and be truer to their own research. Instead, the agencies are compressing ratings into fewer categories and eliminating much granularity for investors. But of course the other approach would have been business suicide and harmed many corporate portfolios.)

Within this, market prophets are now generalizing greatly, mostly those who have not spent their careers in this non-standard, messy, sometimes corrupt and poorly understood state and local financial world.

This brings me to some comments on Rick Bookstaber’s recent post. Many of his points are strong and need to be actively debated, but others generalize to the detriment of this very varied marketplace.

Leverage and Opacity. Leverage in the municipal market comes from making future obligations to employees in order to pay them less now. This is borrowing in the form of high pension benefits and post-retirement health care, but borrowing nonetheless. Put another way, in taking lower pay today, the employees have lent money to the municipality, with that money to be repaid via their retirement benefits. The opaqueness comes from the methods of reporting. For example, municipalities are not held to the same standards as corporations in their disclosure.

Agreed. The Tower Amendment should be abolished and municipalities that want to participate in public capital markets and be rated like corporates should be held to the same reporting standard. Period. Would you buy a corporate bond whose disclosure was two years old?

The argument that it’s too expensive and too burdensome for smaller municipalities to achieve transparency can and must be resolved. Technology and know-how exist to achieve this in a cost effective manner. Those municipalities that cannot produce timely and accurate reporting – should borrow locally and not expect to participate in national markets. Or they should not be given (potentially misleading) ratings. Borrowing locally will likely end up costing more than paying the auditor to get the report done in a timely manner.  Hiding behind the “municipals don’t default, so what difference does it make?” argument is so yesterday.

The rating agencies still do not fully incorporate pension and other benefits into the debt statement that produces their debt ratios and medians. Taxpayers certainly do consider these factors. All obligations that are paid from the public purse should be clearly disclosed. Understandably, rating agencies argue that they serve investors not taxpayers. But political risk – unwillingness to pay – clearly reaches back into the investor’s pocket.

Size and potential systemic effects. That this is a big market in the credit space goes without saying.

This is a big market, but is not uniformly systemic like housing.

Diversification. Geographic diversification would give a lot more comfort for municipals if it hadn’t just failed for the housing market. Think of why housing breached the regional barriers. It was because similar methods of leveraging were being employed through the country. So the question to ask is: Are there common sorts of strategies being applied in municipalities across the nation?

In some cases. Given our federal system, each state has its own set of rules for local municipal finance. For example financing infrastructure for housing and economic development is vastly different in structure and credit quality in California (Mello Roos for example) vs. Florida (community development districts) vs. Texas (municipal utility districts).

Bookstaber’s point does apply to the municipal market in several ways. Investment portfolios and cash management are prey to marketers of the security “du jour”. As one of his commenters suggests, Fannies and Freddies could put municipal investments systemically at risk of a federal policy change — affecting many municipal government investors at one time. I would add to this list: securities lending practices among pension plans and other large public funds  (which some practice but others do not).

Ratings triggers on counterparties that create terminations, unwinds and a change in interest rates, basically legal provisions that automatically change the terms of the deal — also create across the board risk for those borrowers involved. Examples include variable rate securities, swap transactions, LOCs and GICs. These structures effectively embed corporate and market risk into municipal credit.

At the traditional fixed income municipal debt level however, there is significant diversification among security types and legal structures – given the 10th amendment and individual state peculiarities.

Gross versus net exposure. The leverage for municipals is not easy to see. It might appear to be lower than it really is because many, including rating agencies, look at the unfunded portion of these liabilities. They ignore the fact that these promised payments are covered using risky portfolios. And not just risky — the portfolio might apply hefty (a.k.a. unrealistic) actuarial assumptions of asset growth.

Agreed. Analysts and investors should incorporate a haircut for unfunded pension and benefit liabilities that use overly ambitious earnings as a discount rate. The debate about “risk free” vs. a historical earnings rates is an important one. Stated another way, this debate points to the fact that public pensions (defined benefit) are irrevocable, guaranteed and must be paid.  How would you invest funds when you could not afford to lose a penny vs. money you are willing to take on more risk? Since pension obligations are long-lived, the counter-argument that earnings over time should be used has some merit as well.   But the inequities between public retirees and the rest have piqued the taxpayer whose 401K and life savings have been subject to market losses.  Also, the “defined benefit” retirees are facing off against the “defined contribution” beneficiaries.  Fairness is an important public good, as difficult as this debate may be.   

Rating agencies. In terms of the work of the rating agencies, here are two questions to ask. First, list the last time they did an on-site exam of the municipalities they are rating. Second, are they looking at the potential mismatch between assets and liabilities, or simply at the net – the underfunded portion of the portfolio.

Absolutely. Maybe they don’t have to do a site visit on each review, but they should disclose the date of their latest full review for each rating, no question. How many of the re-calibrated ratings have been freshly reviewed?

Defaults. Municipalities are not quite as numerous as homeowners, but there certainly are a lot of them. And they have the same issues as homeowners. Granted, they will not pour cement down the toilet before walking away. But they have a potentially equally irrational group – the local taxpayers – to deal with.

Disagree. See my comments above and other blog posts on this site. Municipalities do not behave the same as homeowners. Clearly there are scoundrels and irresponsible politicians who just want out of obligations they did not understand or were misled from the get-go.

Even with debt repudiation talk in the air, it is difficult to file bankruptcy in most states, and default is not a good option for a municipality that needs capital markets access. Plus, as covered elsewhere, given the 10th amendment, bankruptcy does not give the federal courts the same kinds of control over a municipality as a corporate entity.

Keep in mind that the majority of municipal borrowers (like the majority of homeowners) want to do the right thing.

Neither are taxpayers irrational. Protests are explainable. There are only certain states where initiatives and referenda are permissible (and this too has historical roots). There are correlations between rapid growth in taxable assets, public spending increases and taxpayer protest. (I have written about this on my blog and elsewhere.) 

Taxpayers are right to be angry at politicians who are spending their money mainly to buy votes and for poor policy reasons. We need to look at the spending patterns in government and have this debate. How many say, “It’s a pre-election year, of course nothing will get done.” In the private sector, someone with that approach would be fired.

Two important worries Bookstaber hasn’t addressed directly:

Liquidity: There are major liquidity issues at some of the states, quickly filtering down to the local level. At least three states have held back making payments to localities and vendors – California, New York and New Jersey. At some point liquidity markets may stop lending – or the cost will become prohibitive — which will have immediate impact on the economy in those states. Where enough taxes roll in the next month to cover payments, these states will limp along until they are able to cure their structural imbalance or they will hit the wall. While some look for a federal bailout in this situation, a failure to tackle the cure for structural deficits is bad policy. As we learned in recent banking crisis, institutions that require regular market funding for survival will fail in a liquidity freeze.

State solvency: tied to the first point, there is no mechanism in our society to address state insolvency. States, as sovereign entities, do not go bankrupt. There simply does not exist any legal or political institution with the authority to facilitate an orderly reorganization of state obligations. We need to think up objective, non-political structures that put the brakes on spending increases when times are good and that facilitate reorganization when times are bad.

Several states are showing scary illiquidity.  New Jersey’s governor just yesterday impounded funds the legislature had already appropriated and announced a state of emergency.  He stopped short of “declaring” emergency, which would have given him special powers over contracts.  New Jersey comes up high on the list of states with big budget gaps, heavy pension obligations and loudly falling revenues.  New Jersey spending has grown dramatically over the last 25 years.  While there was one state employee for every 86 people in 1982 in the state, today there is one employee for every 60 people.  In the 2000-2008 time period, spending grew 28% on a constant dollar basis.  Debt as a percent of gross state product (adjusted for real 1982 dollars; bear with me) was 11.1 percent in 2008 — among the top ten states, but no where near the US figure of around 60%.  This is not to mention any unfunded pension liabilities plus $1.2 billion borrowing from the US Treasury to make unemployment insurance payments.

Illinois is in the same deep water.  One month ago the state had $5.1 billion in unpaid bills and is delaying payments to vendors by than 90 days.  Crain’s Chicago Business shows columnist Greg Hinz saying its unclear when full insolvency takes place — it just gets slower and slower until business moves out and payroll isn’t met.  

Lets roll back the clock.  The Reagan administration in the early 1980’s proposed the “Program for an Economic Recovery” which devolved programs from the federal to the state and local level.  The action coincided with the end of the 1982-83 recession when the economy took of sharply leaving surplus in many states’ coffers.  For seven straight years state governments increased their budgets 8% each year or 3.2% in constant dollars.   The recession in the early 1990’s left the states poorly positioned to handle the downturn.  Like today, there were mid-year budget reductions, cuts in aid to local government and increases in taxes.  New Hampshire, Rhode Island, Massachusetts, California and Illinois saw ratings downgrades during that time.  Record tax increases led to voter unrest and new tax limitations.  In the mid-term elections, Bill Clinton lost the House of Representatives to a Republican majority.  Newt Gingrich and his party’s “Contract With America” promised 10 bills in 100 days — to further devolve social programs to the states.  Fast forward to the high tech boom in the late 1990’s and bust, then 9/11.  There was monetary easing and policies designed to advance homeownership and voila, here we are today.  I’ve linked two charts that show state spending increases in constant dollars sorted from high to low state expenditure table1992-2000 and state expenditure table2000-2008.  California, for example, held the line during the “Contract with America” years, but expanded 29% between 2000-2009.  Rhode Island also held the line during the first period but grew 30% from 2000-2008.  Illinois grew its budget in constant dollars in both periods — 22% from 1992-2000 and another 20% from 2000-2008.

Also attached is a power point of a talk I gave this week on these topics at the National Federation of Municipal Analysts advanced seminar in Florida.

Further to our discussion of Detroit’s pension, we see that Missouri’s public pension is in a lawsuit with State Street Bank over their securities lending program.  These programs are intended to act like demand deposits — but the dollars are huge, so any movement of large blocks of funds are likely to affect liquidity.  What with pension plan losses on long term real estate and recession related securities, the plans may well be putting more pressure on the banks and borrowers to get their monies back.

The city of Detroit does not need another financial setback.  With unemployment topping 17% and ever increasing short term borrowing, the city is under an immediate survival imperative to cut spending or face insolvency.  State revenue sharing is being cut in the recent budget.  Local taxes, including the casino wagering tax are falling. 

The good news is that the city’s pension funds are nearly full, largely due to proceeds from the pension obligation certificates of obligation (COPs) that the city sold in 2005 and 2006.  Unlike Providence, Rhode Island or Dover, Delaware whose public employee pensions are less than 40% funded, the Michigan state constitution requires that pensions be funded.  This includes current contributions and the filling up unfunded liabilities through annual payments over thirty years. 

Full funding wasn’t always the case.  Despite the state law, the city’s two funds (police and fire and general retirement: PFRS and GRS) were significantly underfunded at the beginning of the decade.  The UAAL or unfunded actuarial accrued liability, approached $1.0 billion.   Trustees of the Police and Fire Retirement system sued the city in 2003 and 2004 to get them to fund the UAAL which led to the sale of the certificates.   In 2005 the city sold $536 million taxable pension certificates and then sold $936 million in 2006.  What seemed like a good idea at the time, the city also entered into two interest rate swap arrangements which the counterparties had the right to terminate on downgrade of the city’s rating below investment grade.  (The swaps are with UBS and Seibert, Brandford, backstopped by Merrill Lynch; FGIC and Syncora insure the certificates and swap agreements.)  When the city’s credit rating was downgraded this summer, they faced termination payments in the range of $300-400 million.  In exchange for not terminating the swaps, the city agreed to pledge first monies from its casino wagering tax to payment of the swaps.  New conditions that would trigger a termination were drafted including further ratings downgrades, a fall in the tax below 1.75X coverage or a bankruptcy filing.  The agreement is being celebrated as a “deal of the year” by the industry trade publication, the Bond Buyer – a bittersweet celebration given the city’s dire fiscal condition and loss of flexibility to use the wagering tax for other purposes.

Since the COP’s were issued two events could put the retirement systems out of kilter again.  First, retirees petitioned the city for an increase in benefits.  Older retirees felt that they were unfairly being paid less than more recent retirees.  In January, 2008 the city approved a change in the payment formula for older retirees.

Second, like most other investment plans, the pension systems had a significant loss of value in the last two years.  The police and fire retirement audit shows a $506 million decrease in net assets – and this includes about $1.0 billion assets whose value (approximately 25% of the system’s net assets) is determined by management without audit.  The GRS showed a drop in net assets of $429 million in FY2008, including about $1.0 billion valuation done by plan managers without audit (about 29% of net assets).  Add to this the fact that most pension systems assume 8% returns on invested funds an unlikely target.  Hopefully the recent market rally has filled the bucket a bit.

A recent actuarial study (as reported in the Detroit Free Press) showed that if the investment environment does not change, the police and fire pension contribution would have to increase to 50% of payroll (from 25% currently). The police and fire system audit included 8510 members receiving benefits and 4,179 active members.  The General Retirement system has 11,420 members receiving benefits and 9,361 active members.  There were also 2,000 terminated members not yet receiving benefits. 

The city is dependent on the retirement systems to be well managed or there are major budgetary consequences for the city.  The Detroit Free Press has run a series of stories covering excessive travel spending and some questionable alternative investments that the pension fund Trustees have made. 

While we are not equipped to comment on the quality of funds management we turn our attention to another practice that could introduce risk: securities lending.  Concerned about the risks that securities’ lending embeds in the financial system, the SEC held hearings at the end of September.    Losses on collateral and cash re-investment practices were key issues addressed.  Securities lending is a common practice of many large pension fund (and mutual fund) operations.  This large practice (estimates range from $2-3 trillion) grabbed attention when Lehman Brothers went belly-up and its collateral became nearly worthless.  Detroit’s pensions cited a total of $46 million in unsecured Lehman notes held as collateral in their funds.  How Detroit’s pension systems value this paper will not be disclosed until the next audit.  The losses are small relative to the size of the funds.  More troubling is the fact that the systems determine the market value of the whole securities lending program themselves without benefit of a review by the auditor. 

There is virtually no transparency or disclosure by pension funds about their collateral policies and reinvestment practices.  Basically a fund lends securities (U.S. government securities, corporate fixed income, corporate equities, etc) that are idle in exchange for collateral.  The collateral is supposed to be no less than 102% of the loan and good practice dictates daily marking to market.  This process is a way for broker-dealers to maintain liquidity and have the securities they need available for settlement.  In exchange, the funds make a bit of extra money on the securities they already own. 

The lender or its custodian or lending agent will typically re-invest the cash collateral.  While this is a common practice among fund portfolio managers and their agents, few municipal analysts look beyond a system’s UAAL.  Given the serious liquidity problems in short term markets over the last two years, a fund’s lending practices, collateral valuation and re-investment policies could introduce unexpected losses.  A municipality’s budget or taxpayers will ultimately have to make up the difference. 

In mid-October the Detroit City Council approved an additional short term lending for the city, maxing out its authority for the fiscal year.  The fiscal analyst’s office presented the following:

…What is troubling about this scenario is that if Council approves the TANs (tax anticipation notes) sale, the monies would be used essentially to pay off another short-term borrowing.  That is like opening up one credit card to pay off an existing one…In addition these TANs would be sold in November, which is to my knowledge since 2005, the earliest time short-term borrowing notes would be sold during the fiscal year….This would be fine if the notes were paid off in the same fiscal year….But in the City’s case, we are now looking to borrow short-term money earlier in the fiscal year that would be paid off from anticipated receipts during the next fiscal year

Further reading:

The International Securities Lending Association has some good “best practices” pieces on their website:

The Center for Retirement Research at Boston College recently published a survey of funding levels of major U.S. public pension systems

An excellent review of the consequences of our aging societies was done by the McKinsey Global Institute: