Pension Bonds 101

There has been no shortage of people kicking around previous Stockton City Councils and management for their short-sighted and risky investments, contracts, and bond issues in the twenty years prior to their bankruptcy.  I've kicked them around a fair bit myself, but I also wondered if they understood all the risks they were taking and what kind of financial advice they were getting, if any at all. 

That sent me back to look at some old City Council meeting where the decisions about bonds were made, and I was stunned at some of the financial information that was presented to the Council. 

Most notably, there was a special City Council meeting on August 31, 2006 where Lehman Brothers representatives gave a lengthy presentation called "Pension Bonds 101" to the city council as part of their pitch to underwrite a pension obligation bond issue for the City. 

I have described the presentation as deceptive and misleading, and that is now getting a lot of attention by some folks in the press.  It was deceptive, but I suspect pretty typical of the time. 

The presentation described some risks, but ignored several important risks.  In particular, it ignored the enormous market timing risk of pension bonds, the lack of flexibility with bonds compared to alternative strategies such as increasing contributions to CalPers, and that issuing the fixed bonds would likely mean even bigger cuts to services in the event of a large downturn in revenues (which is probably going to be correlated with a bad investment returns from CalPers, compounding the problem). 

Even the risks they did describe, that there was a chance that CalPers 30 year returns would be less than the roughly 5.5% interest rate on the bonds, was downplayed and unquantified.  Lehman also incorrectly stated that the City was "exchanging liabilities" and said the transaction was akin to "refunding" (refinancing) an existing bond.  That statement is crazy and is like saying there is no difference between a) refinancing your first mortgage at a lower rate and b) getting a cash-out second mortgage and investing the proceeds in the stock market.

Finally, they sold the benefit of the bond issue as a budget solution, boosting short-run cash flow and specifically sold the bonds as a superior substitute for other actions to reduce future pension burdens such as contributing more to pensions or cutting benefits (i.e. actually reducing the pension liability).  This makes you roll your eyes when you now hear the pension bond promoters saying the city should now cut pension benefits and city services after their financial contraption didn't work as described.  

That doesn't mean the City has no responsibility or that I agree with the City's "ask" that they should not pay anything further on the pension bonds.  The City wants to stop payment on the General Fund portion of the bond because it is "unsecured" by collatarel, even as they retain the remaining funds invested with CalPers from the bond proceeds.  Although the bonds are unsecured and the city is bankrupt, that still seems too extreme, even considering the City's desperate financial straits.  The City would make a profit from this bond issue since the assets they purchased with the bond proceeds are still invested with CalPers.  My initial thought is that the "haircut" received by the bond holders should be proportional to the harm endured by the City from the bond issue and the losses to other creditors.  This would probably be something in the neighborhood of 30% not 80% of principal. That isn't going to be enough under the City's initial proposal, but I think it would be enough of a concession that the City can successfully go to voters for a sales tax increase and have a sustainable path out of bankruptcy. 

My issue with the bond insurers is their outrageous rhetoric that everything is the City's, unions, and CalPers fault, and they should take no loss at all.  They are even contesting the legitimacy of the bankruptcy filing itself adding unnecessary costs and pain to the process.  They appear numb to the severe problems in the City, the severe losses already taken by its employees and citizens before bond holders took any loss, and are blind to their bonds' contribution to the entire mess.  The fact is that they took on a huge risk insuring a 2007 bond issue by the City of Stockton and underwritten by Lehman Brothers, two financially shaky, risk loving entities ultimately driven to bankruptcy by the recession.  It was clear when they issued the insurance that the City leaders did not understand the risk and Lehman brothers understated the risks and their consequences to the City.  It was also clear that the City's real estate market was already collapsing and budget problems were imminent at the time they insured the City's 2007 bond issues.  The bond insurers did an awful job of evaluating risk, and that is what causes insurance companies to lose money.

(9/10/12: Made a few minor grammar and clarification edits.)

You don't hear this often from the Chamber of Commerce

As evidenced by the Governor's news conference, rationalizing the expense of the Delta tunnels causes people to say all sorts of strange and contradictory things.  This passage from LA Chamber of Commerce President and a prominent Silicon Valley business leader in the SF Chronicle startled me as much as Governor Brown's blunt comments.

The public water agencies that rely on delta water exports would pay for the new project, so the final proposal must make business sense for them. The same holds true for the state and federal governments, which would invest in habitat restoration.

Huh? Government agencies want to issue billions in debt and spend ratepayer and taxpayer money on a big project; thus it must make business sense since government agencies in California want to do it.

This is the logic of the LA Chamber of Commerce and the the Silicon Valley Leadership Group? It sure isn't what you typically hear at a Chamber of Commerce breakfast.

Is this no longer the state where local governments are declaring bankruptcy?  Is this no longer the state with the nation's lowest credit rating?  Is this not the state that just passed a budget that proposes cutting 3 weeks off the school year if the highest in the U.S. income and sales tax rates are not further increased?  Aren't some of these agencies $500 million behind in repaying interest-free federal loans that were made 50 years ago? 

Beyond the surprising faith in the business planning of government bureaucracies, the statement is factually wrong about the willingness of these government entities to pay. Many of those public agencies have openly expressed doubts about whether they want to pay for this revised plan with sharply reduced water supplies, and the water bond that would pay for habitat restoration is seen as so unlikely to pass it has been postponed twice. 

[The rest of the article had facts wrong, but I expect the chamber of commerce to say things like levees are dissolving.  I do not expect them to say there is no need to question the financial acumen of government agencies.]