Thursday, June 28, 2012

To what extent is Wall Street responsible for Stockton's bankruptcy?

It has been said by many, including me, that no one has enough fingers and toes to point at the people who are responsible for the poor and risky decisions that put Stockton into it's mess.  It is true, and that is just looking at twenty years of City officials.  But what about Wall Street and the investors who financed the City's toxic bond sales?  Are they responsible too?

By far, the largest of Stockton's bond issues and its most disasterous is a $125 million pension obligation bond issued in 2007.  In the 2012-13 pendency budget, the City is not paying $6 million in debt service on these bonds, by far its largest single default.  And this particular bond is backloaded, meaning the payments will rise significantly in future years when more of the principal is due.  The original underwriter of that bond was Lehman Brothers, who collected handsome underwriting fees, after selling the idea to Stockton's city management and ultimately the City Council.

See this 2006 story in the Stockton Record from the special City Council meeting in which former Stockton CFO Mark Moses and Lehman Brothers representatives made their pitch to the City Council to approve the sale of the pension bonds.  I have clipped my two favorite paragraphs from the article, but recommend you read the whole thing.
Now is a good time to address the city's retirement debt because the interest rate the city would have to pay on a bond is lower than the rate of return CalPERS expects to make on its investments, Moses said. Taxpayers could save as much as $4.7 million over 30 years by paying interest on a bond instead of watching its debt increase unchecked, he said.
Alternatively, the city could contribute more money each year to its retirement funds, cut benefits or hope to either earn more on its investments or to see its retirees die sooner, said Rob Larkins of the investment firm Lehman Bros., which presented options to the council Thursday. He said he would not recommend that the city try to increase death rates.  
Update: 2:36 P.M. I just listened to Mr. Larkin's 2006 presentation, and the death rate comment wasn't really as significant as in the article. What is very significant is the way he presented the deal. He said "really it is just exchanging a pension liability for a bond liability." That isn't true. The only way to really change the pension liability is to change the benefits themselves, the liability are the promised benefits.  The amount that is "unfunded" is determined by the value of the investments with CalPers and their expected returns. If the bond proceeds were given to employees themselves (perhaps to fund a IRA or 401k type retirement account), and the employees gave up pension benefits (all or a proportional share) in return, then it would be a true exchange of liabilities. The city reduces its risk, and the employees/retirees have more. Instead, the city is depositing the bond proceeds with CalPers to invest and hoping it earns a rate of return higher than their interest costs. It is very simply investing in the stock market with borrowed money. And to make matters worse, the City used a backloaded bond that deferred principal payments. Thus, it was like taking a cash out, interest only mortgage on your house to gamble in the stock market.

Josh Barro explained it well in this Bloomberg piece,
 And a national lesson: Nobody, anywhere, should ever issue pension obligation bonds! Let’s think for a moment about what these really are. They are commonly described as a way of exchanging a pension liability for a bond liability. But really, when a city issues pension obligation bonds, it gets a bond liability and keeps its pension liability -- plus it gains an asset that offsets the bond liability. Typically, the jurisdiction invests the bond proceeds in an equity-heavy portfolio, which may lose value, but the bond liability remains fixed.
If that sounds a lot like buying stock on margin to you, that’s because it is.
In general, pension obligation bonds are sold as a free lunch. That was the idea in Stockton: The bonds bear interest at 5.46 percent while the city was expected to achieve investment returns of 7.75 percent. As such, issuing bonds was supposed to “reduce” the cost of pensions.
But that carry isn’t free. In exchange for a lower average cost, cities that choose pension obligation bonds take on a lot of risk: If the market underperforms, the assets can shrink and become smaller than the bond liability. It’s taxpayers’ responsibility to cover those gaps when they arise, so it’s a big problem that the gaps tend to coincide with weak economic performance and weak tax receipts.
When pension obligation bonds go south, the result is often tax increases and service cutbacks. Stockton shows how, in a worst-case scenario, pension obligation bonding gone wrong can combine with other factors to land you in bankruptcy.

Tuesday, June 26, 2012

Sacramento distressed mortgage rate drops below 10%

It's a bit of a milestone, the % of mortgages that are either in foreclosure process (2.64%) or 90 days delinquent (7.13%) has fallen below 10% in the Sacramento Metro area for the first time since the housing crisis hit.  (See Sac Bee note on the new Corelogic data).

This combined rate peaked at over 15% in 2010 in Sacramento (peaked around 20% in Stockton/Modesto/Merced), so that is significant progress.  At the current rate of decline, it will be down to 5% in 2014, and that is when I think we will start to see a more normal market with rising home values.

Historically, the normal delinquency rate is about 2% (and historically most delinquencies can be successfully resolved when people actually have equity in their homes).

What will happen to Stockton Marina in municipal bankruptcy?

Tonight, Stockton City Council will likely approve a "pendency" budget that will serve as the City's budget during bankruptcy.  The City will likely be officially file for bankruptcy protection tomorrow.

Already, the City has missed payments on 3 bonds, and as a result have already lost 3 parking garages and an 8 story office building (former WAMU building) slated to be the new city hall to creditors.  The pendency budget for 2012-13 completely eliminates debt service payment on several additional bonds and loans; the largest being nearly $6 million due in the next fiscal year on over $130 million in Pension Obligation Bonds that were sold in 2007.  The largest single budget cut is slashing $7 million in retiree healthcare subsidies with full elimination next year.

Now that the City has lost the parking garages and office building, it is particularly interesting to see that happens to any other City owned real estate that has some revenue generating potential for its creditors.  The immediate things to come to mind are the waterfront entertainment venues: arena, marina, and ballpark; all of which are losing money but do generate a revenue stream.

The proposed 2012-13 pendency budget states, "eliminate appropriation for payment of debt service on the State Department of Boating and Waterways Marina loan - $685,000."  However, when it comes to other waterfront entertainment venues (like the arena and ballpark), the city is reducing but not eliminating the general fund operating subsidy.  Thus, the City seems to have signaled that it is more willing to give up the marina than the other waterfront venues.

The State is not seen by Stockton City officials as being particularly helpful with its budget woes due to swiping redevelopment funds, realignment, inaction on pension reform (the City uses CalPers and does not have its own pension fund like San Jose), imposing the AB 506 process on bankruptcy, and sending the Comptroller in for an audit that costs the City time and money.  Add that to the burdens of the Delta Plan (both real and perceived), and I doubt anyone at City Hall feels particularly terrible about defaulting on a loan to a State Agency relative to all the other painful cuts.

Because of bankruptcy protection, Boating and Waterways will not be able to take immediate possession of the marina in the way Wells Fargo sued for the parking garages and office building after default.  I expect the City should continue to operate the marina through the bankruptcy period.

But it will be very interesting to see how Boating and Waterways approaches the loan default, and who will be operating the marina long-term.  DBW is in a tough spot.  Maybe it is another opportunity for American Lands and Leisure which recently took over operations at Brannan Island State Recreation Area.

Saturday, June 23, 2012

Is BDCP a good deal for water agencies? Jason Peltier and David Sunding disagree

In the first part of the BDCP meeting on Wednesday, Jason Peltier of Westlands Water District, the water agency that may have the most at stake in the BDCP, said,
"[The BDCP is] a crappy path for us. This is a crapshoot. Unacceptable... We can't finance it.”
However, in the closing presentation of the meeting, Dr. David Sunding, an economist and principal at the Brattle Group hired by the state Resources Agency, said,
"I think it's really beyond serious debate at this point that the benefits of BDCP to the agencies ... exceed the cost," 
Now that is a disagreement.  It's natural to suspect Mr. Peltier is posturing to negotiate a better deal, and there may be some of that, but I think he is right.

Dr. Sunding went through a presentation that had sophisticated analysis of the usual categories of benefits attributed to the tunnels, a)water supply, b) water quality, and c)seismic risk reduction.  All together, these three added up to about 50 cents of benefits for every $1 in costs to the agencies (using the realistic seismic risk scenario, not the worst case).  So how did he figure that the benefits exceeded the costs for the agencies?

It came from a new category of benefit that was not in his original scope of work with DWR: the value of eliminating regulatory uncertainty.  He put forward a scenario where regulatory assurance was more valuable than all the rest of the benefits combined. $11 billion in one scenario. And he argued that regulatory assurance was the main objective of the agencies in the BDCP process, and a normal component of HCPs under the ESA.  He is right about that.  But environmental lawyers tell me that there are significant limits on the legal assurances in HCPs, and there are serious doubts about whether the BDCP can deliver much regulatory assurance at all due, in part, to enormous uncertainty about the environmental effects of the tunnels.

Thus,Dr. Sunding's conclusion should have been worded "It's beyond serious debate at this point that strong regulatory assurances are required for the benefits of the BDCP to the water agencies to exceed the cost to the water agencies." If he said that, I would agree, and that is very important information for the people negotiating BDCP.  It isn't just posturing, the water agencies really need the assurance in order to seriously consider a $13 billion investment in infrastructure.

With words like "crapshoot", Mr. Peltier is clearly not very impressed with the regulatory assurance in the BDCP.   Apparantly, not many other people are either. I asked a small sample of objective scientists, lawyers, and environmentalists outside the Delta if strong regulatory assurances would or could be part of the BDCP. The responses were "Not a chance", "No way", and "Sunding analyzed a project that is rejected by the regulatory agencies." Maybe there are experts who disagree, but it is clear that Sunding touched on a very controversial topic in the BDCP.  I am pretty sure that any project that might offer some level of regulatory assurance will have lower exports, and thus lower water supply values, than the scenarios he modeled.

I look forward to further debate of the concept of regulatory uncertainty, how much can be provided, and how it should be valued (I'm not buying the $11 billion estimate, more on that later).  But it is important to realize that regulatory assurance isn't very important for statewide benefit-cost analysis.  The regulatory assurance isn't a statewide benefit, it is shifting risk from the exporting water agencies to the environment and everyone else who will have to pay if the tunnels don't work for fish.

The good news is we finally have a rational discussion and debate about economics, and some reliable numbers out in public.  It's about time.  While I disagree with a few parts (mostly with the scenarios he has been given to evaluate), for the most part, I think Dr. Sunding's quantitative estimates are very reliable, and they inform the planning process. Benefit-cost isn't just a pass/fail test at the end of the process. BDCP would have been much better off if they had hired him years ago.

Monday, June 18, 2012

Does American Land and Leisure Know About Covered Actions? (updated 6/21)

Opened the Wall Street Journal this morning, and to my surprise, there was Brannan Island State Recreation Area on page 3 (pictures at link, article behind paywall).

The article about American Land and Leisure (ALL)1 taking over operations for Brannan Island provides enough grist for a series of blog posts.  I will spare you that, but offer a few quick thoughts/observations:

1.  It seems to me that this concession agreement is clearly a covered action that will eventually require a consistency determination with the Stewardship Council's Delta Plan.  [Update: It seems I was wrong about this.  Please click through to comments to read an explanation for why it is not a covered action from Dan Ray of the DSC.] 

2.  If ALL is more successful than state parks at operating Brannan (meaning they don't lose money, take care of the resource, and visitors are satisfied), will that make the realization of the ambitious State Parks plan for the Delta (which includes adding 4 new parks) more likely or less likely?

3.  From the article, it appears that State Parks is guaranteed some payment from ALL (maximum of fixed bid or a percentage) regardless of whether or not they turn a profit at Brannan Island.  If the state can get that kind of return on a park where costs were double revenue, the implications for the system are interesting.

4.  Most importantly, I am very glad the park isn't closing.

Funny for me to see this well written article written by Max Taves, as I have had a few recent conversations with him about Stockton bankruptcy and the regional economy.  I'll have to ask him about his impressions of the Delta.

Wednesday, June 13, 2012

The Delta Plan Approach to Fiscal Responsibility

Capital Project
Analysis Required?
$14 billion
Habitat Restoration
$4 billion
PL 84-99 Levee Upgrades
$0.5 billion

Friday, June 1, 2012

Is the Metropolitan Water District Going to Pay 25% or 75% of the Cost of a Delta Tunnel?

The working assumption of BDCP is that water contractors will pay for tunnel conveyance in proportion to their share of Delta exports.  For Metropolitan Water District, that would be about 25% of the cost, and that is the share they say they expect to pay in their public statements.

However, the financing chapter (8) of the BDCP (page 8-89) declares that conveyance is financially feasible, because the per capita cost of construction is smaller than some recent capital projects built by smaller urban water agencies.  They divide the conveyance cost by the 25 million people who are served by agencies that derive at least part of their water supply from the SWP and CVP to come up with a per capita cost of $508.  This is less on a per capita basis than, for example, San Francisco's Hetch Hetchy aquaduct improvements.  However, it is important to note that Metropolitan represents 75% of the population in this per capita calculation, much higher than their 25% share of Delta water exports and the 25% cost share that they have pledged to pay.  There are many reasons why this per-capita cost comparison is irrelevant, but it has been used by the Southern California Water Commitee, and now it is prominent in the BDCP's own argument for financial feasibility.  At minimum, the per capita cost shouldn't be used at all unless Metropolitan really is supporting a per capita financial plan, which means they will pay 75% of the cost.

As discussed in earlier posts, assuming water exports were to increase by 1.2 maf with a canal (a big if for environmental reasons) as stated in the draft BDCP, the annual capital and operating costs of $1.2 billion in the draft BDCP imply this new water will cost $1,000 af - just to get the untreated water to the pumps near Tracy.  That is very expensive and financially marginal for urban users, and clearly infeasible for agricultural users who receive most Delta water.  [Yes, canal proponents use an average cost of nearly $200af averaged over all Delta exports - including those they will still receive without a canal.  This is a common error made by utilities and boosters of infrastructure mega-projects to promote investments that are not in the best interest of their captive ratepayers.  And the latest rumors are that half this amount of additional water is the best case scenario, putting the marginal cost at a minimum of $2,000 af.]

The reality is that Metropolitan will actually have to pay something close to the 75% cost share implied by the per capita cost comparison for the project to have any chance at being financially feasible.  Even that may not be enough.  Their ratepayers could probably stretch to make the payments (hence making it technically feasible), but it surely isn't a good deal for their ratepayers who have lower cost options.  Most importntly, it is not what Metropolitan has been telling their customers and their board that they are going to pay.