Wednesday, August 29, 2012

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.)

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