How bankrupt Stockton, CA was sold pension obligation bonds

September 7, 2012

Mary Williams Walsh of The New York Times recently dove into the issue of pension obligation bonds (POB), and she came up empty-handed. In her piece on bankrupt Stockton, CA’s POBs, Walsh relied on the analysis of an academic, Jeffrey A. Michael, with little background in municipal bonds, to claim that Stockton was duped into issuing $125 million of these bonds in 2007. Michael contends that the POB underwriter, Lehman Brothers, did not adequately disclose the risks associated with issuing POBs. Walsh writes:

After reviewing an analysis of the bond deal, underwritten by the ill-fated investment bank, Lehman Brothers, and watching a recording of the Stockton City Council meeting where Lehman bankers pitched the deal, Mr. Michael concluded that “Stockton is entitled to some relief, due to deceptive and misleading sales practices that understated the risk.

Lehman Brothers just didn’t disclose all the risks of the transaction,” he said. “Their product didn’t work, in the same way as if they had built a marina for the city and then the marina collapsed.

This “analysis” fails on so many levels that it is hard to know where to begin. The Stockton City Council special meeting on August 31, 2006 where Lehman made a presentation about issuing the POBs contains a broad discussion of the risks by the Lehman representatives, city council members and city officials starting. It starts at about minute 25 of the video here.

Lehman representatives made it very clear that issuing POBs is a method of swapping one liability – unfunded pension costs owed to CalPERS, California’s statewide pension system – with taxable municipal bonds issued to investors. Furthermore, and most crucially, the Lehman representatives explain that issuing POBs at an interest rate of 5.81% will replace payments due over 30 years to CalPERS that would be charged a 7.75% annual penalty rate to catch up. There was a discussion that the rate of return that CalPERS earned on its investments was a separate issue from Stockton catching up its outstanding unfunded liability.

Lehman bankers would have known that presenting in an open public meeting would mean that they would be recorded, and it’s hard to imagine them speaking falsely or misrepresenting the risks of a proposal.

Walsh leaps from the situation in Stockton to claim that all POBs are generally unsuitable for state and local governments. She uses a report from 2010 that cites 2009 pension returns, which were slaughtered by the financial crisis, to sound the alarm. In fact, a report from the Center on Retirement Research (page 4) is in dire need of 2012 data before conclusions are drawn (emphasis mine):

If the [POB performance] assessment date is the end of 2007 – the peak of the stock market – the picture looks fairly positive (see Figure 3A).  On the other hand, by mid-2009 most POBs have been a net drain on government revenues (see Figure 3B).  Only those bonds issued a very long time ago and those issued during dramatic stock market downturns have produced a positive return; all others are in the red. While the story is not yet over, since about 80 percent of the bonds issued since 1992 are still outstanding, some may end up being extremely costly for the governments that issued them.

No recent analysis has been done on POB performance. Daniel Berger of Thomson Reuters Municipal Market Data published a report detailing the level of issuer concentration of POBs. It turns that state governments, usually Muniland’s most sophisticated public participants, have issued the bulk of POBs; more than small local governments:

Illinois is the leading issuer of POBs. It accounts for more than 40% of the POBs issued during the past ten years. That is due to the fact that the (A2/A/A) State of Illinois has issued $19.7bln of POBs, which comprises approximately 36.5% of the POBs issued.

Illinois used the proceeds from the POBs to pay a large portion of the state’s statutorily mandated payments to its pension system. The first issue was sold in 2003, and since then there have been several sales providing Illinois immediate budgetary relief in those years by providing additional funds to address the state’s unfunded pension liability.

Berger also references Walsh’s New York Times piece:

A national newspaper recently addressed the issue of POBs in great detail. According to this account, “thousands” of state and local government issuers may have been pitched this idea. While the problems faced by many of these POB issuers are serious, there is a fairly narrow universe of issuers who have utilized this financing vehicle. We cannot address the aforementioned uninformed speculation, but we know that only 355 issues of POBs have been sold in the past ten years. If we assume that a few issuers have engaged in more than one sale, then there are perhaps only 200 issuers with outstanding POBs.

Still, POBs have not lost their appeal in a low interest rate environment. The Bond Buyer reports that the state of Kentucky is considering a $4 billion POB to catch up its underfunded pension plans:

With Kentucky’s unfunded public pension liability at more than $30 billion, a legislative task force has begun examining how to reform its systems and close the unfunded gap. A number of organizations and unions are urging lawmakers to recommend issuing up to $4.3 billion in pension obligation bonds to reduce the unfunded liability, in addition to other measures.

The likelihood that Stockton, CA was duped into issuing POBs is far-fetched. The Stockton city manager says in the council meeting that he had searched Google for “POBs” to study their advantages and disadvantages, which does not prove deep knowledge of the instruments, but suggests that they were at least on guard against a bad deal. Indeed, states and cities have been sold inappropriate products, but without direct instances of fraud in Stockton, it and other municipalities should not be allowed to walk away from their liabilities.

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