MuniLand

Public pension assets reach highest-ever level

The pension doomsayers, who claim that pensions are direly underfunded and losing ground, may be surprised to hear that public pension assets grew to their highest-ever level for the last fiscal year (ending June 30). Strong equity market returns helped propel the national median investment return to 12.4 percent. The whiff of panic about public pensions should be subsiding, except for the ongoing hot spots like Puerto Rico, Illinois and Chicago. Overall, the winds have calmed.

Reuters’ Lisa Lambert reported:

Asset values at U.S. public pension funds rose 8.4 percent in the latest fiscal year to the highest level in more than 40 years, but their costs also rose, the U.S. Census reported on Monday.

Most retirement systems ended fiscal 2013 on June 30. In the final quarter of that fiscal year the cash and securities holdings of the 100 largest public-employee pensions were $2.944 trillion, up 8.4 percent from a year earlier and the highest level since the Census began collecting pension data in 1968.

With asset values increasing, the overall pension funding-level for the 100 largest funds is improving. Reuters again:

Pensions have slowly marched back to health since holdings reached a low of $2.1 trillion in 2009. In fiscal 2013, investments finally surpassed the peak they reached in 2007 before the recession began.

Detroit’s contentious swaps

The proposed settlement between Detroit’s emergency manager Kevyn Orr and the city’s swaps counterparties, UBS and Merrill Lynch, is on the docket this week in federal bankruptcy court where the case is being heard. The Bond Buyer reported:

Key hearings on #detroit‘s swap settlement originally set for this week may be delayed … parties in mediation. http://t.co/iyU2LuEoA9

— Caitlin Devitt (@Devitt_BB) September 23, 2013

Mediation could be a good alternative for the parties because this is a complex element of Detroit’s bankruptcy. Circling around the perimeter of this bankruptcy litigation and mediation is the bond insurer Syncora, which insured both the underlying pension obligation bonds and the interest rate swaps that are part of the negotiations between Orr, UBS and Merrill Lynch. Orr has worked to force Syncora, the bond insurer, out of the picture and essentially leave it responsible to pay off the pension obligation bonds without access to Detroit’s casino tax revenues. Syncora believes that it is legally entitled to access the casino revenues because it insured the pension obligation bonds, which have a cross-default covenant with the swaps.

A pension system that swings with investment returns

Although the media is full of hair on fire stories about the level of funding in public pension funds some of the funds are in great shape. State run pension systems like the North Carolina Local Government, Wisconsin Retirement System and numerous Washington state funds have extremely high funding levels, near 100 percent in the latest figures from 2011. Each plan has different state funding requirements, retiree benefit schemes, asset mix and projected investment returns. But each plan has been prudently managed, and, most importantly, excessive benefits have not been promised to retirees.

Almost every public pension has a “defined benefit” structure, which means that the benefits promised to an employee upon retirement are a fixed amount and may also have mandated annual inflation increases. The pool of assets that these benefits are paid from fluctuates in value from year to year and state and local governments are responsible to make up any funding shortfall in the plan. This structure, where the government is responsible for all shortfalls, is what has caused large and accelerating government contributions to make up for investment losses from the 2001 and 2008 financial crises. And when governments have to unexpectedly increase pension contributions it crowds out funds that would have been used for education or other social services. Or taxes must be raised.

Unique among state pension funds, the Wisconsin Retirement System is structured as a “defined contribution” fund where everyone, taxpayers, employees and retirees share the risk that the fund will not achieve the returns necessary to fully fund pensions. Wisconsin is structured like a giant 401(k) for its members with steady contributions from the government and employees but the annual payout to retirees varies according to how well the fund is performing. Institutional Investor describes it:

How much profit can non-profit hospitals make and be tax exempt?

I’ve been involved in a local community effort to downsize a large proposed hospital expansion in my tiny historic village, Rhinebeck, New York (population 2,657). It’s been very interesting because it exposes many of the issues that I’ve long studied and thought about. There is the broad issue of what level of profitability hospitals can have while still being tax exempt from property and corporate income taxes. There are issues around the levels of executive compensation. And most interestingly is the question of non-profit hospital being used as shells for profit-making entities. And what does all this do to their status as tax-exempt institutions?

The Illinois General Assembly studied the issue of setting some standards to determine if hospitals were operating as non-profits, but their hospital lobbying group derailed the legislation. The practice of sheltering for-profit activity is beginning to be studied because it reduces state and federal corporate income and property tax collections. Local governments generally rely on property taxes for 50 percent or more of general fund revenues and exempting hospitals from property taxes can place an enormous burden on taxpayers.

The Internal Revenue Service has been grappling with the issue of profitability and tax exempt status for non-profit hospitals. In its most recent study, in March 2013, it surveyed 500 nonprofit hospitals nationally to analyze the ratio of revenues to expenses to get some sense of profitability. The numbers varied but the IRS determined that profit or median excess revenue (operating revenues minus operating expenses) for hospitals with total revenue below $250 million was 3.8 percent (page 27):

Puerto Rico mired in troubling economic news

Some Puerto Rico bonds traded with yields north of 10% yesterday, again on no new news. That’s a federally tax free 10%.

— Rochester Funds (@RochesterFunds) September 10, 2013

Most financial reporting about Puerto Rico in the U.S. is centered around its skyrocketing bond yields and the announcement from the government’s fiscal agent, the Government Development Bank, that it will scale back their borrowing in the municipal bond market this year. But there is not much reporting about the underlying economic conditions of Puerto Rico. These conditions have a lot of bearing on the ability of Puerto Rico to service the massive debt load it carries. Reuters Miami bureau recently filed a piece about emigration from the island and its effect on the weakening economy:

For generations, Puerto Ricans have been migrating to the mainland United States in search of a better life. But the Caribbean island’s long recession has turned a steady flow into a torrent, stripping the territory of its young and educated population and pushing its economy into a deeper rut.

Does America need to support credit rating agency competition?

The implosion of the global credit bubble in 2007 and 2008 laid bare the inflated credit ratings on several trillion dollars of US structured finance products. These inflated ratings were a big contributor to the creation of a global credit bubble. In many cases these AAA securities suffered major principal losses as the underlying mortgages defaulted at rates that had never been modeled or even imagined. Bill Gross of Pimco famously said in 2007:

“AAA? You were wooed Mr. Moody’s and Mr. Poor’s by the makeup, those six-inch hooker heels and a ‘tramp stamp,’” Gross said in his monthly commentary posted on Pimco’s website today. “Many of these good looking girls are not high-class assets worth 100 cents on the dollar.” 

Following the global financial collapse, the agencies that assigned these ratings were lashed in Congressional hearings and saddled with more regulation via Dodd-Frank. Foreign governments kicked their regulatory engines into gear and begin crafting new frameworks for regulation of raters.

Pennsylvania’s worthy debate over swaps

It was a mixed picture as Pennsylvania Senate Local Government Committee took testimony today about how local PA governments issue debt and enter into interest rate swaps. Has every local government in Pennsylvania made as big a mess issuing debt as Harrisburg? Was every school district bamboozled into multiple layers of expensive and unnecessary interest rate swaps like the Bethlehem School District?

Philadelphia Treasurer Nancy Winkler assured Committee Chairman John Eichelberger that the city had reined in its swaps portfolio and was mostly assuring members of the committee that Philadelphia would not suffer substantial losses from swaps. She was fighting off legislation that would have banned Philadelphia from entering swap agreement. The Philadelphia City Council passed a resolution asking the General Assembly to ban the city from the practice.

Meanwhile the former Auditor General of Pennsylvania Jack Wagner, in standout testimony, used former government official Larry Summers as an example of how risky interest rate swaps are:

Rockland County is sinking

There is the idea in muniland that all state and local governments balance their budget at the end of every year. But the reality is a little messier because governments often do short term borrowing from Wall Street. The Federal Reserve reports $54 billion of short term municipal borrowing in the first quarter of 2013, at least part of which is used as deficit financing. Cities and states also borrow internally from other government funds, like a water fund, to balance the general fund. That is what sunk San Bernardino, California, which sucked money from its external funds to paper over huge deficits in the general fund. That story ended with San Bernardino in bankruptcy.

Rockland County, New York is running an accumulated $125 million deficit and awaiting approval from New York governor Andrew Cuomo to issue a $96 million long term bond to shore up its general fund budget hole. The State Legislature approved the borrowing in June but the governor has not moved to sign the law. His counsel continues to study the legislation. The county’s accumulated deficit comes from failing to raise taxes, the public unions’ unwillingness to renegotiate labor contracts and the county’s support of the county nursing hospital which runs large deficits. The Journal News tells the story:

Since 2012, Rockland officials have viewed [long term] deficit borrowing as a way to avoid the stopgap trips to Wall Street two or three times a year, during which time Rockland rolls over its debt with short-term borrowings. The county pays the interest and lucrative fees to outside attorneys, but never touches the principal.

Bridging the wholesale – retail market divide

One of the most difficult issues related to improving the structure of bond markets for retail investors is that wholesale trading happens entirely apart from retail trading. Retail investors suffer because they pay much higher prices than institutions do. This differs from equities markets where every investor, large or small, can buy a share of Google at the same price at the same time.

In muniland, we have institutional trading platforms like Tradeweb and MarketAxess and retail platforms like Bonddesk and The Municenter that execute “odd-lot” trades or generally those under $100,000. Institutional trading desks and platforms typically execute orders over $1 million and the two pools of trading don’t interact. This structural difference creates two sets of pricing; one with thin spreads for institutional clients and the other with enormous bid/ask spreads for retail clients. 

Two tiered bond pricing differs from the equity market where buyers and sellers of all sizes meet at the same place via the consolidated trade and quote tapes. For equities, institutional and retail size bids and offers flow onto the consolidated tape. These are aggregated by various systems into central order books. You can see all bids and offers at a certain level and their size. This helps pricing for a security remain in lockstep regardless of the trade size. There is no equivalent in muniland or the corporate bond markets. For most of the bond market this would be hard to do because individual securities trade so infrequently. But one part of the bond market is liquid enough to mimic the way equity pricing systems work. This is the $16 trillion U.S. Treasury market, the most liquid bond market in the world.

Puerto Rico’s borrowing goes private

Barron’s ran a cover story last week and more articles followed in the financial press about the economic disabilities of Puerto Rico. These disabilities have been fueling a sell-off of the commonwealth’s public debt. Here is a chart showing the spread (or extra yield) that Puerto Rico bonds have had over the last three months:

You can see that the 20 and 30-year bond spreads have been rising since early June in a consistent pattern. This may be related to mutual funds selling their long Puerto Rico bonds. Thomson Reuters Municipal Market Data senior analyst Daniel Berger describes the situation:

Because Puerto Rico bonds are triple tax they are widely held by some well-known mutual funds. The wider spreads in these names have lowered prices of these muni mutual funds that rely on Puerto Rico bonds for higher income (very important in a low interest rate environment.)

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