MuniLand

The real history of public pensions in bankruptcy

There appears to be a frenzy of comments lately that public retirees receive excessive pensions in the current economy and that they need to be reduced. Many in the media have taken a brief look at Detroit and decided that costly pensions were the cause of the city’s bankruptcy. Nothing could be farther from the truth. Detroit pays a relatively modest median pension of $19,000 a year to general government retirees and $30,000 to police and fire retirees. Detroit’s pension system was funded at 82 percent in 2011 (and at 99 percent for its police and fire retirement system). That is higher than the national median of 74 percent. But public benefits make easy targets for critics. Let’s take a tour of pensions in bankruptcy through the years.

Attorneys Kenneth E. Noble and Kevin M. Baum describe Prichard, Alabama:

Prichard, Alabama, which experienced a population decline of approximately 50 percent over the past 50 years, filed for bankruptcy in 1999 after it was unable to pay approximately $3.9 million in delinquent bills. In addition to the unpaid bills, Prichard also admitted to not making payments to its employees’ pension funds and, even though the city had withheld taxes from employees’ paychecks, the city failed to submit such withholdings to the state and federal governments.

While in bankruptcy, the city successfully revised its budget so that it no longer operated at a deficit. However, Prichard was still unable to meet its pension obligations. In 2009, Prichard filed for bankruptcy for the second time in order to stay a pending suit brought by its pensioners after it failed to make pension payments for six months. In its chapter 9 petition, the city claimed that during the previous year it had operated a $600,000 deficit on its $10.7 million budget. Further, Prichard had failed to make a $16.5 million payment to its pension fund under its previous plan of adjustment.

Prichard, although it filed for bankruptcy in 2009, has not yet met the court’s eligibility requirements and pensions have not been paid, leaving retirees to struggle:

Central Falls, Rhode Island’s bankruptcy is described in Benefits Pro:

The saga began in August 2011, when the city of 18,000 declared bankruptcy. Myriad woes stemming from an industrial economy in decline helped cause the problem. When Central Falls declared bankruptcy, it had a debt of $21 million, an unfunded pension liability of $80 million and an annual budget of $16 million against $21 million in expenditures. Something had to give.

The looming battle between Chicago and Illinois

 

The bankruptcy filing of Detroit has thrust the fiscal health of America’s cities into the spotlight. This is a good thing, because a number of U.S. cities are facing similar problems: Declining populations, rising costs, heavy pension burdens and thin budgets.

Detroit’s pension troubles are not a major contributor to the city’s insolvency, in my opinion, but many are going on to question Chicago’s large pension challenges.

Chicago is in a unique situation where, burdened with enormous pension costs, it is unable to adjust current pension commitments. This is because the State of Illinois has control of the law that applies to Chicago’s pensions. This may sound odd, but it is how muniland works. In addition to state capitols passing revenue to local governments, they often have significant control over the disposition of local finances.

The deafening roar has subsided

The recent sell-off in fixed income markets, led by the decline in U.S. Treasuries, was big by historical standards. Here the Federal Reserve Bank of New York compares past Treasury bond sell-offs with the most recent one. The recent rout was much deeper and more sustained than most in history.

If we drill down a little deeper into muniland, we see some interesting patterns. Using index data from Standard & Poor’s and Morningstar we can see how July and year-to-date losses compare for various classes and maturities of bonds:

Treasury bonds were hardest hit this year-to-date. Long-dated Treasury bonds had a loss of over 7 percent for the year. Short muni bonds squeaked out a small gain, while long munis suffered. Long corporate bonds fared slightly better.

The return of the bond vigilantes?

On Thursday, a small municipal bond deal for a Michigan county was postponed due to “lack of investor interest.” This is unusual, given the yield premium offered on the bonds. The Wall Street Journal has the story:

In the most tangible sign of fallout from Detroit’s bankruptcy filing, a Michigan municipality postponed a $53 million bond sale as investors blanched at the offered terms.

The Genesee offering didn’t attract enough buyers at a yield of 5.34 percent on a 29-year bond, the longest in the deal, according to people familiar with the offering. The average yield on a comparable 29-year municipal bond is 4.91 percent as of Thursday, according to Thomson Reuters Municipal Market Data.

How much federal money already goes to Detroit?

 

Members of the House of Representatives are trying to gather support from other members of Congress to hold hearings on a federal fund to help Detroit through its bankruptcy.

As I have been saying for months, the likelihood of a federal bailout for Detroit is miniscule. Federal spending, excluding transfer payments like Social Security, Medicare and Medicaid, has been shrinking as a percentage of the U.S. GDP. The federal government’s discretionary spending is contracting. Moreover, it is difficult to find the political will to rebuild Detroit. Federal money is spent on sudden, massive disasters like Hurricane Sandy, not on a slow crash like Detroit.

The likelihood of a federal bailout for Detroit is small to none, but there is a discussion about the funds that the federal government sends to Detroit on an annual basis. This has been a form of life support for the city. The question is how much Detroit already receives from the federal government.

How ratings agencies will approach pension liabilities

The New York Times recently ran a piece discussing how new pension valuation methods, put in place by the Government Accounting Standards Board, were far superior to the historical methods of valuing unfunded pension liabilities. They were even endorsed by some academic commentators. I have not heard of any state or local plan using these new methods to increase the funding of their pensions. Governments are not forced to use them, rather only to do the calculations and show the results on their balance sheets. Despite the revisions, governments will likely continue to use the averages of their historical rates of return on their pension investments to make decisions about the size of their annual contributions to their pension funds.

Here is the rationale that pension funds have used for decades, according to the Times:

Much of the theoretical argument for retaining current methods is based on the belief that states and cities, unlike companies, cannot go out of business. That means public pension systems have an infinite investment horizon and can pull out of down markets if given enough time.

Developing a new heartbeat for muniland

Trading bonds in muniland is a mess unless you have access to systems that provide information on current market levels for various types of bonds. It’s almost impossible to know, as a retail investor, if your bond purchase is close to a market level or if it is, in fact, marked up excessively. You are basically shooting in the dark and it’s probably best to just stay away from buying these bonds individually.

Institutional systems are very expensive to lease and are usually too pricey for retail investors. The Securities and Exchange Commission recommended in their two recent municipal market reports that investors be provided with more market data by the Municipal Securities Rulemaking Board, which oversees muniland. The MSRB already provides good access to prices for individual bonds that have already been traded. But those are old prices. Most individual bonds don’t trade on a daily basis, so it is hard to guess at current fair value levels. Municipal bond prices are also influenced by the daily rise and fall of the U.S. Treasury market, the same as most fixed income, which is anchored by the yield on the ten-year U.S. Treasury bond.

The MSRB announced last week that it would be publishing several requests for comments asking for more information so investors can make informed investment decisions. The Wall Street Journal ran a story following the MSRB press call that gives a glimpse into the regulatory struggle between the MSRB and the SEC on developing a set of pre- and post-trade pricing tools for retail investors. The SEC is leery of giving retail investors benchmarks that rely on data that is not based on actual trades. From the WSJ:

Puerto Rico issues bonds for energy

Though it has not borrowed in the bond market this year, the Commonwealth of Puerto Rico appears to have started by taking two loans from unnamed banks. Unfortunately we don’t have much information about these transactions, so the amount and purpose are unclear (July 9, July 29). The Puerto Rico Electric Power Authority (PREPA) has filed a bond offering that is expected to come to market on August 5th. Janney Montgomery’s Alan Schankel wrote about the deal:

For the first time in more than a year, we expect to see a new bond issue from Puerto Rico, in the form of $600 million Puerto Rico Electric Power Authority (Baa3/BBB/BBB-) with all three rating agencies affirming outstanding ratings. Pricing is expected next week.

What is PREPA?

The largest public power provider in the US, PREPA depends on fuel oil for 61 percent of its energy production. Although improved from a 73 percent share five years ago, this dependence on high cost fuel has stunted demand. Much of the utility’s capital investment plan, including $2.3 billion in the past 5 years, and $1.5 billion in the coming 5 years, is focused on conversion of energy production to natural gas, with oil projected to account for only 10 percent of fuel by 2017.

Muniland’s regulator hard at work

I heard an economics editor give an amusing response the other day when asked if the U.S. has “free” markets. She responded that, since all markets are regulated, that, pretty much, yes. I had to chuckle because municipal bond markets, although regulated reasonably-well on the primary side when bonds are issued, have minimal supervision or regulation on the secondary or trading side after bonds have been issued. It’s difficult to have confidence that investors are always protected when you read stories about abuses like excessive mark-ups, for example.

Listening to a press call with the MSRB (the municipal market’s overseer), after its quarterly meeting on Friday, I felt a jolt of enthusiasm. The board has been spending a lot of effort untangling the thorny issues that must be addressed to bring more transparency into primary and secondary municipal bond markets. Here is the MSRB’s priority list (my comments in parentheses):

Trade Reporting Concept Release: To support the MSRB’s ongoing commitment to increasing transparency in the municipal market related to pricing of municipal securities, the Board agreed to publish the second concept release in a series of releases on the MSRB’s existing transaction reporting system. The new concept release will seek public comment on improving the quality and usefulness of available post-trade information and the appropriate standards for the collection and dissemination of pre-trade information on the MSRB’s Electronic Municipal Market Access (EMMA®) website. (I can’t wait to see the details)

Inflationumberitis

As the Detroit bankruptcy is prepared to begin in the courtroom of Federal Bankruptcy Judge Steven Rhodes, a lot of debate is taking place in muniland. Many of these arguments are over whether secured bondholders will take haircuts, where the money will come from to pay off the swaps termination fees that are currently being negotiated and whether Detroit Emergency Manager Kevyn Orr has authority to cut the earned pensions of the city’s retirees. Orr has been making the media rounds to bolster his case for why these well-funded pensions should be cut. Of course, the more he cuts retiree benefits, the more he can force cuts on bondholders. Let’s shed a little light on Orr’s pension voodoo. Here is how the Detroit pension funds are represented in the 2012  annual financial report (CAFR) (page 145):

 

We don’t know Detroit’s pension returns for 2012, but it was a good year overall for public pension funds, with an average return of 12.69 percent, according to Wilshire Trust Universe Comparison Service. In 2012, according to the CAFR, Detroit contributed $64 million to the General Retirement System and $50 million to the Police and Fire System (page 146). That is $114 million, or about 10.3 percent of the $1.1 billion of general fund revenues in 2012. The voodoo comes in when Orr projects pension contributions jumping to $285 million in 2017 from $114 million. That is an increase by a factor of about three (June 14 Creditor Proposal page 91):

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