MuniLand

Moody’s flawed estimate on public pension liabilities

As the debate continues over public pension funding levels, we have this headline from the Financial Times this week: “US States need $980 billion to fill pension gap, says Moody’s.” This is not exactly news. A number of studies, including ones from the Pew Trust and the Public Fund Survey, have identified a massive shortfall for public pension funds. In fact, the Pew Trust said that the shortfall in 2010 was $1.38 trillion, so perhaps we should be applauding state legislatures for improving the gap since then.

The shortfall numbers in these studies, to put it simply, are all over the place. There are many variables that go into these models, but the main factor that causes variation is the expected rate of return on the assets in the plans. The official assumed return on the assets that are held in trust to pay pension liabilities is 8 percent, according to the Public Fund Survey. Fiddling with this projected rate of return can cause swings in the amount of unfunded liabilities. The Moody’s study uses an unconventional assumption. According to the Adjustments to state pension liabilities document:

Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation (of the fund).

Rather than using the average historical investment return rate of 8 percent, Moody’s uses a return on a taxable bond index. This return would be no higher than that on a basket of high-rated corporate bonds ranging from 4.4 to 6.2 percent, the FT says. The problem with using this rate is that we have been in a five-year period of zero-interest rate policy while the Federal Reserve has artificially suppressed interest rates to promote financial stability and spur economic growth.

If we look back over the last 54 years in the Fred chart above, we see that Aaa and Baa corporate bond rates have had higher yields than what Moody’s is using. The historical corporate bond rate is in fact much closer to the rate used by government actuaries. The fact is that using any suppressed bond yield in an easy money period will make future projections unreasonable.

The high cost of borrowing for Illinois

Illinois, the state with the lowest credit in the United States, had to pay up this week to bring a $1.3 billion general obligation bond offering to market. Reuters reported that the general obligation bonds due in 25 years were priced at 5.65 percent on Wednesday. This was approximately 180 basis points (1.80 percent) over Thomson Reuters MMD AAA, compared to a spread of 138 basis points on Tuesday. In other words, Illinois got spanked hard.

Illinois has massively unfunded public pensions and a huge stack of unpaid bills that make the state less creditworthy and force it to pay higher interest rates when it borrows. But a new study by the Mercatus Center suggests that, since the risk of default for Illinois is very small, the state is overpaying for its bond offerings. The study’s author, Marc Joffe, formerly a Senior Director at Moody’s Analytics, developed a fiscal simulation model that takes into account pension, education and health care payments over time in addition to debt service:

In a bond market massacre, liquid products win

It comes as no surprise to those who understand markets that the less liquid a product is, the more its price will decline in a fast market rout. This has happened over the last few days in the municipal bond market.

The buying and selling of individual municipal bonds can be especially illiquid for retail investors because they don’t have much real-time market data. More importantly, they face very steep transaction costs, or markups, that dealers put on bonds sold in small lots. I wrote about this last week:

Securities and Litigation Consulting Group of Fairfax, Virginia, recently published a report that analyzed almost $3.7 trillion worth of municipal bond trades that happened between 2005 and 2013 (page 8). SLCG found that the median markup for a trade up to $25,000 in size is 1.79 percent.

Free speech or securities fraud?

Mark Funkhouser, the director of the Governing Institute and a former mayor and auditor of Kansas City, took a few swings at the SEC for its securities fraud prosecution of Harrisburg, Pennsylvania. Funkhouser has three concerns with the SEC’s case.

First, he correctly points out, as the SEC case contends, that the city of Harrisburg did not issue any financial statements between January 2009 and March 2011. The SEC says that because of this, investors had to seek out other statements made by public officials that included material misstatements. Funkhouser blames it on investors for poor diligence. He says:

You’d think it would be obvious to potential investors that if there’s not much current information available about a city’s finances they might want to think twice about buying its securities. But investors don’t always exercise proper diligence, and it wouldn’t have hurt for the SEC to have driven home that point.

Puerto Rico tweets about bankruptcy

The twitter handle for Puerto Rico’s executive branch is @fortalezapr. Here are some of the tweets from Thursday:

We are in pretty grim times when an investment grade government is tweeting about bankruptcy to encourage people to approve big tax and fee hikes.

Who is in line to finance the $2 billion for the Highway Authority? Good luck with that.

When Detroit goes to bankruptcy court

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Detroit Emergency Manager Kevyn Orr predicts that the chances of Detroit entering bankruptcy are about 50/50. But if we consider what the major participants, bondholders, public employees and retirees are likely to do, it’s almost 100 percent certain that Mr. Orr will be entering the federal bankruptcy court house on West Fort Street in Detroit.

The bankruptcy case of Stockton, California provides an indication of how willing bond insurers will be to make upfront concessions. In Stockton, they were totally unwilling to give up anything. From the written ruling of the bankruptcy judge in Stockton, Christopher Klein: (page 17)

Bond insurers are the legal grinding stone of the municipal bond market. They don’t give anything away if litigating would gain them some advantage. They have stables of high-powered attorneys to fight their battles.

Is there such a thing as a ‘fair’ markup in muniland?

It’s well known in muniland that retail investors, who buy smaller lots of bonds than institutional buyers, get hit with high markups. The rule is that dealers must deal “fairly” with investors. Translation: Markups to customers cannot exceed 5 percent. So if a dealer sells a bond worth $5,000, he may not charge the client more than a $250 markup. However, there is no regulatory requirement for the dealer to tell the client how much the bond has been marked up; just that it was marked up. Many believe these differences in bond prices are excessive, but no one has figured out a way to reduce or stop the practice.

Securities and Litigation Consulting Group of Fairfax, Virginia, recently published a report that analyzed almost $3.7 trillion worth of municipal bond trades that happened between 2005 and 2013 (page 8):

SLCG found that the median markup for a trade up to $25,000 in size is 1.79 percent. Here is an example of a trade with an excessive markup, from page 11 of the study:

A call for monitoring municipal heart beats

New York State’s Comptroller Tom DiNapoli has published the results of his Fiscal Stress Monitoring System. Taxpayers in many communities have been identified as having moderate to significant stress. This is a clarion call to those communities to look more closely at their revenues and expenses before a crisis.

DiNapoli started developing the system last year and went through a multistep process. From his press release:

DiNapoli began shining a spotlight on fiscal stress in 2012 after his office noticed a number of alarming trends among local governments. For instance, his auditors found that nearly 300 local governments had deficits in recent years, and more than 100 had inadequate cash on hand to pay their current bills. DiNapoli’s office drafted the ‘early warning’ monitoring system last September and shared details of the proposal with all of the state’s local governments and school districts for their review during a 60-day comment period. More than 100 local government and school district officials, as well as a number of affiliated organizations, provided feedback.

Is the U.S. Treasury bailing out Puerto Rico?

Puerto Rico budget negotiations for fiscal 2014 are in the final stretch for the year’s July 1 start date. A massive $1.5 billion difference between spending and revenues must be closed. Discussion has included expanding the commonwealth’s sales tax to services and transactions between businesses. Local businesses fought hard against this proposal, and eventually, Governor Garcia Padilla switched focus. Reuters explains:

[Puerto Rico Treasurer Melba] Acosta told reporters that policymakers had agreed to scale back by 73 percent the governor’s proposed sales-tax expansion, which was strongly opposed by local businesses. The expanded sales tax will be levied only on a small group of industries and will raise $287 million during fiscal 2014.

To make up for the lost revenue, the government will assess a business tax on gross sales on a sliding scale, depending on sales volume. It is expected to generate $522 million.

Detroit’s 10 cents-on-the-dollar meme

Detroit’s emergency manager, Kevyn Orr, held his big creditor meeting today and presented his Proposal For Creditors Powerpoint (PDF) for how he would like to treat the city’s liabilities. The mainstream media is running with the story that Orr’s proposal will give creditors 10 cents on the dollar, but the proposal is far from having those terms.

The Proposal calls for the following treatment of various classes of debt:

For secured debts:

For the $5.5 billion of secured water and sewer revenue bonds, Orr proposes to issue new bonds with the current full principal amount (with accrued interest) at a lower interest rate (i.e. no haircuts or reduction in principal). (page 101)

For the $411 million of Secured General Obligation Debt (unlimited property tax pledge) Orr says, “Treatment: Subject to negotiation with holders”. So no stated haircut there. (page 104)

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