Time for Stockton to wrestle with CalPERS

Muniland turned a very big corner today when U.S. Bankruptcy Court Judge Christopher Klein determined that the insolvent city of Stockton, California had met the criteria for municipal bankruptcy. Stockton became the largest city ever to enter Chapter 9 bankruptcy. The admittance of Stockton to the protection of the court does nothing to address the central question of Stockton’s solvency: what can be done with the massive unfunded pension liability owed to CalPERS, the statewide pension system? Stockton itself has done nothing to address the problem. Judge Klein did have one very important thing to say:

With this statement he mirrored the ruling of the Vallejo, California bankruptcy judge, Michael S. McManus, Jr., who specifically said in his 2009 ruling (page 73, clause 3102.1):

Debtors’ authority to reject executory contracts, as set forth in the Bankruptcy Code, preempts state law by virtue of the supremacy clause, the bankruptcy clause, and the contracts clause. U.S.C.A. Const. Art. 1, § 8, cl. 4; U.S.C.A. Const. Art. 4, § 1 et seq.; U.S.C.A. Const. Art. 6, cl. 2.

As said last August about the McManus ruling:

Translation: Public pensions benefits are construed as a “contract” under California state law, but bankruptcy law is federal and preempts state contract law. A city in Chapter 9 bankruptcy has the ability to lower pension benefits by rejecting their pension contract.

Bringing truth to the pension debate

The increasing cost of municipal pension plans has recently caused mild hysteria among reporters covering muniland, and some of their coverage has been overdone. To pick one example, several weeks ago the homepage of the New York Times screamed that cities in New York State had to borrow from the state fund to pay its annual pension contributions. What this article overlooked was the fact that the state plan is already over 100 percent funded and that delaying communities’ payments would place no stress on the state plan. Moreover, the local communities could have skipped their annual payments, and the New York fund would remain the healthiest in the nation.

As the article illustrates, pension promises and actuarial projections are hard to verify. Some have used this to their political advantage to claw back benefits that public workers have already earned. We in the media have often swallowed it whole because it’s complex stuff.

A recent article that avoided this trap appeared yesterday in the Bond Buyer article and had to do with officials exaggerating pension fund woes for political gain. Often these public exaggerations directly conflicted with what bond offering documents say for the officials’ communities. Some are alleging that this opens up the officials who made the misstatements to violations of anti-fraud provisions of securities laws. From the Bond Buyer:

Playing the pension game

Two national stories yesterday shed light on the foolishness that’s taking place on the fringes of the public pension world. The first story, from the Los Angeles Times, is about pension obligation bonds – a classic tale of fancy, Wall Street-devised products that promised more than they could deliver. The second story, from the New York Times, is about a scheme, dreamed up in an ivory tower, of having state government pension plans take over responsibility for the pensions of corporate retirees. The mind reels at the complexity and difficulty of this idea.

Nathaniel Popper of the LA Times does an excellent job of describing the speculative risks that state and local governments take by borrowing in the bond markets to fund their contributions to their pension plans. Pension obligation bonds are a form of interest-rate arbitrage: a municipal issuer borrows at, say, 4 percent and invests these funds in its actively managed pension plan. The hope is that the funds will earn higher rates of return, usually from investments in the stock markets. It’s basically a way of borrowing to speculate, but since Congress won’t allow municipalities to do that using tax-exempt bonds, a new approach was developed. The LA Times says:

Congress made it illegal in 1986 to issue normal tax-exempt municipal bonds for this type of speculation, but municipalities and their outside advisors realized they could get around this by issuing taxable bonds, like corporations. These bonds come with higher interest rates, but many local government officials have believed they could earn enough from investments to come out on top.

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