Tuesday, June 30, 2015

The Ticking Time Bomb of the Underfunded Pension Promises of Many U.S. Cities and States ... It's Not Exactly the Same as, but it Clearly 'Rhymes' with, What's Happning in Greece and Puerto Rico ... Similarities Abound

Geographically, Greece is a long way from the U.S. mainland. So is Puerto Rico.

But financially they are encountering problems much like those currently facing lots of big U.S. cities and states. Given enough time, big spending, low taxing and unaccountable governments can do a lot of permanent financial damage as a result of underfunding public sector entitlement programs, including pension promises. And that they've done.

That's because many U.S. cities and states, to make an understatement of epic size, currently have huge unfunded pension obligations which grow with each passing day. It's both exciting and shameful.

Government policies and practices designed to placate public sector unions and their members are mostly, albeit not totally, to blame.

These lurking debts may turn U.S. cities, states into Greece paints a troubling but true picture of the situation:

"When Chicago Public Schools announced on June 24 that it would borrow $1 billion to make a $600 million-plus pension payment due June 30 an eerie feeling spread across bond investors and taxpayers alike.

It was the same feeling that gripped investors when Moody’s Investors Service downgraded Chicago’s credit rating to junk based almost entirely on the city’s pension problems.

The fear was that elevated pension costs, in cities like Chicago, might push these public entities into insolvency, wiping out much of the holdings of municipal-bond investors.

Once a sleepy corner of the municipal bond market — often not even properly reflected on cities’ balance sheets — public pensions have recently turned into the biggest headache for taxpayers and municipal bond investors, threatening to bring down the finances of U.S. cities and states.

In some places, like Puerto Rico, Illinois, New Jersey and Chicago, entire balance sheets of cities or states hang in the balance.

Detroit, as well as three Californian cities — Vallejo, Stockton and San Bernardino — had to declare bankruptcy because of their overwhelming pension costs.

In those cases, the courtroom turned into a brutal battlefield pitting bond investors trying to save the money they invested in those cities’ municipal bonds on one side. And on the other side have been public employees trying to save the dwindling pensions that were promised to them.

Recent cases have shown that bond investors are clearly losing this battle.

In the bankruptcies of Detroit, Vallejo, Stockton and San Bernardino, bondholders have faced losses of up to 99% of their holdings, according to a Moody’s report dated May 18. Meanwhile all three California cities chose to preserve full pensions for their employees, while Detroit only cut pensions by approximately 18%.

As the following chart shows, bond values have taken haircuts that far exceeded those of pension benefits:

Part of the reason bondholders have been taking it on the chin is the process of so-called “Chapter 9 bankruptcies.” A Chapter 9 is the type of bankruptcy in the Federal bankruptcy code regulating the bankruptcy of cities and other municipal governments.
The way Chapter 9 works, a city has to present an outline of its assets and liabilities to a bankruptcy court and propose a plan, known as a “plan of debt adjustment,” essentially saying how much it will pay each creditor, such as bondholders, pensioners and employees.

But unlike other bankruptcies, where creditors can also put forward plans — including the proposal to liquidate assets — in a Chapter 9 bankruptcy, the city council is in control of the process and the judge can only determine whether the plan is “fair and equitable,” explains Ty Schoback, a municipal bond analyst at Columbia Threadneedle Investments.

This practically means that once the bankruptcy begins, creditors find themselves “at the mercy of the city’s proposed treatment,” Schoback added.

Pension supremacy . . .

In many states, public pensions are protected by state constitutions or statutory law, and as a result are afforded many privileges . . . . 

In legal circles, this has come to be known as “pension supremacy” and it is a real headache for bond investors.

In Chicago, the state’s constitution dictates that pension benefits for current workers “shall not be diminished or impaired.” New York carries a similar clause, while Hawaii, Louisiana, and Michigan have constitutional provisions that have been interpreted as protecting all pension benefits earned to date. . . .

Most states have some legal type of pension protection, including the so-called “promissory estoppel” which is the protection of a promise even where there is no contract. . . .

Pensions are underfunded all over the nation

Combine the legal supremacy of pensions with low funding levels all over the nation and you may have a recipe for a national crisis.

A report by the Center for Retirement Research that came out last week and surveyed 150 state and local pension plans showed that their average ratio of assets to liabilities was 74%. In other words, for every dollar those funds owe their pensioners, they only have 74 cents in assets....
Center for Retirement Research
If 74% sounds bad, consider this: Chicago’s six pension plans are 40% funded, New Jersey’s are at 51.5%, while Puerto Rico’s, which was facing its own crisis moment Monday, is woefully underfunded at 3%.

Because their pensions are underfunded, cities are forced to spend more of their payroll on pension contributions:
Center for Retirement Research
The increase in required pension contributions over the past several years began just as the recession eroded state and local government revenues.
Pension obligation bonds

Many cities have turned to a special type of risky bonds called pension obligation bonds or POBs to fund their pensions without taking unpopular measures like raising taxes.

But these bonds only provide “short-term budget relief, a strategy to kick the can down the road and pass difficult choices on to future decision makers,” . . .

Over the last 30 years state and local government issued pension obligation bonds to shore up the unfunded portion of their pension liabilities without raising taxes.

In simple terms, POBs allow a city or state to borrow money to make its pension payments and issue bonds that will be repaid by future city revenues.

But here’s the problem:

“When you buy POBs, you’re exposing yourself to the pension fund and essentially lending money to leverage its portfolio,” said Kenneth Potts, a principal at Samson Capital Advisors who specializes in muni bonds.

In other words, there is neither a real asset backing these bonds, nor a specific revenue stream to guarantee repayment.

As the Moody’s report points out, “in essence, pension obligation bond is a misnomer because the bonds are simply a vehicle to fund pensions.”

So when push comes to shove and there are not enough funds to go around, a bankrupt city can choose to give the little money it has to its pension funds but not to its pension obligation bondholders.

The latest fiasco of this type happened this May, when the city of San Bernardino, Calif., offered to pay only 1% to its POB investors, while committing to pay 100% of its pension liability."

Summing Up

Public sector pension underfunding is both a national tragedy and a shameful scam on taxpayers.

The deal is often struck in public sector labor negotiations to pay higher salaries immediately rather than allocate a portion of the budgeted money to necessary and proper pension funding.

Public sector unions like this approach as it results in both higher salaries for those members currently working as well as greater pension benefits for those same members at retirement.  

The greater retirement benefits paid to retirees are due to the higher salaries received during their working years --- which is due to the lower pension funding.

And future taxpayers will eventually get the bill for the underfunded pensions.

Current taxpayers probably won't even know what happened, but even if they do know, they probably won't care since their taxes aren't being raised in the here and now.

It's a shameful scam and frequently a 'constitutional' thing which is done by various cities and states in agreement with the public sector unions.

But someday soon there won't be money to pay for all this stuff, and then all hell will break loose.

It's only a question of when 'soon' will arrive.

For Greece and Puerto Rico, 'soon' is now.

That's my take.

Thanks. Bob.

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