STUMP » Articles » Are Public Pensions in a Crisis? Part 5: On Bonds and Bailouts » 28 August 2019, 05:14

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Are Public Pensions in a Crisis? Part 5: On Bonds and Bailouts  


28 August 2019, 05:14

As I mentioned in the prior post of this series, for those systems in a crisis, it’s due to benefits already accrued. Much of the “escalating cost” problem of public pensions comes from needing to try to pay for the old benefits, not to pay for the benefits just accrued this year. That escalating pattern generally comes as reality catches up with the fantasy of valuation methods that low-balled the value and costs, while pretending more would be paid later.

From my earlier comments on the “pay more later” problem:

The big problem with the “pay more later” idea — which is “we can’t pay much more right now, but because of growth/inflation/whatever, we’ll be able to pay more later” in longer form — is that it doesn’t necessarily become easier to pay more in the future.

Ask Detroit and Puerto Rico, which saw substantial population drops in small periods of time, in a vicious cycle that lead to more-and-more unaffordable debt payments.

In Detroit’s case, it was able to blow away some of its debt, because it had recourse to federal bankruptcy.

Puerto Rico is still limping along, because it’s not being allowed any sort of normal federal bankruptcy process.

Illinois is more like Puerto Rico than Detroit in that matter. There is no federal bankruptcy process for a state. A state can default, though.

So let us look at various ways to try to stanch these increasing costs, by either filling the current hole with bond proceeds, or by looking to a federal bailout.


So one concept is to fill the hole in the pension funds by issuing pension obligation bonds. Once the proceeds from the bonds are in the pension funds, it becomes extremely difficult for bondholders to claw the money back out of the funds.

With current interest rates being at all-time-lows, especially at fairly long durations, it’s looking really attractive for governmental entities to issue long-duration bonds at very low rates, and put the proceeds in the pension funds. If you look at the 30-year rate for Treasuries, it’s at its lowest point ever. Perfect time to issue a 100-year bond, eh?

The gaps are from when we didn’t issue any 30-year bonds. I will come back to the possibility of issuing Treasuries to bail out public pensions later in this post.

I’ve written about pension obligation bonds many times before. I’m not a fan.

In all the cases of looking at the profitability of POBs assume that the government issuing them will pay back the principal at maturity. What if that entity simply defaults? Win-win!

I’m being sarcastic, of course. This would be devastating to the muni bond market.

The big problem with issuing more bonds to fund the pensions is that it increases governmental debt load, making it more likely for the issuers to default… or “restructure” their debt. Even if they don’t do that, it will constrain the issuers from issuing bonds for actual capital needs, like roads and bridges. There will be a point at which the sponsoring entity will not even be able to keep up with interest payments, forget about paying back the principal.

There are various ways muni bonds can be structured — for capital projects, a sinking fund approach is appropriate, and there are revenue bonds and the like. I am an outsider looking in on POBs, so I cannot say the usual way they’re structured and covenanted.

But the problem is that more bonds = more leverage = more financial precariousness for the sponsor.

If it were a private entity issuing bonds, well, if they go bankrupt, it’s the business of them and the bondholders.

But in a public pension/governmental bonds situation, there are lots of stakeholders (taxpayers, politicians, public employees, public retirees, bond insurers) and it can get very legally messy in a way that a private bankruptcy would not.

There are legal proceedings right now surrounding these issues, involving Puerto Rico and Illinois. Let’s look at those.


Currently, we are seeing some things going on with a lawsuit regarding Illinois pension obligation bonds, and what the Puerto Rico bankruptcy-in-all-but-name may do with respect to bondholders.

As you can imagine, I’m keeping an eye on developments. I really don’t expect the Illinois lawsuit to go much of anywhere. The Puerto Rican situation is a mess, and I’m not sure that it will serve as a precedent for anything outside of Puerto Rico, for a variety of reasons.

Puerto Rico is in a much worse financial position than Illinois, to make it clear. I don’t think they even have recent audited financials. I think the last such was back in 2014.

The problem is that Puerto Rico definitely does not have enough money even to keep up with bond payments. There is an oversight board, appointed by Congress, that is doing something-like-bankruptcy-procedures-but-not-really, but the legal position of that board is… unclear to me. And there are interests galore on various sides. Not all bonds or bondholders are equal in this case.

For Illinois, it has been getting more and more constrained in bond issuance. Its credit rating is flirting with junk status. Last year, someone floated an idea of issuing $100 billion in POBs. This is not tenable.

In both cases, there are lawsuits/legal maneuvers to try to cut down already issued bonds.

Keep in mind, this is a trick one can use only once (yes, I know about how some sovereigns default, and then come back afterward to borrow more. And then bondholders get soaked when they inevitably default again.) But if one is in the position to default/clawback/restructure bonds, you were probably in the position of not being able to issue more bonds as it is.

Illinois can (and is) issuing more bonds. Puerto Rico is in a more complicated situation.


In June, there was a bit of a hiccup in the muni markets when the Puerto Rico oversight board not only wanted the bondholders to suck up a default… the bondholders were going to be asked to pay back the interest payments they already received.

Check it out: The Far-Reaching Effects if Puerto Rico Snubs Precedent and the Rule of Law

HAMILTON, Bermuda—(BUSINESS WIRE)— The current Financial Oversight and Management Board for Puerto Rico (Oversight Board) is attempting to invalidate more than $6 billion of general obligation bonds and to initiate clawbacks of principal and interest payments to bondholders. It claims that the bonds were issued in excess of a Puerto Rico constitutional debt limit, notwithstanding the Commonwealth’s specific representations to the contrary when the bonds were issued. In taking these actions, the Oversight Board ignores U.S. Supreme Court precedent, dating back to the 19th century, that if an issuer specifically represents the validity of its bonds to investors at the time of issuance, it is barred from later denying repayment based on a claim of invalidity.

Think about what that would do to the muni bond market, if that argument is allowed. Think Illinois would be able to issue a bond ever again?

You’re in a really bad place when you not only want to say “Screw you, you’re getting nothing back” and “Oh, and not only will we wipe out what you lent us, we’re going to grab back whatever repayment we already made.”

Yes, the muni bond market has been really taking off in the low interest rate environment, and the Puerto Rico case still has a bunch of lawsuits from various parties.

But, as I said, I’m not sure that the Puerto Rican case will extend to lawsuits involving states, because, unlike with Puerto Rico, you’re not going to be able to have the federal government send in a financial oversight board to any state. There are sovereignty problems with doing that….but it has happened before.

A few recent stories on lawsuits related to Puerto Rico bonds:

A little from that last piece:

Puerto Rico bond insurers this month filed suit against eight well-known investment banks (UBS, Citi, Goldman Sachs, J.P. Morgan Securities, Morgan Stanley, Merrill Lynch, RBC and Santander) for failing to perform proper diligence on Commonwealth bonds worth approximately $11 billion. The train of neglect ran from 2001 to 2015 and included revenue and expenditure falsification and misleading debt gimmicks. In short, the suit alleges that the Official Statements promoted by the banks were fraudulent.

The ensuing defaults have had tragic consequences for Puerto Rico and its residents, as well as costing the insurers $720 million. The insurers are now seeking damages. If the case is allowed to proceed, its findings regarding the legality of various Commonwealth debt issuances could be more valuable to the people of Puerto Rico than any awards eventually paid by the banks to the bond insurers.

As I mentioned above, Puerto Rico hasn’t had financial statements for many years. I was able to find this… which ends with 2013-2014 CAFRIf I go to the upper level site I see this disclaimer:

Thank you for visiting the archive website of the Government Development Bank for Puerto Rico (GDB). The GDB is in the process of winding down its operations in an orderly fashion under Title VI of the Puerto Rico Oversight, Management, and Economic Stability Act, Publ. Law 114-187 of June 30, 2016 (PROMESA). Here you will find historical documents that were published in the GDB website, including financial reports, presentations, and press releases. This website also features a section listing GDB’s real estate properties for sale with contact information.

The oversight board info is here. I have started looking at the documents here, but the financial info is not really there or current.

In any case, the legal issues surrounding Puerto Rico will not necessarily stay with Puerto Rico. It’s in a position similar (though not the same) with respect to various government entities, such as states, which have no real bankruptcy process.


As I said above, I don’t really expect this to go anywhere, but it’s good to look at the arguments.

‘I would be shocked’: $14 billion Illinois bond fight a longshot

(Bloomberg) — The municipal-bond market is putting long odds on a think-tank chief’s bid to have $14 billion of Illinois debt tossed out in court.

While the yields on some of the challenged state bonds jumped by more than a third of a percentage point in the weeks after the suit was filed on July 1, they’ve since reversed course amid the market’s broader rally, indicating little risk that their legal status will be cast into doubt. Taxable Illinois debt due in 2033 is now yielding 4.46%, only about 0.3 percentage point more than bonds the state issued in April that aren’t being questioned by the suit.

The lawsuit, filed by the head of a conservative think tank and backed by a hedge fund, has drawn widespread attention in the $3.8 trillion state and local government debt market because it could set a novel precedent for groups seeking to challenge government spending. It came after Puerto Rico’s federal overseers asked a court to void a big chunk of that bankrupt island’s debt, arguing that it was illegally issued after the government had already run up against its borrowing limits.

John Tillman, the chief executive of the Illinois Policy Institute, a conservative think tank, claims that Illinois’ bond sales for its pensions in 2003 and to cover a backlog of unpaid bills in 2017 were deficit financings that violated the state constitution, which says bonds must be issued for “specific purposes.” Illinois officials have said the borrowings were valid and criticized the case as politically motivated. Sangamon County Circuit Court Associate Judge Jack Davis is expected to issue a decision this week on whether the petition can move forward.
Even if the Illinois judge allows the case to move forward, Nuveen’s Miller said he “can’t imagine that an outside plaintiff could prevent” Illinois from making its debt payments. The required three-fifths of the state’s legislators approved the debt and its purpose to pay accruing bills, Miller said.

“I would be shocked if that’s not a legitimate purpose,” Miller said.

Yeah, I don’t know that the argument is going to go very far.

Here’s an editorial on the matter: Editorial: Pension, bond lawsuit should get its day in court

A Sangamon County circuit court judge is expected to decide soon whether to allow an unconventional lawsuit that challenges Illinois’ borrowing habits to proceed.

We’ll cut to the chase: We hope Judge Jack Davis Jr. allows the case to move forward. Why? About 244 billion reasons. That’s how many dollars the financial watchdog group Truth in Accounting estimates Illinois taxpayers eventually will owe due to unfunded pension liabilities, health care obligations and unpaid state bills. The debts have piled up over decades but accelerated since the early 2000s, dragging the state’s credit rating to near junk status.

So yes, taxpayers deserve a shot at having someone contest Illinois’ tradition of overborrowing. The case is considered a Hail Mary attempt, even though it raises legitimate concerns about the manner in which Illinois politicians have borrowed money in the bond market to balance budgets and pay for operations.

At this phase, the judge is merely deciding whether the case is frivolous or malicious, the threshold for tossing taxpayer cases before they can be formally filed in Illinois. This lawsuit is neither.

The state borrowed $10 billion in 2003 to pay down pensions and cover operational expenses. Lawmakers and Gov. Bruce Rauner approved borrowing in 2017 to pay down unpaid bills, which also violated the intent of the clause, the plaintiffs argue. The only exceptions for massive borrowing under the constitution are for emergencies or for short-term debt that can be repaid swiftly. But that’s not how general obligation bond debt has been deployed.

In Illinois, government and political leaders have used borrowing to cover over the damage caused by their profligate spending. That’s less a specific purpose than it is a desperate scheme.

The state, represented by Attorney General Kwame Raoul, argues the lawsuit is nonsense and should be tossed at the get-go. Raoul’s office questions the motives of the plaintiffs. The hedge fund wants to protect its interests in Illinois bonds it holds, and could benefit from a wiping clear of some of the state’s debt. Tillman is a longstanding advocate for fiscal discipline in government. The plaintiffs are not secretive about their motives.

Gov. J.B. Pritzker and other Democratic statewide officeholders have mocked the lawsuit and shamed the plaintiffs for pursuing a potentially injurious legal challenge that, if successful, could further destabilize state finances and limit future borrowing.

We would ask: How injurious have previous legislatures and governors been to rank-and-file Illinois citizens who now face a mountain of debt? Piling up irresponsible, unbalanced budgets and imperiling the state’s five pension funds seems pretty injurious, doesn’t it?

So, here is my take: Illinois residents and taxpayers — you voted for this.

You kept voting in people who kept promising you that you could just pay for it later.

Well, it’s later. Pay for it.

That’s easy for me to say from New York (we’ve got our own issues), but I don’t think this lawsuit will either invalidate the debt nor stop Illinois from issuing more bonds.

In any case, the Puerto Rican and Illinois bond lawsuits indicate BUYER BEWARE to bond buyers. Many have been attracted to these bonds due to their favorable tax status and higher yields than Treasuries, but some issuers are going to hit a wall if they keep issuing bonds to cover current expenses (the Illinois bonds to cover bills) or past expenses (pension obligation bonds).

We haven’t had a state default on its bonds in a long time, but it has happened before. Let’s take a look.


Check out this piece from John Mauldin about states defaulting on debt:

In 1933, debt-plagued Arkansas unilaterally restructured and extended maturities on a series of highway and other bonds. Nowadays, we call that a default.

Bondholders sued, of course. The next year the state and its creditors reached a compromise refunding. Creditors exchanged their old bonds for new ones funded by a 6.5 cent per gallon gasoline tax.

In today’s dollars that would be about $1.16 per gallon, so this was a hefty tax on Arkansas drivers. I’m sure they complained. That deal fell apart, and after more twists and turns, the federal Reconstruction Finance Corporation (predecessor to the FDIC) bought the new bonds.

More on the situation:

Arkansas was already in bad shape when the Great Depression hit. In 1927, the state took over the task of building highways from local authorities, because the locals built far more roads than they could pay for. The state takeover included new revenue for the roads, but it also authorized the state to build even more highways.

The result, said University of Arkansas Little Rock history professor Fred Williams, is that the state debt mushroomed. The local economy took a big hit when a third of the state flooded in 1927, and the stock market crash two years later made things worse. By 1933, Arkansas piled up $160 million in debt. That meant, of its annual $14 million budget, the state spent $13 million on debt service for roads.

The state simply couldn’t keep up with its bills. In 1933, Arkansas defaulted on its bonds – the only state to do so during the Great Depression – and its state government essentially functioned on federal money for two years. It started digging itself out only when it passed a sales tax, and even then, the state had to stop building roads for 16 years.

The Great Depression default wasn’t Arkansas’ first missed debt payment. The state was one of eight states, along with the territory of Florida, to miss its bond payments in the early 1840s.

That wave of defaults came in the wake of the Panic of 1837, a banking crisis that triggered a five-year recession. Generally, the Northern states of Illinois, Indiana, Maryland, Michigan and Pennsylvania were unable to pay debt service for bonds they used to build canals and other infrastructure improvements. Arkansas, Louisiana and Mississippi in the South, along with the territory of Florida, ran into trouble when state-backed banks for large landowners became insolvent.

The defaults didn’t cripple the states’ ability to borrow for long, but, in Mississippi’s case, the state’s refusal to pay bondholders hung over the state government until 1996. That’s when the state Supreme Court dismissed a case brought by the heirs of British bondholders who sought $13.8 million for the $1.5 million of debt they held, plus 152 years of simple interest.

Take a look at that. States can and have defaulted on bondholders. In some cases, the federal government stepped in.

Let’s think about $160 million in debt in 1933. That’s $3.2 billion in 2019. That’s… puny compared to the debt many states have currently accrued in 2019. If I compare $160 million against the $12.6 billion federal budget in 1933, that’s 1.3% of the total budget. Fairly small.

In 2019, the federal budget is approximately $4.7 trillion, and 1.3% of that is $61 billion. The total Illinois unfunded pensions (just for the state, not including Chicago etc.) is over $100 billion. If I go to Truth in Accounting’s info, Illinois has a total debt of over $200 billion. Just bailing out Illinois would be a bigger problem than bailing out Arkansas back in 1933.

Illinois and many other states were hit hard in the Great Recession of 2008-2009. What if we got another such recession? Heck, maybe one not so deep, but one as bad as in 2001? Market returns were negative in 2000, 2001, and 2002.

What would happen to the pensions? To tax revenue?

Let’s look at a federal bailout possibility next.


I’m not going to spend a huge amount of time on this, but I just want to make some comparisons.

I have the combined national data from the Public Plans Database. This incorporates the official census of public plans, which obviously includes plans not in the database.

According to the U.S. Census Bureau, roughly 6,000 public sector retirement systems exist in the U.S. Some of the 299 state-administered plans and 5,977 locally-administered plans date back to the 19th century and each has evolved independently. Collectively, these plans have:

$4.3 trillion in assets

14.5 million active (working) members and 10.3 million retirees

$283.4 billion in benefit distributions annually

Okay, so let’s stop there for a moment. Compare the 10.3 million retirees/beneficiaries to how many people are receiving Social Security benefits: about 49 million people receiving old-age benefits. Now, these are not necessarily measuring the same period, but let’s just say that the number of public retirees is about 20% of the number of people receiving Social Security (yes, some people receive both… I don’t want to get into that right now). That can give you an idea of how many retirees we’ve got in the U.S., and how many public retirees.

From the same sheet, the aggregate plans are about 72% funded. Again, this is just to make estimates – that means the unfunded liabilities are about $1.7 trillion. That’s using their own numbers.

The whole federal budget is about $4.7 trillion.

The amount of federal debt held by the public in July was about $16.2 trillion.

Now, there was a guy named Tim Alexander who John Bury allowed to post at his blog, who had the idea of paying public pension proceeds from the huge amount of Treasury cash flows we’ve got going.

The problem, of course, is that those cash flows are already being used for other expenditures. If those get “diverted” to public pensions, then something else goes unpaid.

So, I say, let’s consider the feasibility of the federal government simply issuing more debt to pay for these cash flows, or to fill these holes. Sound good?

Let’s look at a graph of the U.S. debt vs GDP: from a CBO report in January 2019

Now, that’s a relative measure, but combining the 78% of GDP in 2019 with $16.2 trillion in 2019, we can see that adding on $1.7 trillion in debt would be an increase of about 10%, so to about 87% of GDP.

Well. That sounds doable, right?

If you forget:

  • that’s using standard GASB measures of unfunded liabilities, which may lowball their value
  • that’s not incorporating future benefits accrued, which bad actors will likely continue to underfund
  • there are others lining up for bailouts, such as multiemployer pensions.
  • then there’s the whole issue of dealing with Medicare and Social Security (which aren’t included in the debt number above)

Let’s consider that last: Truth in Accounting puts the true debt number at over $100 trillion.

That’s a lot bigger than $17 trillion, eh?

Almost all of that debt comes from Social Security and Medicare.


Back in 2016, even before Trump was elected, I said there would be no bailouts. The summary version:

There can be partial bailouts, but people will not be made whole. In those prior posts, I didn’t actually look at the numbers. Well, the numbers are above. You let me know who is going to absorb all those bonds, and at what price.

I mean, I know I’d love to have higher yields, which could happen if there is too much issuance. But the question is: will people even pick them up?


Or, rather, someones.

The someones are likely to be bondholders, taxpayers, public employees, AND public pension retirees in combination. It really depends on how well states and localities have been in keeping up with funding the pensions, and how much non-pension debt they’ve taken on. There will be more than enough pain to go around.

I’ve been focusing on state-level positions, but for localities, which can file Chapter 9 bankruptcy, the method for adjusting current debts may end up being regularized. Detroit was a really big bankruptcy, and pensions were adjusted in that bankruptcy. I believe that, so far, Calpers has managed to avoid getting defaulted on for bankrupt California entities, but that may not hold forever. In any case, if enough localities have trouble, I can imagine the federal bankruptcy judges will get used to prepackaged bankruptcies… but that’s for a different time.

Let’s focus on the states, where the pain really resides, because there are no such bankruptcy proceedings for states.

We’ve already seen one kind of workout before with Rhode Island: they basically cut down COLAs, but they still have a lot of trouble. They’ve been hovering under 60% fundedness since the change.

I’m not saying any of this is going to be easy, but it’s going to be a lot easier if it’s handled earlier rather than waiting until all the Boomers are retired.

Yes, it’s going to require amending some state constitutions. There will be lawsuits galore (I believe the Rhode Island situation has all the lawsuits retired at this point, but I could be wrong — the legislation was in 2011). The first fix may not be completely effective. Some states are not all that far down and it would not require huge fixes, probably, such as COLA cuts or some kind of risk-sharing. But others, such as Kentucky, are probably going to require some more extreme adjustments. Given that every pension reform has been knocked down by Illinois courts, they’re going to require amending their constitution, for instance.

Some places have already made their changes, but for most states, they still have the structures and unfunded liabilities that mean many are going to receive less than they originally expected.

Higher taxes, haircuts for bondholders, increased contributions, and lower benefits — they’re all painful, and they’re all likely results when one has large unfunded liabilities. It may not be now, but these results will surely come over time. It’s not as if it will be a surprise when another recession hits, or a specific state sees population decline, or people keep living longer, or… .

It’s not like a freak catastrophe nobody could see coming.

Call it a crisis now, or call it a crisis later. I don’t care how you define it.

But don’t pretend that any of the bad results were unexpected. It’s in the official numbers, forget about the numbers I’d prefer to use.

Given my current life expectancy, I’ll probably get to see how this turns out. It will be interesting to see what happens. I would rather fixes be made now, when there’s still some maneuverability for those systems not on a stable trajectory (I don’t consider running out of assets before all benefits are paid as stable). But I know many of the states will not do it.

That’s the benefit of federalism. I can watch what happens to Wisconsin versus Illinois.

Best wishes to all, but don’t expect the thriving states to bail out the failing ones.


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