STUMP » Articles » Positioning for a Potential Interest Rate Hike: Public Finance and More

Positioning for a Potential Interest Rate Hike: Public Finance and More

by meep

15 February 2022, 20:33

Given how mortality-heavy this blog has been for at least 18 months now, you may be unaware that my blogging was originally about public finance and not death.

(But death and taxes do go so well together.)

With a little help from my meme brain trust (they know who they are), I have some items on various state and local governments trying to get ready for an increase in interest rates.

You may notice all these memes have a Valentine’s Day theme, and today is the day after V-Day…. well, I learned something from my mother:

It also works for memes.

Likelihood of interest rate rise: increasing

Let’s take a look at that “temporary” inflation, shall we?

Using the non-seasonally adjusted CPI-U, here are the year-over-year percentage changes, going back to 1960. No reason to push it back farther.

Oh yay, I get to relive my childhood. Except this time, I know about money and debt.

Well, the Federal Reserve will likely have to raise interest rates. I would rather not see the trajectory of the late 1970s/early 1980s of double-digit inflation.

But it will likely take some time before this shakes out, which will have effects both for personal finance as well as public finance.

While there are different instruments and strategies at hand for dealing with increasing interest rates — for you as an individual versus states (I doubt you can tax people), there are some similar strategies that can be tried.

Improving credit score or credit rating before borrowing more

The Comptroller of Illinois has mentioned – hey, we’ve improved our situation with unpaid bills. Why not improve our credit rating?

Illinois Comptroller Susana Mendoza is asking the credit ratings agencies to upgrade Illinois’ worst-in-the-nation status.

S&P Global has Illinois at BBB. Moody’s has the state at Baa2. That’s after upgrades from the agencies last year. Fitch has Illinois at BBB-.

“My office is doing everything possible to manage the current backlog of bills and address Illinois’ finances head-on,” Mendoza said in a letter to the agencies that her office announced Monday. “The Illinois Office of Comptroller urges you to consider these positive factors and progress made in strengthening Illinois’ financial position when evaluating Illinois’ creditworthiness.”

Mendoza said in the letter she has paid back recent borrowing from a federal program. Illinois was the only state to borrow from the Federal Reserve’s Municipal Liquidity Fund for a total of $2.6 billion.

I want to jump back for a moment and talk about Susana Mendoza. I have written about her several times, especially with respect to the unpaid vendors program. I just happened to have gotten a little derailed by the pandemic, as did everybody else.

The last time I wrote about her in any detail was three years ago. Mendoza herself wasn’t involved in the lawsuit, and if the unpaid bills are no longer sitting in limbo, then the 12% guaranteed interest being paid through these unpaid vendors programs are moot, as these vendors don’t have to sit around being unpaid.

But this isn’t really about Mendoza. It’s about Illinois’s creditworthiness, and that a shower of federal funds got them to clear their short-term bills. So they’re saying “Hey! Our credit score, uh, I mean, credit rating should improve!”

The governor in his budget address last week proposed spending nearly $4 billion more than the current fiscal year. He did not address the $4.5 billion in unemployment trust fund debt.

After the governor’s address Wednesday, Mendoza heralded the work she’s done to pay down the state’s bills that peaked at nearly $17 billion by borrowing $6 billion.

“By leveraging these federal matches, I was able to turn that $6 billion into $9 billion and then shave that off the $16.7 billion backlog,” Mendoza told The Center Square.

That is all short-term debt.

I have written about the unpaid bills of Illinois, and no, I’m not talking about the pension debt — this is more mundane stuff, like goods and services for current year activities of the state of Illinois. I have been writing about this reaching back about a decade:

April 2013: Illinois Vendors and Other Operating Expenses to Go On Credit Card

After last month’s posts, Illinois Vendors, Ask for Cash on the Barrelhead and No, Really, Illinois Vendors — Require Cash, we see there may be good news for vendors currently owed money from the state of Illinois.

They’re going to put it on the credit card:

….
Having to issue long-term bonds to pay operating expenses is a REALLY BAD SIGN.

Long-term, general obligation bonds, from principles of sound finance, should be issued only for capital expenditures. Chances are pretty good that this backlog does not represent capital expenditures.

Now, issuing debt for operating expenses is not necessarily bad — if it’s short-term debt and it’s just a timing of cash flow problem. For example, I have a very lumpy cashflow stream in and out. I will have cash inflows twice the usual some months, and outflows (such as this month) much greater than usual. The fluctuations in the inflows and outflows do not match, so sometimes the credit card bills for groceries do not get paid off for a month or two.

But I’m not trying to refinance my current grocery bills with a 30-year loan.

That the Comptroller of the state of Illinois was finally able to flush out a lot of these sorts of bills due to federal largesse during a pandemic… is not really the sign of a state with responsible financial practices.

This tip may be a little too late for you as well, but maybe you will actually be able to eke out a tax return this filing season (boy, do I have some bad news for some people), and I highly recommend shoring up one’s debt situation to make the credit score look better before borrowing more money.

Mendoza at least has the right idea.

The difference, of course, is credit rating agencies, when rating states, only have 50 states to look at, and they can look very closely at those states. They know the distinction between a state that has decades’ worth of misbehavior and a temporary righting of accounts.

Credit scoring outfits have millions (if not billions) of individual borrowers to evaluate, so said individuals have a better chance of gaming the system, actually.

It’s worth a shot.

Refinancing debt before an increase in rates

This is one everybody tries to time, and sometimes the timing just sucks.

In this case, the refinancing is of pension debt, via pension obligation bonds (POBs).

So there are some recent stories on POBs via Actuarial News:

Bonds are the key to reining in runaway municipal pension plans

In what is the product of the sustained low-rate environment, many municipalities are considering addressing their pension position through bonds. This should be encouraged by policymakers and explored by pension systems.

Bond markets are offering municipalities the opportunity to exchange discount rates of 6, 7 and sometimes even 8 percent for bonds with yields below 3 percent. The spread between the discount rate and the bond yield is the root of the appeal of pension obligation bonds.

A natural question is “How do pension systems become underfunded?” The answer is a combination of issues. The two largest are underperforming investments and insufficient employee contributions.

Are you kidding me.

Employee contributions?!

Given that all pension benefits, all the municipal employee payments, etc. come from the employers… it seems to me all the contributions come from the employers, ultimately.

Who is this person writing this piece?

Eric J. Mason is the Chief Financial Officer for the City of Quincy, Massachusetts. Quincy recently issued $475 million in bonds to address its unfunded pension liability.

Ah. I see.

Next piece on POBs:

USVI to refinance bonds to save public pension system

The governor of the U.S. Virgin Islands signed a bill Wednesday to refinance more than $800 million worth of bonds following numerous attempts to save a public pension system that officials say faces collapse.

Gov. Albert Bryan Jr. said the savings from improved interest rates would help stabilize the pension system for at least 30 years. Nearly 9,000 government retirees and 8,000 active workers rely on the public pension system, which officials warned could run out of funds by 2024 or sooner without a fix.

The signing marks Bryan’s fourth and final attempt to save the pension system, which has nearly $6 billion in unfunded liabilities. If the refinancing is successful, it is expected to generate some $4 billion total for the system.

I want you to pay attention to these numbers. So $800 million in bonds. This is covering benefits for 9K retirees and 8K active workers… and they were going to run out of assets by 2024. When public pension funds talk about running out of funds, they mean completely running dry, unlike with private systems or insurance companies talking about insolvency.

But this is only covering less than 1/6 of the unfunded liability.

So they’re expecting to cover the rest of the unfunded liabilities by future contributions, I assume….

Here is one more — a report that was recently released related to Providence, Rhode Island. I kept an eye on Rhode Island and Providence, specifically, before I was blogging on STUMP.

The report recommends the following:

Providence should request state legislative and city voter authorization to
issue a pension obligation bond sized to deposit $500 million into the ERS if
advantageous borrowing conditions and terms are met.

After much review, discussion, and deliberation, the Working Group supports the City
being granted the ability to issue a pension obligation bond (POB) that results in the
addition of $500 million to the ERS

….
POBs are fundamentally a funding opportunity that can, in the right market conditions
provide benefit, but which are not without risk. The concept is that a government issues
POBs and deposits the proceeds in its pension fund to increase the available assets.
The retirement system invests the pension fund assets which are projected to earn a
given rate of return – in Providence’s case 7.0 percent annually. This rate of return, if
higher than the interest due on the bond principal, results in potentially lower annual
costs. For example, if a government-issued a POB and earned, on average over the life
of the bond repayment schedule, a 7.0 percent rate of return and paid interest on the
bond at an annual average rate of 4.0 percent during the repayment period, it would
have generated an annual 3.0 percent positive benefit, on average. However, as the
City’s internal and external financial team notes – and good fiscal practice dictates –
taking on a fixed-debt service like a POB to invest in variable pension system assets
should never be considered a zero-risk approach because there are market and other
risks to weigh

This pension fund has been under 40% funded since 2002, and the contribution rate is over 50% of payroll as of FY2019.

This is not a sustainable situation.

I don’t think a POB is actually going to make it more sustainable.

My opinion of POBs — negative

Long-time readers know I am very negative about POBs (yeah, you know me!)

The nutshell version of how POBs “work”:

A sponsoring entity (often a state) will issue a POB, which is a long-term bond at a fixed rate, to cover part of the unfunded pension liability
The proceeds of that sale get handed over to the pension plan, which is then invested in assets to support the pension promises

Basically, the sponsor is borrowing money to fund the pension.

Why would this be a good idea?

Let’s try out three explanations.

Explanation 1. The pension liability is often valued at a relatively high discount rate, such as 7%, whereas the sponsor can borrow at a lower rate, such as 5%. This makes for a valuation arbitrage. Automatic savings. It’s bullshit arbitrage on paper. It’s just accounting.

Explanation 2. One can “guarantee” earning a return on assets for the investment at a higher rate than what you’re borrowing at… a real arbitrage. Which you can’t actually do. This is bullshit. Do not be a fool. This is how it used to be sold to trustees.

Explanation 3. By issuing a POB to cover the entire unfunded liability, the sponsor gets locked into more responsible behavior in paying the coupons of the POB, which are predictable. And then the sponsor will also be completely responsible from now on and cover the normal costs of the pension plan going forward.

That last reason is the only legit reason to do a POB. But that’s generally not what actually happens.

Usually, it’s the bad actors who do the POBs, because they built up very large unfunded liabilities due to their bad actions, and they use it as an opportunity to do even worse things.

Meep’s Cavalcade of Pension Obligation Bonds

Some old POB-related posts: [in no particular order]

You’ll notice most of my examples are from Illinois, but most of those are failed attempts at POBs.

That said, Illinois did manage to issue some POBs.

Not that it has done much for their unfunded liabilities, ultimately. You can barely see the effect of their old POBs as I roll forward in my old graphs.

So, as an individual, I bet you’d have more success in improving your credit score by reducing your short-term debt (via tax returns and stimulus payments) and improving your leverage via refinancing than do states via trying similar tricks before the interest rates start increasing.

And, just in case you missed getting your SO an impressive gift yesterday….

Best wishes!

STUMP » Articles » Positioning for a Potential Interest Rate Hike: Public Finance and More » 15 February 2022, 20:33