STUMP » Articles » Illinois Idiocy: Let's Issue Pension Obligation Bonds When Our Ratings Are Low! » 30 January 2018, 09:59

Sounds like a plan.

Before I get to the obvious downsides of such a thing, let us look at the straight news stories on this idiotic idea.

LET’S DO THE LARGEST PENSION OBLIGATION BOND EVER

Illinois ponders pension-fund moonshot: a $107B bond sale

(Bloomberg) — Springfield lawmakers are so desperate to shore up the state’s massively underfunded retirement system that they’re willing to entertain an eye-popping wager: Borrowing $107 billion and letting it ride in the financial markets.

The legislature’s personnel and pensions committee plans to meet on Jan. 30 to hear more about a proposal advanced by the State Universities Annuitants Association, according to Representative Robert Martwick. The group wants Illinois to issue the bonds this year to get its retirement system nearly fully funded, assuming that the state can make more on its investments than it will pay in interest.

It would be by far the biggest debt sale in the history of the municipal market, and in one fell swoop would be more than Puerto Rico amassed in the run up to its record-setting bankruptcy.

“We’re in a situation in Illinois where our pension debt is just crushing,” Martwick, a Democrat who chairs the committee, said in a telephone interview. “When you have the largest pension debt in the world, you probably ought to be thinking big.”

Illinois owes $129 billion to its five retirement systems after years of failing to make adequate annual contributions. Because the state’s constitution bans any reduction in worker retirement benefits, the government’s pension costs will continue to rise as it faces pressure to pay down that debt, a squeeze that has pushed Illinois’s bond rating to the precipice of junk.

The debt is crushing, so let’s issue more debt.

Ironclad logic.

via GIPHY

Up there with assuming they’ll be able to make more in investments than it costs in interest… with one being speculative, and the other being “sure”.

I wonder how many suckers they’ll find… I have an amusing theory regarding the intersection of the SALT cap and crazy muni issues. I will leave that to another time, because I’m trying to see what the muni market will actually do this year. I think higher yields are to come, but I could be wrong.

Another straight news piece: Funding gap spurs unlikely proposal for $100 billion of new Illinois pension bonds

CHICAGO – Municipal market participants threw cold water on a proposal pitched by an Illinois pension advocacy group to borrow more than $100 billion to pay down the state’s massive unfunded pension tab.

The proposal pitched by the State Universities Annuitants Association calls for Illinois to issue $107 billion of 27-year fixed-rate bonds this year to bring the five-fund state system up to a 90% funded ratio.

The state has $128.9 billion of unfunded liabilities and the retirement system is just 39.9% funded based on fiscal 2017 actuarial data. Based on the market value, the tab totals $129.1 billion for a funded ratio of 39.8%.

Here’s my question: if the “arbitrage” is real, why not borrow the full shortfall on the pensions? Why do only 90%?

The 10-year yield on the state’s $4.5 billion GO sale late last year landed at a 184 bp spread to the Municipal Market Data’s AAA benchmark. The spread is currently at 185bp and the average over the last 12 months is 206bp, said MMD municipal strategist Dan Berger.

“There is a reason almost nobody that is concerned with either government finance best practices or protecting taxpayers recommends using POBs unless it is part of a holistic pension funding solution,” the buyside analyst said.

I don’t see that this is going to be pulled off at all, unless there is some kind of state constitutional amendment on the table, which allows for dialing down pensions for those currently working (and even current retirees).

Final straight news piece: Illinois Could Consider $107 Billion Pension Bond Gamble

SUAA proposal to be entertained Jan. 30.

Scrambling for a solution to shore up its pensions and eliminate its $129 billion pension debt, Illinois lawmakers will meet Tuesday to discuss a proposal that could see the largest municipal debt sale in history.

DON’T DO IT!!!

I don’t know what the outcome is going to be this evening, but they should not pursue this idea.

PROMO MATERIAL

This is the promo item with the bright idea.

There are an awful lot of assumptions behind that, don’t you think?

via GIPHY

Here is a press release touting the actuarial academic they hooked in for this:

University professor develops model to address pension crisis

The pension system in Illinois, which costs $8.5 billion annually to run, is putting the state in a financial crisis, but University professor Dr. Runhuan Feng may have found a solution.

Feng has developed a mathematical model to address the state’s pension crisis, which is crushing the state budget and draining resources from public universities, according to the State University Annuitants Association, or SUAA.

The SUAA works to protect the pensions and benefits of retired and current university professors in Illinois.

They hired Feng to develop a mathematical model to fund the pension system, said John Carr, Springfield lobbyist for the SUAA.

Carr said the cost to run the state pension system would double by 2045.

The full debt from the pension system right now is around $129 billion and according to state law, 90 percent of that debt must be paid to the pension system by 2045, Carr said.

Feng’s model proposes combating this debt by selling $107.42 billion in 27-year, fixed-rate bonds, while setting aside and investing approximately 35.82 percent of the sold bonds in special funds.

“That’s called interest rate arbitrage, and according to professor Feng’s model, it will pay the debt service until 2045,” Carr said.

It’s a bullshit arbitrage.

For this to “work”, requires multiple things to happen:
- the bonds can be sold at a low enough interest rate
- the assets the bond proceeds are invested in will give the expected dollar-weighted return of 7.9% (or whatever) for the liabilities they’re supposed to cover
- and the non-investment valuation assumptions are spot on

I would love to see the purported model and paper, so I could do a little sensitivity testing on the results.

CRITIQUES

Multiple critiques, but Wirepoints gets pride of place.

Martwick’s reckless approach to Illinois pension ‘reform’ – Wirepoints Original

A new proposal to pay down Illinois’ pension debt by borrowing more than $100 billion from Wall Street should be called out for what it is: reckless.

State Rep. Robert Martwick (D-Chicago) wants the state – meaning taxpayers – to borrow $107 billion so that those proceeds can be given to the state’s pension plans. Proponents of the plan say that the pension bonds would actually save the state $103 billion over the next 25 years.

Martwick’s plan also includes a voluntary COLA buyout which is also destined for failure. But it’s his borrowing plan that deserves the most attention.

Martwick’s bond deal is a non-starter for many reasons.

First, the plan does nothing to alleviate the stress that state debt is putting on the residents of Illinois. Martwick’s plan simply trades out one form of debt for another. That’s not reform by any means.

Instead, his plan would curse Illinois with a junk rating. Today, the state already has more than $31 billion in state-supported debt.
…..
That forecast assumes the pension funds can hit, on average, their 7 percent annual investment returns for the next 25 years.

It also assumes that retirees won’t keep living longer. There’s lots of assumptions that can go wrong and make things worse – which is how it’s been for the last three decades.

There’s lots of meat in the Wirepoints post – go check it out.

Here’s a key graph:

Mind you, POBs were already issued by Illinois over a decade ago. How have they done?

I totally agree with the Wirepoints conclusion:

Illinois has to change its constitution and work with the federal government to enact some form of bankruptcy protection. It’s the only way to both protect retirees and still allow the state to provide core services.

Here are the choices Illinois employees & retirees have:

- have an orderly adjustment of their benefits, under a constitutional change, etc.
- have a disorderly adjustment when the money runs out

I think the first is preferable. The second is a likely outcome.

Second, John Bury’s take: Pension Obligation Bonds: Fallacies & Realities

Here is what will be conveniently overlooked by those pushing these Pension Obligation Bonds (POBs)….

Funded Ratio:

Fallacy: Put the bond money into the plan and the funded ratio goes from 42% to 100%.

Reality: It’s a liability. A debt. Even if the repayments will not be filtered through the plan itself it will need to come from a source (taxpayers) who would otherwise be making those payments into the plan. It is deceptive and disingenuous to pretend an asset has been created without a corresponding liability.

Interest Rate Arbitrage:

Fallacy: You make repayments at 4% that earn 7.5% per the plan assumptions

Reality: Interest rate assumptions for funding public pensions are a fiction designed only to understate contribution calculations. There could easily be an honest estimate of what the asset mix in a particular plan will return but picking a random (high) number is so much more efficacious for the deciding parties.

Cost of Borrowing:

Reality: There is a cost to borrowing. You pay it to get a house or a car since you are willing to pay the price of admission into the middle class. But if you already have an obligation to pay off (either student debt or a home mortgage) are you going to take out another loan with the proceeds to be invested in hedge funds that hopefully return more than the loan payments? Who would buy that as a reasonable strategy…..outside of an Illinois politician?

Mind you, I don’t think this POB idea is seriously on the table, because the days of Illinois receiving favorable interest rates are long gone.

Other commentators: Zero Hedge notes –
Illinois Unveils Another Shocker: Sell A Record $107 Billion In Debt To Fund Insolvent Pensions

If there is such a thing as financial hell, it is probably Greece… with Illinois coming in close second.

For those unfamiliar, here’s a quick recap: Illinois (rate just one notch above junk) is drowning under a mountain of debt, unpaid bills and underfunded pension liabilities and it’s largest city, Chicago, is suffering from a staggering outbreak of violent crime not seen since gang wars engulfed major cities from LA to New York in the mid-90’s, while rising taxes have prompted a mass exodus with the state lost 1 resident every 4.3 minutes in 2017.

….
According to Bloomberg, Illinois lawmakers are so desperate to shore up the state’s massively underfunded retirement system that “they’re willing to entertain an eye-popping wager: Borrowing $107 billion and letting it ride in the financial markets.”

If that number sounds oddly large, is because it is: an offering of this size would be by far the biggest debt sale in the history of the municipal market, and amount to roughly 50% more debt than bankrupt Puerto Rico accumulated in the run up to its record-setting insolvency.

Putting the proposed deal in context, Illinois had $26.3 billion of general-obligation bonds as of July and the state sold $750 million of bonds in November to pay down unpaid bills that had accumulated during its two-year budget impasse. The state still has $8 billion of unpaid bills even after that issuance, according to the comptroller’s office.

An Illinois Democrat came up with the perfect soundbite framing this head-scratching proposal:

“We’re in a situation in Illinois where our pension debt is just crushing,” Martwick, a Democrat who chairs the committee, said in a telephone interview. “When you have the largest pension debt in the world, you probably ought to be thinking big.”

In other words, with left nothing to lose, Illinois may as well go big. So big, in fact, it’s never been seen before.

Here’s the deal. There has to be somebody on the other side of the deal.

There are institutional investors – there may be ones currying favor with Illinois politicians, betting with other people’s money, and so maybe they don’t mind the risk. It’s not theirs, right?

But more to the point, there are individual investors – people like John Kerry & Nancy Pelosi – who need the tax break from munis. Well, with their tax-exempt income taking a hit with the SALT cap, maybe they are ripe suckers. I’d love them to be plucked. I bet these are the sorts of suckers who assume they wouldn’t be defaulted upon… or, at least, they’ll be dead by the time these POBs default.

LET’S GET REAL: THIS IS SMOKE

The commentators above are talking as if these POBs are a serious plan, with likelihood of being pursued.

It’s not.

Let me explain why.

Or perhaps this explanation will do:

In 2008, Puerto Rico opted to plug a hole in its retirement system funding by issuing Pension Obligation Bonds (POBs). The Commonwealth borrowed $3 billion from bond investors to contribute to its Employees Retirement System (ERS), Puerto Rico’s analog to CalPERS.

Puerto Rico’s timing could not have been much worse. Between early 2008 and early 2009, the Dow Jones Industrial Average declined by about 50%.

ERS disclosures do not allow us to see precisely how poorly the investments purchased with the POB money performed, but we do know that the total value of the system’s assets fell from $5.77 billion on June 30, 2008 to $5.07 billion on June 30, 2009 – a decline of about 15%. One saving grace for ERS is that a lot of its assets were held in cash or cash equivalents. That is usually a bad practice for a pension fund investing for the long term, but it worked in this case.

We have been on a very long bull market run.

Now, perhaps it will continue longer, with Trump’s tax cuts and deregulation push.

But perhaps there are bubbles in the market.

Anyway, there was a POB idea in California last year. California still has a better bond rating than Illinois (I have no idea how long that will last). California has not yet issued any such POBs.

What’s California’s pension shortfall?

Using state info from the Public Plans Database, here are the official shortfalls of Calpers and Calstrs as of fiscal year 2015:

Calpers: $414.2 billion
Calstrs: $280.0 billion

Total: $694. 2 billion

Even bigger than the 5 Illinois funds. California may have better funded ratios, but they also have even bigger liabilities, unsurprisingly, given how bigger California is.

And that’s using official valuations. I assume the true shortfall is much bigger.

If California dare not issue POBs to cover their hole, I doubt Illinois will to fill something much smaller.

Various Illinois politicians may keep pursuing this idea, but perhaps the bond market will price them out of this “clever” idea.

via GIPHY