Toxic Pension and Municipal Bonds; State and Local Borrowing Hits All-Time High

According to the Wall Street Journal, state and local borrowing as a percentage of U.S. GDP has risen to an all-time high of 22% in 2010.

Please consider America's Municipal Debt Racket.

Nearly 40 years ago the Garden State borrowed $302 million to begin constructing the Meadowlands. The goal was to pay off the bonds in 25 years. Although the project initially went according to plan, politicians couldn't resist continually refinancing the bonds, siphoning revenues from the complex into the state budget, and using the good credit rating of the New Jersey Sports and Exposition authority to borrow for other, unsuccessful building schemes.

Today, the authority that runs the Meadowlands is in hock for $830 million, which it can't pay back. The state, facing its own cavernous budget deficits, has had to assume interest payments—about $100 million this year on bonds that still stretch for decades.

California's redevelopment regime is an object lesson. Starting in the 1950s, the state gave localities the right to create public agencies, funded by increases in property taxes, which can issue debt to finance redevelopment. A whopping 380 such entities now exist. They collect 10% of all property taxes—nearly $6 billion annually—and they have amassed $29 billion in debt never approved by voters for projects ranging from sports facilities to concert venues to retail malls, museums and convention centers.

In 1999, Fresno conceived plans to revive its downtown area with various projects, including a baseball stadium for the minor-league Grizzlies, which it had lured from Phoenix. The city's redevelopment agency floated some $46 million in bonds to build the stadium. But the Grizzlies fizzled in their new home, demanded a break on rent, threatening to skip town and stick taxpayers with the entire $3.4 million annual bond payment on the facility. The team is now receiving $700,000 in annual subsidies to stay in the city.

Another weapon in the debt arsenal is the so-called pension-obligation bond. For two decades, governments have played a risky arbitrage game in which they issue bonds and then deposit the money in their pension funds to be invested in the stock market with the hope that the money will outperform the interest rate on the bonds. In a stock market that's been stagnant for years, pension bonds have become fiscally toxic. As the Center for State and Local Government Excellence noted in a report earlier this year, most pension bonds issued since 1992 have been money losers for states and cities, exacerbating severe underfunding of pension systems in places like New Jersey.

Pension Bond Madness

Even though pension bonds issued since 1992 have been money losers for states and cities., professor Joshua D. Rauh, at the Kellogg School of Management, Northwestern University, has proposed Pension Security Bonds in a New Plan to Address the Pension Crisis.

While I agree with several aspects of professor Rauh's plan, pension bonds is certainly not one of them.

I recently discussed why in Seven State Pension Plans Out of Money by 2020

Pension Security Bonds

I am exceptionally leery of new government programs because the programs always cost more than expected. The proposed "Pension security bonds" will prove to be no different.

For starters, I sincerely doubt we see 8% returns on average for a very long time. Indeed it would not surprise me to see negative stock market returns for a few more years.

Japan had two lost decades and it looks like we are headed that way as well. Even flat returns would be a disaster for pension plans.

Main Points of Agreement

I am certainly in agreement with Professor Rauh that [public] pensions are THE number one thing bankrupting states.

I also agree with Rauh that we need to kill defined benefit plans going forward. Moreover, we really need to go the next step and get rid of public unions altogether. They wrecked Europe and they are wrecking the US.

At a bare minimum, the defined contribution plans and wage scales for public unions should be no better than in the private sector.

However, I cannot support pension bonds even though I understand Rauh's point that "politicians will inevitably cave in and waste loads of money on the bailout... they do it every time."

As I see it, pension bonds are nothing more than a taxpayer sponsored bailout (caving in) in advance. If returns come in at 0% for 5 years, exactly what will the bailout cost?

I would like to see some real numbers here and I do not want taxes to go up one dime to pay for this mess.

Fantasyland Projections

Given that 8% returns are likely Fantasyland material, I believe states will be out of money long before the dates proposed.

The economic headwinds right now are enormous. Those headwinds include massive debt overhang, boomer demographics, global wage arbitrage, massive housing inventory, massive shadow inventory, rising taxes, rampant overcapacity, and structurally high unemployment. ...

Pension Bonds are Money Losers

As Bloomberg reports, pension bonds have been money losers since 1992.

Worse yet are the current unsustainable pension plan assumptions of 8% coupled with a horrific fundamental backdrop of debt deflation, boomer retirement dynamics, and short-term treasury yields at close to 0%.

It is extremely difficult right now to make money on borrowed money with the above conditions and with short-term treasury yields close to 0%.

Moreover, pension management clowns are nearly always 100% invested, 100% of the time, and typically 100% long. Good luck with that.

If the stock market rises 2-4% annualized for the next five years, that will be a good achievement.

However, borrowing money at at 3% and getting a 3% return before interest (netting zero%), while needing 8% is a veritable disaster. Yet 3% annualized is my best case scenario, and I doubt we hit it.

Pension bonds are not the answer.

Mike "Mish" Shedlock
http://globaleconomicanalysis.blogspot.com
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