By Pro Publica. Originally published at ValueWalk.
When Wall Street Offers Free Money, Watch Out
by Cezary Podkul, ProPublica, and Allan Sloan, The Washington Post July 10, 2015, 10:15 a.m.
This story was co-published with the Washington Post.
If there were ever a time not to bet the moon on the stock and bond markets, it’s now, with U.S. stocks at near-record highs and interest rates on quality bonds at near-record lows. But Wall Street is urging state and local governments to do just that 2014 and they’re listening.
Despite the risks, governments are lining up to issue billions of dollars in new debt to replenish their depleted pension funds and, as a bonus, take some pressure off strapped budgets. In some cases, the borrowing makes their balance sheets look vastly better.
Bankers, who make fat fees for raising the money, are encouraging this borrow-and-bet trend. Their sales pitch is that borrowing at today’s low interest rates all but guarantees a profit for the governments because they can invest the proceeds in their pension funds and for decades earn returns higher than the 5 percent or so in interest that they will pay on the bonds.
But there’s a catch: If the timing is wrong, these so-called pension obligation bonds could clobber the finances of the government issuers. Pension funds and beneficiaries will be better off because pensions will be more soundly financed. But taxpayers 2014 present and future 2014 might be considerably worse off. They will be running huge risks and could get stuck with a massive tab.
“It’s sold as a magic bean,” said Todd Ely, a professor at the University of Colorado at Denver who has studied pension bonds. “But when it goes bad it’s not free. Then it isn’t really magic. If it could be counted on to work as often as it’s supposed to, then everyone would be doing it.”
Plenty of takers are bellying up to the borrowing bar. Governments sold $670 million worth of pension bonds through the first half of this year, more than double the $300 million raised for all of last year, according to deal-trackers at Thomson Reuters.
That total would more than double if Kansas completes a pending $1 billion deal, which would be its biggest bond issue. A $3 billion sale is under consideration in Pennsylvania, that state’s largest as well. Lawmakers recently rejected record multibillion-dollar deals in Kentucky and Colorado, but those proposals are expected to resurface. And new proposals are being pitched to other governments.
Pension bonds have waxed and waned since the 1980s, but the current boom is different. An examination by The Washington Post and ProPublica found that it’s being driven not only by the prospect of investment profits but also by a new accounting quirk that has largely escaped public notice while morphing into a major marketing tool for Wall Street banks.
The quirk stems from a rule change that, ironically, was meant to force governments to more clearly disclose the health of their pension funds. But a side effect is to allow governments with extremely underfunded pensions to slash reported shortfalls by $2 or more for each $1 borrowed.
Here’s how: If a pension plan is so poorly funded that it is projected to run out of cash, the new rules require it to make less optimistic projections about future returns. That increases the reported pension shortfall. But if governments infuse a big slug of borrowed money into the fund, they can resume using optimistic projections, and the shortfall shrinks.
It’s like getting a new credit card, borrowing on it to pay off part of an existing loan, then having the total amount owed magically shrink by more than what is borrowed. Sounds impossible 2014 but it’s true.
The impact can be dramatic. In March, the town of Hamden, Conn., reduced its unfunded pension amount by about $320 million with a $125 million pension bond and promises of future payments, according to an estimate by ProPublica and The Post. The Kentucky Teachers’ Retirement System said it estimates that a $3.3 billion bond issue plus payment promises could carve $9.5 billion off its unfunded liability.
Those figures don’t reflect the decades of debt and risk placed on taxpayers.
The rule change, from the Governmental Accounting Standards Board, has been in the making since 2006, but is only now starting to take effect 2014 and to be noticed. So GASB (pronounced GAZ-bee) is fast becoming a recognized acronym in state capitals.
“GASB is certainly a huge concern,” said Beau Barnes, deputy executive secretary of the Kentucky system. Until this year the term was unfamiliar to state legislators, he said, “but in 2015 when you say ‘GASB,’ most of them have an idea that it’s going to be bad.”
It’s not clear whether anyone involved in the long rulemaking process realized that the change would encourage governments to sell bonds to improve their balance sheets.
We asked GASB Chairman David Vaudt about this, but couldn’t get a clear answer. His response was, “We follow our due process, and the input that we consider is from our stakeholders: the preparers, auditors and users” of governmental financial statements.
The question of whether governments will come out ahead in the real world 2014 as opposed to the accounting world 2014 with pension bonds is far from clear. In large part, it depends on governments’ willingness to make substantial payments to their pension funds after the bonds are sold.
A review by ProPublica and The Post of the 20 largest pension bonds issued since 1996 found that in three-fourths of the deals, governments did not make their full required contribution in the years after the bonds were sold. Those bonds account for nearly two-thirds of the pension debt issued since 1996, according to Thomson Reuters. In more than half the deals, some proceeds even went on to make annual pension contributions 2014 borrowing from the future to pay today’s expenses.
Because of the underfunding, most of the pension funds now are worse off than before the bonds were issued.
In all five recent or proposed bond sales examined 2014 by Kentucky, Kansas, Pennsylvania, Colorado and the town of Hamden, Conn. 2014 the issuers and potential issuers said they were planning to make less than full payments for many years.
“These bonds are pernicious,” said Alicia Munnell, director of the Center for Retirement Research at Boston College. “They discourage pension funding. They shift costs forward to future generations.”
2018 Dark Road With Thorns’
Munnell said that soundly funding pensions is a much more important factor in the overall success of a bond issue than outearning interest costs 2014 which is largely a roll of the dice.
A 2010 study by Munnell’s group of all the pension bonds issued since 1986 showed that, in most cases, the interest paid on the bonds exceeded the return on pension fund assets. Returns had been hurt by the 2007-2009 market crash. But a 2014 update, five years into the current bull market, showed the reverse, with most issuers ahead.
Given this mixed history, Wall Street salespeople point to the bonds’ other benefits. Bonds offer “immediate budget relief,” as Citigroup put it in sales pitches to Colorado and Pennsylvania, whereas funding pensions “contributes to budget stress.”
In a pitch book to Kentucky, investment bank Raymond James asserted that the bonds would “materially reduce the reported liability” that the teachers’ retirement system would have to disclose under the new GASB rule. Bank of America Merrill Lynch also cited the rules in a pitch book to Pennsylvania. Both banks declined comment, as did others we contacted.
There’s big money at stake not only for the prospective borrowers, but for Wall Street as well. The pending $1 billion Kansas issue is expected to generate more than $3 million in fees for bankers, while providing budget relief for Gov. Sam Brownback (R) and lawmakers.
You can see why people whose time horizons don’t extend past the next election might like pension bonds: Reducing the required annual pension payments leaves more money for schools, roads and other needs.
Hamden’s experience shows how this can play out. In 2014, after years of underfunding, the small New Haven suburb’s pension fund was about to run out of money. The town faced the prospect of having to pay pensions directly out of its $211 million operating budget. The tab was projected to grow to more than $60 million annually, said Mayor Curt Leng, an amount Hamden simply couldn’t afford without a “gigantic tax increase.”
Hamden also would have had to show a huge increase in its unfunded pension liability under the new rules.
Connecticut law requires issuers of pension bonds to make the full required annual pension payments after the bonds are issued 2014 a safeguard to make sure politicians can’t dig the hole deeper later on. The law would have compelled Hamden to put in $29.5 million this year.
“We would have had to lay off half our police force and three-quarters of our fire department to make it happen,” said Scott Jackson, who was Hamden’s mayor when the
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