Haven’t we had enough financial shenanigans for one lifetime? Can’t we at least wait for the next generation of politicians and bankers before we repeat the economic sins of the last decade or so?
The governor of Pennsylvania wants to issue $3 billion worth of bonds and use the proceeds to meet the state’s mandatory pension contribution. This sort of activity is not new, but it has long since been discredited. When a city, state or other entity borrows money to make a pension contribution, they are betting on a certain outcome. The borrower must believe that the pension plan will earn a higher rate of return than the interest paid on the debt. If it earns less than that, the borrower ends up in even more debt.
This is exactly what happened to the State of Illinois in the early 2000s. It owed the bondholders no matter what, but the funds didn’t earn anything near their expected return. The problem is that issuers are trading an obligation that is certain — the bonds they sell and must pay off — for a return that is expected, but uncertain.
Clearly, issuers that use this sleight-of-hand have financial difficulties. If they didn’t, they would have the funds necessary to make their pension contributions. But there in lies the rub – state pension contributions aren’t mandatory. There’s no way to force a state to make them.
When they skip payments, it doesn’t show up as an unpaid bill — it just means that their pension liabilities loom larger. Until a city or state misses a pension benefit payment, there’s no injured party that can sue to demand regular contributions.
Since all this is widely known, you’d expect investors to demand higher interest payments on pension obligation bonds, but they don’t. That’s because their need for yield is so desperate that investors of all stripes look past the red flags. “Surely the city or state will handle it,” they think.
Only, as we found out with Detroit, local government can leave bondholders almost empty-handed.
Bondholders Feeling the Blues in Motown
When the Motor City went bankrupt, the city, like many others, had borrowed money in the mid-2000s to make its pension payments. When things went south, it sued to have the bond issue declared illegal. It claimed that city officials at the time had improperly indebted the city.
Even if that was the case, the pension fund should have simply returned the borrowed money to the bondholders, less interest paid. Instead, those bondholders ended up at the bottom of the totem pole. They received just 13 cents on the dollar of what the pension funds owed them.
Now again, we have city and state officials entering into questionable financial transactions, and investors playing the part of willing accomplice. This leaves two groups without a seat at the table — current and future retirees who want their money, and taxpayers who are on the hook to pay the benefits and debt service…as taxpayers usually are.
When these bonds deals go bad, as they so often do, it’s these folks who feel the pain. While it seems outrageous that states like Pennsylvania and Kansas, as well as various counties and cities across the nation, would implement the same transactions, consider the alternative: definite bankruptcy, or “maybe-not-if-we-pull-a-few-strings bankruptcy.”
I guess rolling the dice on a bond deal that will eventually be someone else’s problem is a lot easier than actually addressing the issue.
DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer