Monday, November 5, 2012

Will California Bankruptcies Rock Munis?

Cities' disputes with CalPERS have ramifications, Moody's says:
San Bernardino's and Compton's disputes with CalPERS, the state's public employee pension fund, could have ramifications for other cities and their creditors, credit rating firm Moody's said in a new report.

"These situations could open the door for courts to decide whether pension payments can be legally suspended or modified if a California local government is in financial distress and/or bankruptcy," Moody's wrote in its weekly credit outlook released Friday.

On one hand, the report warned that if the financially troubled cities succeed in delaying or reducing their CalPERS payments, it "could incentivize other financially distressed cities to seek concessions from all creditors," including bondholders.

On the other hand, if cities are not required to make full pension payments while in bankruptcy, the report said, more might be left for other creditors, including bondholders.

San Bernardino, facing a $46-million general fund deficit, filed for Chapter 9 bankruptcy protection Aug. 1 and stopped making the employer portion of its pension payments. As of Friday, the city owed nearly $5 million to the pension fund, CalPERS spokeswoman Amy Norris said.

CalPERS filed an objection to San Bernardino's bankruptcy, suggesting it was simply a maneuver to avoid creditors and that the city had not developed a plan to pay its expenses in the future.

"It appears that the City is financing its postpetition operating deficit by incurring postpetition obligations and simply not paying its postpetition bills," the filing said. It accused the city of "digging a hole that gets deeper every day."

The city said deferring pension fund payments was necessary to allow the city to pay employees and "keep providing the most basic and critical services to the community."

Compton, which has not filed for bankruptcy but has struggled with a $40-million deficit and a lack of cash to pay bills, also fell behind on its CalPERS payments, prompting the agency to file a lawsuit against the city in September.

At that time, the city owed about $2 million, which later grew to $2.7 million, but it has since paid down all but about $600,000.

City Manager Harold Duffey said the city will be able to bring its payments up to date in December, when it expects to receive about $5 million from a parcel tax designated to pay pension costs. The city is also hoping to secure a $10-million line of credit this month.

"If PERS looks through their records, they clearly understand the city has had a history of falling behind on PERS payments and catching up in December," Duffey said.

He said the current issues with CalPERS stemmed from a conversation about bankruptcy at a City Council meeting in July. City officials have since said they have no intention of filing for bankruptcy, but the discussion "made everyone nervous," Duffey said.

Other California cities that previously filed for bankruptcy, including Vallejo and Stockton, continued to make their CalPERS payments. Some of Stockton's creditors, including bond investors, have challenged that city's bankruptcy filing, arguing that the city should have sought concessions from CalPERS.

"If either San Bernardino or Compton succeed in redefining its pension obligations, it would set a precedent that CalPERS (and potentially CalSTRS, the California State Teachers' Retirement System) can be brought to the negotiating table," the Moody's report said. "CalPERS, however, has every incentive to pursue all of its legal rights to their fullest extent to make these cities pay under California law, and so discourage other fiscally stressed California municipalities from withholding their required pension payments."
The issue of suspending pension payments has received a lot of attention in California, with no shortage of opinions in the media over who's to blame. Dan Walters of the Fresno Bee reports, Pension crises end up in courts:
As financially troubled cities suspend their payments to California's pension fund, federal bankruptcy judges may have the final word on the long-assumed inviolability of retirement benefits.

Neither Vallejo nor Stockton mentioned pension rights of current or retired employees when they filed for bankruptcy, even as they sought relief from holders of bonds and other creditors. But companies that had insured hundreds of millions of dollars in Stockton's bonds mounted stiff resistance, contending that if they had to take a financial haircut, the city's retirees should as well.

The California Public Employees Retirement System (CalPERS) geared up for legal war, insisting that pensions are sacrosanct.

That issue is still pending, but the Sacramento bankruptcy judge handling the Stockton case ruled in a related issue that Stockton's contractual health-care obligations to its retirees could be voided under federal bankruptcy law, thus heightening legal uncertainty about pensions.

Then San Bernardino filed for bankruptcy, listing CalPERS as its largest single creditor at more than $140 million, and stopped making pension fund payments.

Once again, CalPERS geared up for legal war and asked the judge handling the San Bernardino case to reject its bankruptcy petition, saying the city was trying to improperly renege on its pension debts.

That issue, too, is still pending.

And then Compton, which hasn't yet sought bankruptcy but may be headed in that direction, stopped making its payments to CalPERS, at least temporarily. Compton owes CalPERS nearly $3 million.

Once again, CalPERS geared up for legal war.

Paperwork filed by San Bernardino illustrates how rapidly rising pension costs have hammered many California cities. The city says in its filing that retirement costs had escalated from $6 million in 2000-01 to $22 million in 2009-10 and are projected to hit $24 million in a few more years.

"The increased retirement costs that the city will experience are unsustainable," the city says, "and therefore immediate major intervention is necessary now."

On one level, cities suffering pension-cost angst don't deserve our sympathy. They expanded pension benefits, especially those for high-cost police officers and firefighters, with little regard to future impact.

But CalPERS encouraged those increases by supporting legislation to raise state employee pensions in 1999, claiming that investment gains would easily pay for them.

Moreover, much of the cities' added costs are being imposed by CalPERS to make up for the horrendous investment losses the pension fund incurred in the last decade. A day of reckoning is coming, and it may come in federal bankruptcy court.

Whoah! A shot to CalPERS there in that last paragraph, one that is grossly unfair and totally false.

I've already covered the showdown in San Bernardino and what's going to happen if other cities follow the lead straight outta Compton. The potential nightmare for CalPERS and other US public pension funds cannot be be underestimated, which is why CalPERS is pursuing all legal means to secure these pension payments.

Back in August, Steven Greenhut of Bloomberg wrote an article, California Bankruptcies Shield Retirees, Not Bondholders:
The recent war of words between the California Public Employees’ Retirement System and a Bermuda- based bond-insurance company called Assured Guaranty Ltd. (AGO) has made it clear that California officials would rather stiff bondholders than trim even the most generous pension benefits promised to public-sector workers.

The debate centers on Stockton, California, the largest city in the nation to declare bankruptcy. In its initial proposal to creditors, the city would fully fund its pension system while walking away from $124 million in debt from pension-obligation bonds it floated in 2007.

Stockton couldn’t meet its financial obligations to pay for enhanced pension benefits five years ago, so it borrowed the money. Rather than cut unsustainable benefit levels while it has the chance to do so now, officials there would rather default on the $103 million it owes Assured (AGO) Guaranty.

Stockton and other Californian cities have slashed public services, thus putting the demands of public employees above the concerns of taxpayers and residents who rely on public services. Now we see that even bondholders don’t stand a chance when their interests collide with those of public-sector unions.

It’s easier to take on an offshore firm than confront CalPers, which had threatened to wage a protracted court battle against another Californian city, Vallejo, if it decided to reduce pension promises after its 2008 bankruptcy. Stockton officials no doubt are aware of that threat.
Investor Warning

“Chapter 9 was not intended to be used as a sword to prefer one class of similarly situated creditor over another,” said Assured Guaranty in an Aug. 1 statement. “Stockton’s attempt to transfer the cost of lucrative, above-market employee wages and benefits granted when tax revenues were flush to capital markets creditors by haircutting bond principal is unprecedented, a contortion of the bankruptcy process and will foreclose Stockton’s access to the capital markets for the foreseeable future.”

CalPers’s general counsel, Peter Mixon, responded to Assured Guaranty, with bravado typical of the retirement fund: “The obligations owed to the public workers of the city have priority over those of general unsecured creditors including bondholders,” he said. “Unlike insurance companies, policemen, firefighters and other public employees are not in a position to evaluate credit risk of their employers. Assured Guaranty is in the business of evaluating these risks.”

Stockton City Manager Bob Deis also took aim at the company. He told the Stockton Record that Assured Guaranty is only interested in getting its money and didn’t care if anarchy reigned on Stockton streets, a reference to reports that 20 or more police officers were leaving or thinking of leaving an understaffed department. “Assured Guaranty wants more than that?” Deis said. “If that’s not bad faith and whining, I don’t know what is.”

Yet Assured Guaranty can’t be blamed for any anarchy on Stockton’s streets. That’s largely the fault of city officials there who have for years gone on a spending spree. Deis himself blasted the health plan the city approved in the mid-1990s that gave many city employees and their spouses “free” lifetime health care -- something that created a $417 million unfunded liability. Stockton officials also granted police and firefighters a 50 percent pension increase in the early 2000s, allowing them to retire at age 50 with 90 percent of their final year’s pay.

When real-estate prices were soaring as commuters headed east into the Central Valley to flee exorbitant Bay Area prices, Stockton officials spent every dime of the increasing tax revenue and more. They “invested” in taxpayer-funded arenas, a waterfront park complex and other dubious redevelopment structures now scattered throughout a downtown known mainly for its high crime and vacancy rates.
Buffett’s Pullback

Some Stockton officials blame the economic decline for their current mess. Housing prices have fallen almost 70 percent from the height of the market, leaving a wake of foreclosures and plummeting tax revenue. Had officials shown restraint during the good years, however, they wouldn’t need to slash a quarter of the police force and other services during these bad years.

Stockton’s and CalPers’s “tough luck” approach toward Assured Guaranty could have troubling long-term consequences. Writing in the Prop Zero blog, Joe Mathews noted that Warren Buffett’s Berkshire Hathaway Inc. -- which had played down concerns about municipal bankruptcies -- dramatically cut its municipal investments after the Stockton and San Bernardino bankruptcy news.

A report released by the Securities and Exchange Commission last month called for Congress to embrace new disclosure rules so that investors are better informed of the risks involved in municipal-bond investments. The insistence by CalPers that full pension payments come above even bondholders’ investments should provide impetus for those reforms, and could stoke SEC fears that the public will lose confidence in bond markets.

Fortunately, just because CalPers claims that pensions take precedence over everything else doesn’t resolve the issue. Marcia Fritz, the president of pension-reform group California Foundation for Fiscal Responsibility, claims this is the opening shot in a long legal battle. She says CalPers is misconstruing the state constitution, which requires agencies to make sure there is money to pay for its pension obligations, but it doesn’t mean pensions can’t be cut during a bankruptcy proceeding.

If the CalPers argument holds, then “nothing is safe anymore, except pension promises,” she said. “What Stockton is exposing is the vulnerability of bond insurers in the pension crisis. I’m concerned they may be undercapitalized to handle major bankruptcies like Los Angeles if judges rule that pension promises, no matter how outrageous, are senior to bond debt.” Bond debt, she said, will be more expensive to handle because of higher insurance premiums.
Offloading Costs

The unfolding battle reminds reformers that municipal bankruptcy is no panacea for a city’s woes. If elected officials don’t have the courage to confront existing pension obligations, then such bankruptcies will do little more than offload the costs onto bondholders and taxpayers.

Stockton reduced its overly generous retiree medical plan, but the pensions of current employees remain an enormous problem. If the courts allow Stockton to proceed on its current path, then instead of helping cities fix their fiscal woes, a coming wave of municipal bankruptcies might only encourage them to continue foisting their troubles on others. Bondholders aren’t the only ones who should be worried.
Indeed, bondholders aren't the only ones that should be worried. As cities slash costs and miss pension payments, taxpayers and retirees will feel the pain too.

What amazes me is how well the municipal bond market is holding up in spite of the rumblings in California and other states facing even more dire pension woes. In fact, debt sold by Illinois issuers is rallying the most in 20 months in the face of a warning that the state’s pensions may run out of money and drain funding from education, infrastructure and local aid:
Investors seeking to enhance returns amid the lowest municipal interest rates in a generation shrank the extra yield on bonds of Illinois and its localities to 1.43 percentage points last week, the least since February 2011, data compiled by Bloomberg show. The yield spread relative to AAA tax-exempts is still the highest among 19 states tracked by Bloomberg.

Debt-holders in the lowest-rated U.S. state by Moody’s Investors Service are willing to take the risk because of their confidence in getting repaid. Illinois is one of seven states with the strongest legal provisions for paying debt service on its general obligations, according to Fidelity Investments.

“You would think the state would be penalized for its lower rating, but I believe people look at its statutory requirement to pay debt,” said Michael Belsky, head of muni research at SF Investments Inc., which oversees about $500 million in Highland Park, Illinois. “Before they pay the governor, build a highway or fund a prison, they have to pay debt service first.”
Maybe but I wouldn't count on it. I'm uneasy about how muni bonds and pension-obligation bonds will fare if courts end up deciding who is entitled to what. This could get very messy for all parties, not just bondholders.

On Tuesday, voters will decide the fate of scores of bond referendums totaling $34.2 billion along with a slew of ballot measures, including several dealing with raising or restricting taxes:
The amount of bond authorizations requested by states, cities, schools and other issuers in the $3.7 trillion municipal bond market is up from the $16.5 billion of bonds on ballots in November 2011 and November 2010's approximately $15.8 billion.
But it is well under the $67 billion of debt voters were asked to approve during the last presidential election in November 2008, according to data company Ipreo.

Chris Mier, a managing director at Loop Capital Markets, said the sharp drop from four years ago reflects a growing sensitivity about borrowing amid concerns over the excess of public debt that is fueling the crisis in euro zone countries and the U.S. government's own huge debt load.

"Politicians and public servants are much more reluctant to bring bond issues before the public," he said.
Worries about the economy may also lead to more 'no' votes on bond issues. Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management, said the 80 percent passage rate enjoyed by bond measures on presidential election ballots over the last 10 years may slip this year because voters may decide that "the economic times are not conducive to adding taxes" needed to pay off the debt.
Not conducive to adding taxes? That's an understatement! Voters are fed up with public spending run amok and paying for sweet pension perks offered to public sector workers. While I'm all for defined-benefit plans, it's time to put an end to abusive practices in public pensions.

No matter who wins the election tomorrow, austerity is coming to the USA. And even though it won't be another Greece, it won't be pretty. As more cities go bankrupt, taxpayers, bondholders and retirees will all feel the pain from years of ignoring the pension catastrophe.

Below, Thornburg Investment Management's Brian McMahon talks about municipal bonds and why muni investors are buying California's bonds. And Peter Hayes, head of municipal bonds at BlackRock Inc., talks about the impact of Hurricane Sandy and the presidential election on the muni bond market and investment strategy.