Author Archives: Eileen Norcross

Municipal pension news: Baltimore to offer DC plan

Earlier this month, Baltimore’s city council approved a measure to give the city’s workers a choice between a defined contribution or defined benefit plan plan. According to Pensions and Investments, new hires will contribute 5 percent of their salary to whichever plan they choose, a significant increase from the 1 percent that workers were required to begin contributing to the city’s pension system last year. (Previously, workers had not contributed to their pension). As the article notes, the choice between a DB and a DC plan is a compromise. Mayor Rawlings-Blake preferred to move all newly hired employees to a DC plan, but this was not agreed upon by unions. In total, Baltimore two pension systems have an unfunded liability of $1.4 billion on a GASB-basis.

Baltimore’s proposed reforms are a bit stronger than the plan currently considered by Chicago mayor Rahm Emanuel, which is largely focused on filling in very daunting funding gaps in the city’s multiple plans. The Wall Street Journal reports that the mayor’s plan to raise property taxes by $250 million represents an increase of about $50 a year for the owner of a $250,000 home. And, it’s not enough to cover the gap. The state will demand an additional $600 million in annual payments for the city’s police and fire funds by 2016. In addition, Mayor Emanuel proposes benefit cuts, such as  increased employee contributions and reduced COLAs. But structural reforms aren’t being pushed too strongly, instead, the focus in Chicago appears to be a search for more revenues. Consider a proposal floated by The Chicago Teachers Union. They would like to see a per-transaction tax levied on futures, options, and stock trades processed on the Chicago Mercantile Exchange (CME) and Chicago Board Options Exchange.  Both the CME and Mayor Emanuel oppose the idea recognizing that it will simply drive the financial industry out of town.

 

Is American Federalism conducive to liberty?

In new Mercatus research, Dr. Richard E. Wagner, Harris professor of Economics at George Mason University tackles a fascinating question: Is the American form of federalism supportive of liberty?

His answer is a qualified ‘yes.’ Under certain conditions, American federalism does support liberty, but that very same system can also be modified resulting in the expansion of political power relative to the liberty of citizens. The question of what results from the gradual constitutional transformation of the American federalist system is a salient one for not only students of government but also policymakers.

The important conditions that determine which form of federalism prevails (liberty-supporting or liberty-eroding) are rooted in competition among governments. Today we are experiencing a very different kind of federalism than the one instituted by the Founders. For the better part of a century, the US constitution has often been amended in a way to encourage collusion among the states thus undermining a key feature of a liberty-supporting federalism.

Restoring a liberty-supporting federalism first requires a deeper diagnosis of the American federalist system. Dr. Wagner develops that possibility through a very engaging synthesis of public choice theory, Austrian and new institutional economics.  Student of Dr. Wagner may be familiar with many of these concepts, developed in his public finance books including Deficits, Debt and Democracy (2012, Elgar). Rather than summarize the paper in today’s blog post, for now I encourage you to read the piece in full.

Hercules, California’s Herculean debts

What lead the city of Hercules, California to default on its debts? Guest poster Marc Joffe, Principal Consultant at Public Sector Credit, finds a case of mission-creep in the “dynamic city on the Bay’s”  decision to issue debt to finance power plants and affordable housing.

(For more of Marc Joffe’s research on modeling credit risk, read his 2013 Mercatus Working paper comparing Illinois and Indiana)

Hercules, California Public Power Failure Leads to Default

by Marc Joffe

Cities can default on obligations to their creditors without filing for Chapter IX bankruptcy protection.  This is the lesson of Hercules, California – a 25,000-resident San Francisco suburb whose finances are not quite as mighty as its name implies. Hercules experience is also illustrative of the risks that cities take when they expand beyond their core functions of public safety and public works.

The city is threatening to default on $12.8 million of municipal bonds as early as this August.  In a tender offer issued earlier this month, Hercules offered holders of these bonds 90% of their securities’ face value. According to the bondholder notice, “If an insufficient number of bonds are not tendered, the City anticipates it will soon default on the bonds.” Offering bondholders 90 cents on the dollar in order to avoid facing the risk of non-payment is, for all intents and purposes, a default.

In fact, it is the city’s third default in recent years. In 2011, Hercules failed to repay a $3.75 million loan from the California Housing Financing Agency (CHFA). The state loan was intended to support a mixed use development Hercules planned to build. The development, which included a large affordable housing component, was stymied by neighborhood opposition to low income housing and the City’s inability to acquire a portion of the intended construction site from a nearby homeowner’s association. Earlier this year, Hercules sold the site to a developer who plans to build market rate housing. It has also agreed to repay the CHFA loan in installments through 2026 at a reduced interest rate.

Hercules’ second default occurred on February 1, 2012, when it failed to make a $2.4 million interest payments on Redevelopment Agency (RDA) bonds. The default was absorbed by Ambac, the agency’s municipal bond insurer. Ambac filed suit against the city claiming it had failed to remit RDA related property tax collections to the bond trustee as required. In March 2012, Ambac and the City settled the litigation with the City pledging two parcels of land to the insurer. The City further agreed to place these two properties on the market, apparently to offset the $4.05 million property tax remittance the city had failed to make earlier.

The most recent default (or, more euphemistically, the current tender offer) involves bonds issued to finance a failed public power scheme. In 2001, the City established a public power company – the Hercules Municipal Utility (HMU) – on the assumption that it could replace the area’s for-profit utility, Pacific Gas & Electric (PG&E). The expectation was that HMU would generate a similar rate of profit to PG&E, but under public ownership, those profits could fund other city spending priorities. Unfortunately for Hercules creditors and taxpayers, things did not work out as planned.

In a 2011 expose, the Huffington Post reported that HMU was serving only 840 customers, charging rates 17% higher than PG&E and had lost money in every year since its 2003 inception. In 2010, the City issued $13.5 million in new bonds to finance HMU, but the proceeds were never invested. Now the City has agreed to sell its power plant to the local utility – Pacific Gas & Electric. Unfortunately, PG&E’s bid was insufficient to retire the $12.8 million in 2010 bonds still outstanding and (for reasons discussed below) the city lacks reserves that could be used to fully redeem these remaining bonds. Thus the need for a 90% tender offer.

Municipal bond analysts often assess a city’s fiscal well-being by reviewing its audited financial statements. Unfortunately, Hercules routinely files its audited financials on a delayed basis. Currently, the latest available statements for Hercules are for the fiscal year ended June 30, 2011. Many California cities have already filed their 2013 audits. The failure to file audited financials on a timely basis is part of a larger financial management issue in Hercules. In May and November 2012, the State Controller’s Office issued three audits highly critical of the city’s fiscal controls. One report “found the City of Hercules’ administrative and internal accounting control deficiencies to be serious and pervasive.” These insufficient controls may explain why RDA tax revenues could be directed away from debt service, thereby subjecting the city to costly litigation.

As shown in the accompanying table, Hercules has persistently run large General Fund deficits since 2008.  The city’s inability to balance its books has resulted in the depletion of its financial reserves. According to Hercules most recent budget, the city had a negative unassigned General Fund balance at the end of FY 2012 and FY 2013, meaning it had no reserves that had not already been earmarked for one purpose or another. Despite having borrowed over $150 million, the city thus lacked liquid assets to cover contingencies.

Hercules General Fund Performance (FY 2008-FY2013)

Year

Revenues

Expenditures

Surplus/(Deficit)

2008

13,927,154

15,238,000

(1,310,846)

2009

14,738,289

17,274,960

(2,536,671)

2010

16,422,677

20,683,147

(4,260,470)

2011

11,823,076

16,232,313

(4,409,237)

2012

10,754,530

12,893,983

(2,139,453)

2013

11,151,014

12,288,943

(1,137,929)

Sources: Hercules Audited Financial Statements (FY 2008-2011), FY 2014 Budget.
FY 2012 and FY 2013 are unaudited estimates.

 

Hercules fiscal straitjacket appears to be the result of government overreach. Instead of focusing on efficient delivery of basic services and providing effective financial oversight, City leaders ventured into enterprises attractive to many of their Progressive constituents: publicly owned power and publicly-financed affordable housing. Lacking the skills to properly manage these undertakings, city leadership squandered large sums of borrowed money and ran down their financial reserves. The result for Hercules will be years of higher taxes, subpar real estate performance and reduced access to the municipal bond market.

 

The “pension tapeworm” and Fiscal Federalism

In his annual report to shareholders, Warren Buffett cites the role that pension underfunding is playing in governments and markets:

“Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made. During the next decade, you will read a lot of news –- bad news -– about public pension plans.”

He zones in on pension mathematics – “a mystery to most Americans” – as a possible reason for accelerating liabilities facing state and local governments including Puerto Rico, Detroit, New Jersey and Illinois. I might go further and state that pension mathematics remains a mystery to those with responsibility for, or interest in, these systems. It’s the number one reason why reforms have been halting and inadequate to meet the magnitude of the problem. But as has been mentioned on this blog before: the accounting will eventually catch up with the economics.

What that means is unrelenting pressure building in municipal budgets including major cities. MSN Money suggests the possibility of bankruptcy for Los Angeles, Chicago and New York City based on their growing health care and pension liabilities.

In the context of this recent news and open talk of big municipal bankruptcy, I found an interesting analysis by Paul E. Peterson and Daniel J. Nadler in “The Global Debt Crisis Haunting U.S. and European Federalism.”(Brookings Institution Press, 2014).

In their article, “Competitive Federalism Under Pressure,” they find a positive correlation between investors’ perception of default risk on state bonds and the unionization rate of the public sector workforce. While cautioning that there is much more at work influencing investors’ views, I think their findings are worth mentioning since one of the biggest obstacles to pension reform has been the reluctance of interested parties to confront the (actual) numbers.

More precisely, it leads to a situation like the one now being sorted out in federal bankruptcy court in Detroit. Pensioners have been told by Emergency Manager Kevyn Orr that if they are willing to enter into a “timely settlement” with the city and state, they may see their pensions reduced by less than the 10 to 30 percent now suggested. Meanwhile bondholders are looking at a haircut of up to 80 percent.

If this outcome holds for Detroit, then Peterson and Nadler’s findings help to illuminate the importance of collective bargaining rules on the structure of American federalism by changing the “rules of the game” in state and local finances. The big question for other cities and creditors: How will Detroit’s treatment of pensions versus bonds affect investors’ perception of credit risk in the municipal debt market?

But there are even bigger implications. It is the scenario of multiple (and major) municipal bankruptcies that might lead to federalism-altering policy interventions, Peterson and Nadler conclude their analysis with this observation:

[public sector] Collective bargaining has, “magnified the risk of state sovereign defaults, complicated the resolution of deficit problems that provoke such crises, heightened the likelihood of a federal intervention if such crises materializes, and set the conditions for a transformation of the country’s federal system.”

Does statehood trigger Leviathan? A case study of New Mexico and Arizona

I was recently asked to review, “The Fiscal Case Against Statehood: Accounting for Statehood in New Mexico and Arizona, by Dr. Stephanie Moussalli for EH.net (the Economic History Association).

I highly recommend the book for scholars of public choice, economic history and accounting/public finance.

As one who spends lots of time reading  state and local financial reports in the context of public choice, I was very impressed with Moussalli’s insights and tenacity. In her research she dives into the historical accounts of territorial New Mexico and Arizona to answer two questions.  Firstly, did statehood (which arrived in 1912) lead to a “Leviathan effect” causing government spending to grow. And secondly, as a result of statehood, did accounting improve?

The answer to these questions is yes. Statehood did trigger a Leviathan effect for these Southwestern states –  findings that have implications for current policy – in particular the sovereignty debates surrounding Puerto Rico and Quebec. And the accounts did improve as a result of statehood, an outcome that controls for the fact that this occurred during the height of the Progressive era and its drive for public accountability.

A provocative implication of her findings that cuts against the received wisdom:  Are the improved accounting techniques that come with statehood a necessary tool for more ambitious spending programs? Does accounting transparency come with a price?

What makes this an engaging study is Moussalli’s persistence and creativity in bringing light to a literature void. She stakes out new research territory, and brings a public choice-infused approach to what might otherwise be bland accounting records. She rightly sees in the historical ledgers the traces of the political and social choices of individuals; and the inescapable record of their decisions. In her words, “people say one thing and do another.” The accounts speak in a way that historical narrative does not.

For more read the review.

 

How are your state’s finances?

Just how well do your state’s finances compare to those of other states?

I sat down with our state policy group last week to discuss recent Mercatus research that ranks states’ fiscal condition based on the their 2012 Comprehensive Annual Financial Report (CAFR). The findings contained in State Fiscal Condition: Ranking the 50 States by Dr. Sarah Arnett are aimed at helping states apply basic financial ratios to get a general picture of fiscal health. Dr. Arnett’s paper uses four solvency criteria developed in the public finance literature – cash solvency, budgetary solvency, long-run solvency and service-level solvency. In this podcast, I discuss how legislators and policy analyst might use the study and the limitations of ratios and rankings in understanding a state’s deeper financial picture.

Healthcare: Searching for Steve Jobs

Steve Jobs transformed technology, bringing affordable smart phones and personal computers to households across income levels and around the world. In a 15-minute podcast Dr. Robert Graboyes asks why health care hasn’t seen this kind of innovation and explores the potential for health care under free markets. Click here to listen or subscribe.

 

Credit Warnings, Debt Financing and Dipping into Cash Reserves

As 2013 comes to an end recent news brings attention to the structural budgetary problems and worsening fiscal picture facing several governments: New Jersey, New York City, Puerto Rico and Maryland.

First there was a warning from Moody’s for the Garden State. On Monday New Jersey’s credit outlook was changed to negative. The ratings agency cited rising public employee benefit costs and insufficient revenues. New Jersey is alongside Illinois for the state with the shortest time horizon until the system is Pay-As-You-Go. On a risk-free basis the gap between pension assets and liabilities is roughly $171 billion according to State Budget Solutions, leaving the system only 33 percent funded. This year the New Jersey contributed $1.7 billion to the system. But previous analysis suggests New Jersey will need to pay out $10 billion annually in a few years representing one-third of the current budget.

New Jersey isn’t alone. The biggest structural threat to government budgets is the unrecognized risk in employee pension plans and the purely unfunded status of health care benefits. Mayor Michael Bloomberg, in his final speech as New York City’s Mayor, pointed to the “labor-electoral complex” which prevents employee benefit reform as the single greatest threat to the city’s financial health. In 12 years the cost of employee benefits has increased 500 percent from $1.5 billion to $8.2 billion. Those costs are certain to grow presenting the next generation with a massive debt that will siphon money away from city services.

Public employee pensions and debt are also crippling Puerto Rico which has dipped into cash reserves to repay a $400 million short-term loan. The Wall Street Journal reports that the government planned to sell bonds, but retreated since the island’s bond values have, “plunged in value,” due to investor fears over economic malaise and the territory’s existing large debt load which stands at $87 billion, or $23,000 per resident.

This should serve as a warning to other states that continue to finance budget growth with debt while understating employee benefit costs. Maryland’s Spending Affordability Committee is recommending a 4 percent budget increase and a hike in the state’s debt limit from $75 million to 1.16 billion in 2014. Early estimates by the legislative fiscal office anticipate structural deficits of $300 million over the next two years – a situation that has plagued Maryland for well over a decade. The fiscal office has advised against increased debt, noting that over the last five years, GO bonds have been, “used as a source of replacement funding for transfers of cash” from dedicated funds projects such as the Chesapeake Bay Restoration Fund.

 

Medicaid Expansion: State Policy Challenges

Dr. Robert Graboyes, Mercatus scholar and expert on the Affordable Care Act, recently discussed the law’s impacts on Medicaid and challenges facing states considering Medicaid expansion on Mercatus’ Inside State and Local Policy podcast. In 20 minutes, Dr. Graboyes discusses principles legislators may consider while attempting to improve opportunities for health, strengthen the healthcare system, and why the two might not be the same mission.

Pension reform from California to Tennessee

Earlier this month Bay Area Rapid Transit (BART) workers went on their second strike of the year. With public transport dysfunctional for four days, area residents were not necessarily sympathetic to the workers’ complaints, according to The Economist. The incident only drew attention to the fact that BART’s workers weren’t contributing to their pensions.

Under the new collective bargaining agreement employees will contribute to their pensions, and increase the amount they pay for health care benefits to $129/month.  The growing cost of public pensions, wages and benefits on city budgets is a real matter for mayors who must struggle to contain rapidly rising costs to pay for retiree benefits. San Jose’s mayor, Chuck Reed has led the effort in California to institute pension reforms via a ballot measure that would give city workers a choice between reduced benefits or bigger contributions, known as the Pension Reform Act of 2014. Reed is actively seeking the support of California’s public sector unions for the measure that would give local authorities some flexibility to contain costs. Pension costs are presenting new threats for many California governments. Moody’s is scrutinizing 30 cities for possible downgrades based on their more complete measurement of the economic liability presented by pension plans.  In spite of this dire warning, CalPERS has sent municipalities a strong message to struggling and bankrupt cities: pay your contributions, or else.

Other states and cities that are looking to overhaul how benefits are provided to employees include Memphis, Tennessee which faces a reported unfunded liability of $642 million and a funding ratio of 74.4%. This is using a discount rate of 7.5 percent.  I calculate Memphis’ unfunded liability is approximately $3.4 billion on a risk-free basis, leaving the plan only 35% funded.

The options being discussed by the Memphis government include moving new hires to a hybrid plan, a cash balance plan, or a defined contribution plan. Which of these presents the best option for employees, governments and Memphis residents?

I would suggest the following principles be used to guide pension reform: a) economic accounting, b) shift the funding risk away from government, c) offer workers – both current workers and future hires – the option to determine their own retirement course and to choose from a menu of options that includes a DC plan or an annuity – managed by an outside firm or some combination.

The idea should be to eliminate the ever-present incentive to turn employee retirement savings into a budgetary shell-game for governments. Public sector pensions in US state and local governments have been made uncertain under flawed accounting and high-risk investing. As long as pensions are regarded as malleable for accounting purposes – either through discount rate assumptions, re-amortization games, asset smoothing, dual-purpose asset investments, or short-sighted thinking – employee benefits are at risk for underfunding. A defined contribution plan, or a privately managed annuity avoids this temptation by putting the employer on the hook annually to make the full contribution to an employee’s retirement savings.