Category Archives: Debt

Municipalities in fiscal distress: state-based laws and remedies

The Great Recession of 2008 “stress tested” many policies and institutions including the effectiveness of laws meant to handle municipal fiscal crises. In new Mercatus research professor Eric Scorsone of Michigan State University assess the range and type of legal remedies offered by states to help local governments in financial trouble.

“Municipal Fiscal Emergency Laws: Background and Guide to State-Based Approaches,” begins with some brief context. Most municipal fiscal laws trace their lineage through the 1975 New York City fiscal crisis, the Great Depression and the 19th century railroad bankruptcies. Writing in 1935, attorney Edward Dimock articulated three pieces to addressing municipal insolvency:  1) oversight of the municipality’s financial management 2) stop individual creditors from undermining the distressed entity and 3) put together a plan of adjustment for meeting the creditor’s needs.

These general parameters are at work in state laws today. The details vary. Some states are passive and others much more “hands-on” in dealing with local financial troubles. Scorsone documents these approach with a focus on the “triggers” states use to identify a crisis, the remedies permitted (e.g. can a municipality amend a collective bargaining agreement?), and the exit strategies offered. Maine has the most “Spartan” of fiscal triggers. A Maine municipality that fails to redistribute state taxes, or misses a bond payment triggers the state government’s attention. Michigan also has very strong municipal distress laws which create, “almost a form of quasi-bankruptcy” allowing the state emergency manager to break existing contracts. Texas and Tennessee, by contrast, are relatively hands-off.

How well these laws work is a live issue in many places, including Pennsylvania. In 1987 the state passed Act 47 to identify distressed municipalities. While Act 47 appears to have diagnosed dozens of faltering local governments, the law has proven ineffective in helping municipalities right course. Many cities have remained on the distressed list for 20 years. Recent legislation proposes to allow a municipality that can’t “exit Act 47” the option of disincorporating. Is there a middle ground? As the PA State Association of Town Supervisors put it, “If we can’t address the labor issues, if we can’t address the mandates, if we can’t address the tax exempt properties, we go nowhere.”

Municipalities end up in distress for a complex set of reasons: self-inflicted policy and governance failures, uncontrollable social and economic shifts, and external shocks. Unwinding the effects of decades of interlocking problems isn’t a neat and easy undertaking. The purpose of the paper isn’t to evaluate the effectiveness various approaches to helping municipalities out of distress, it is instead a much-needed guide to help navigate and compare the states’ legal frameworks in which municipal leaders make decisions.

 

 

 

Some private sector pensions also face funding trouble

A new report by the Pension Benefit Guaranty Corp (PBGC) warns that while the market recovery has helped many multiemployer pension plans improve their funding there remain some plans that,”will not be able to raise contributions or reduce benefits sufficiently to avoid insolvency,” affecting between 1 and 1.5 million of ten million enrollees.

Multiemployer plans are defined as those which unions collectively bargained for, with multiple employers participating within an industry (e.g. building, construction, retail, trucking, mining and entertainment). They are also known as Taft-Hartley plans. Multiemployer plans grew out of the idea of offering pension benefits for unionized employees in transient kinds of work such as construction. These plans have been in trouble for awhile due to a variety of factors. Many plans have taken measures by increasing contributions and in a few cases cutting benefits according to GAO. But those steps have not been nearly enough to fix the growing shortfalls.

When a PBGC-insured pension plan goes insolvent beneficiaries are only guaranteed a fraction of their benefits. Those funds come from the premiums paid by remaining plans. The projected deficit for the ailing multiemployer plans range from $49.6 billion to $79.6 billion in 2022. By contrast the PBGC reports that single employer plans fare better with the current funding deficit of $27.4 billion narrowing to $7.6 billion by 2023.

Source: FY 2013 PBGC Projections Report

 

Strong words from the SEC on Public Sector Pensions

As state and local governments begin to pull back the curtain on the true value of their pension liabilities with the implementation of GASB 68, Daniel Gallagher, Commissioner of the SEC issued an important statement last week, noting in plain terms that how governments measure their liabilities would have serious repercussions in the private sector. Here’s part of the remarks worth considering:

 …for years, state and local governments have used lax governmental accounting standards to hide the yawning chasm in their balance sheets…

The riskiness of a pension obligation depends on state law.[32]  If pension obligations have the same preference as general obligation debt, then the municipality’s own municipal bond yield (generally around 5%) would be the proper discount rate.[33]  Or, if as we’ve seen from Detroit, pensions will be saved before all else, then we should use a default-free measure to discount the liability:  specifically, the Treasury zero-coupon yield curve.[34]  This would result in a discount rate in the low 3% range.

Obviously, the higher the discount rate, the lower the present value of the liability.  The difference between a discount rate in the range of seven percent and one in the range of three percent is in large part responsible for the hidden $3 trillion in unfunded liabilities that are currently going unreported.

This lack of transparency can amount to a fraud on municipal bond investors, and it does a disservice to state and local government workers and retirees by saving elected officials from making the hard choices either to fully fund the pension promises that were made to public employees,[35] or not to make the promises in the first place.

In the private sector, the SEC would quickly bring fraud charges against any corporate issuer and its officers for playing such numbers games.  And, we would also pursue and punish the so-called fiduciaries who recklessly seek yield to meet unrealistic accounting assumptions.  We should not treat municipalities any differently.”

GASB 68 asks that sponsors use a high- yield, tax exempt 20-year municipal GO bond only on the unfunded portion of the liability. This will reveal bigger funding gaps in public sector pension plans. But it does not reveal the full value of the liability since it allows sponsors to continue using the higher discount rates on the funded portion of the liability.

 In addition to using the new GASB standards, Commissioner Gallagher advises that governments should also disclose their pension liabilities on a risk-free basis. This would have the effect of showing the value of these promises on a ‘guaranteed-to-be-paid’ basis. Commissioner Gallagher’s suggestions are extremely sensible and a call to basic transparency in public sector liability reporting.

Ignoring the value of pension benefits is not going to make them cheaper to fund, and the longer a state waits to accurately measure the liabilities and payments, the worse it gets. Just ask New Jersey –  which is struggling to balance its budget and meet a fraction of a fraction of the required annual pension contribution to its state pension system. The situation is so dire that it could trigger yet another downgrade for the Garden State.

 

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.”

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.

 

Maryland’s “severe financial management issues”

Budgetary balance continues to evade Maryland. In FY 2015 the state anticipates a deficit of $400 million. A fact that is being blaming on entitlements, mandated spending, and fiscal mismanagement in the Developmental Disabilities Administration. The agency has been cited by the HHS Inspector General as over billing the Federal government by $20.6 billion for Medicaid expenses.

For over a decade the state has struggled with structural deficits, or,  spending exceeding revenues. The state’s method of controlling spending – the Spending Affordability Commission – has overseen 30 years of spending increases, and its Debt Affordability Commission has compounded the problem by increasing the state’s debt limits in order to expand spending.

For the details, visit my blog post for the Maryland Public Policy Institute. Of related interest is the Tax Foundation’s recent ranking of government spending the states. Maryland ranks 19, and has increased spending by 30.5% since 2011  2001.

Obama Administration will bailout Detroit

The Obama administration announced today it plans to send Detroit $320 million to “aid in its recovery,” according to The Hill.

The dollars come from existing federal money that is being re-purposed. It includes $24 million to rehabilitate buses and install safety cameras, $1.35 million for a community policing program, and the underwriting of 150 new firefighters. There are also funds for streets lights, police bike patrol, $3 million to hire new police, dollars for urban revitalization, and $25.4 million for demolition. A few months ago the administration said Detroit would have to work with creditors to resolve its bankruptcy issues. The city owes its creditors $18.5 billion.

Another example of how Detroit ended up in this awful position is highlighted in yesterday’s New York Times report of how Detroit City Council members skimmed $2 billion off of the pension system’ “excess earnings” to give employees ‘extra payments’ that had nothing to do with their pension benefits. This practice which spanned a 23 year period was justified as follows, quoting the NYT:

“People were having a hard time, living hand-to-mouth, and we thought we would give them some extra,” Ms. Bassett said.

Of all the nonpension payments, she said, 54 percent went to active workers, 14 percent went to retirees and 32 percent went to the city, which used its share to lower its annual contributions to the fund. The excess payments were often made near the end of the year, when recipients needed money for the holidays, or to heat their homes.

Of course the practice sounds wrong. Except it’s really another example of what happens when pensions value their liabilities based on asset returns. Detroit gave workers these “excess earnings.” New Jersey and scores of other states believed they were overfunded also and they “skipped payments” when the market was hot in the 1990s and early 2000s. The accounting gave them the illusion that this would all work out in the end. It is a dangerous fiction that these pension systems operate under.

That illusion of “overfunding in boom years” flows from the practice – discussed often in this blog – of discounting liabilities based on expected asset returns.The math really matters. For a long discussion, see here. 

How much damage has this accounting assumption and all the behaviors that flow from it caused? For Detroit – a significant amount. The city reports its pensions are underfunded by $634 million. It’s actually $9 billion underfunded on a market basis. 

I am not entirely surprised by the bailout, which sounds like a mini-stimulus via federal municipal grant programs. And I openly wonder what it portends for other cities that find themselves looking at similarly dire economic and financial situations.

New resource: Mercatus Center’s 2013 State and Local Policy Guide

Are you interested in the practical policy applications of the kinds of research the State and Local Policy Project is producing?

For an accessible and very useful review have a look at the inaugural edition of the Mercatus Center’s 2013 State and Local Policy Guide produced by our Outreach Team.

The guide is divided into six sections outlining how to control spending, fix broken pensions systems, control healthcare cost, streamline government, evaluate regulations, and develop competitive tax policies. Each section gives an overview of our research and makes brief, specific, and practical policy proposals.

If you have any questions, please contact Michael Leland, Associate Director of State Outreach, mleland@mercatus.gmu.edu

How are the states doing with pension funded ratios?

The Tax Foundation has a new pension map. It shows the funding levels of plans in the states, based on a risk-free discount rate. The numbers were crunched by State Budget Solutions, using a yield on (notional) 15-year Treasury bonds of 3.2 percent.

They estimate that the overall funding gap in the states is $4.1 trillion, much larger than the $1.3 trillion typically reported when using the state’s own assumptions (or a discount rate of about 7.5 percent). According to this map, no state is anywhere near the general standard of 80 percent funded. Most states are hovering around the 30 to 40 percent funded ratio. The state with the lowest funded ratio is Illionis at 24%funded. Connecticut is next at 25% funded. The best funded are Wisconsin (57%) and North Carolina (54%) – better, but not great.

taxfoundation