Category Archives: Debt

Eileen Norcross on News Channel 8 Capital Insider discussing Virginia and the fiscal cliff

Last week I appeared on NewsChannel 8’s Capital Insider to discuss how the fiscal cliff affects Virginia. There are several potential effects depending on what the final package looks like. Let’s assume the deductions for the Child Care Tax Credit, EITC, and capital depreciation go away. This means, according to The Pew Center, where the state’s tax code is linked to the federal (like Virginia) tax revenues will increase. That’s because removing income tax deductions increases Adjusted Gross Income (AGI) on the individual’s income tax filing (or on the corporation’s filing) thus the income on which the government may levy tax increases. According to fellow Mercatus scholar, Jason Fichtner, that could amount to millions of dollars for a state.

On the federal budget side of the equation,the $109 billion in potential reductions is now equally shared between defense and non-defense spending. Of concern is the extent to which the region’s economy is dependent on this for employment. Nearly 20 percent of the region’s economy is linked to federal spending. Two points: The cuts are reductions in the rate of growth in spending. For defense spending, they are relatively small cuts representing a return to 2007 spending levels as Veronique points out. So, these reductions not likely to bring about the major shakeup in the regional economy that some fear. Secondly, the fact that these cuts are causing worry is well-taken. It highlights the importance of diversification in an economy.

Where revenues, or GDP, or employment in a region is too closely tied to one industry, a very large and sudden change in that industry can spell trouble. An analogy: New Jersey’s and New York’s dependence on financial industry revenues via their income tax structure led to a revenue shock when the market crashed in 2008, as the New York Fed notes.

On transportation spending there are some good proposals on the table in the legislature and the executive. Some involve raising the gas tax (which hasn’t been increased since 1986), and others involve tolls. The best way to raise transportation revenues is via taxes or fees that are linked to those using the roads. Now is no time to start punching more holes in the tax code to give breaks to favored industries (even if they are making Academy-award quality films) or to encourage particular activities.

Virginia’s in a good starting position to handle what may be in store for the US over the coming years. Virginia has a relatively flat tax structure with low rates. It has a good regulatory environment. This is one reason why people and businesses have located here.

Keep the tax and regulatory rules fair and non-discriminatory and let the entrepreneurs discover the opportunities. Don’t develop an appetite for debt financing. A tax system  is meant to collect revenues and not engineer individual or corporate behavior. Today, Virginia beats all of its neighbors in terms of economic freedom by a long shot. The goal for Virginia policymakers: keep it this way.

Here’s the clip

Illinois conjures Squeezy the Pension Python

Illinois Office of the Governor has released a video aimed at school kids. It’s subject: the importance of paying workers their government pensions. It’s meant to get Illinoisans excited about pension reform. Illinois has the worst pension system in the country. The pension liability grew by $12 billion this year. According to Illinois official accounting the unfunded liability is $100 billion. Under market valuation the unfunded liability is over $200 billion. The Civic Federation calls the system, “Unfixable.”

Enter, Squeezy the Pension Python.

Cute.

There’s some history about the Romans, the American Revolution, and World War I. There’s a basic message about why we (i.e. government on your behalf)  should make sure promises are kept. But, not surprisingly, this video totally misdiagnoses why the pension fund is running on empty. I didn’t expect it to contain much in the way of discount rates. Instead the blame is shifted to yesterday’s politicians and the 2008 Wall Street crash (and the fact that people live longer). There is barely a mention of why the economic assumptions that drive the valuation and accounting really matter. Sure, it’s not easy to explain arbitrage, present value, discounting, or the time value of money to second graders. So, instead the video makes the case for how the buck has been passed time and time again, for the children.

Reactions to the video have been decidedly mixed.

 

The most egregious budget gimmicks of 2012: pension underfunding

Bob Williams at State Budget Solutions has a nice chart that shows by how much states are underfunding their pensions. Budgets are always about tradeoffs. But not funding the pension is similar to skipping credit card payments without cutting into your daily expenses at all (or figuring out how to boost your income).

Here’s the link.

In addition, the article notes all the other ways states  have of papering over deficits – floating bonds, revenue estimates, shifting dates around. This isn’t confined to the usual suspects (Illinois, New Jersey, California). There are plenty of examples to share from across the country.

 

 

Giving Illinois local governments control over their workers’ pensions

The Chicago Tribune makes a “modest proposal” this week. Discouraged by the inaction of the Illinois General Assembly on state-wide pension reform, the editorial board supports the idea that costs for teacher pensions should be shifted and shared with local governments. Republicans, fearful of property tax hikes, don’t like the notion. But the Tribune makes a good point: the cost shift should be accompanied with the ability of local governments to directly negotiate with their employees minus the influence of Springfield. It’s an interesting idea.

Ultimately, pension reform must proceed according to certain principles that clarify the following:

a) What is the true and full value of the benefit? The market valuation principle.

b) How do you incentivize such a system to properly value, steward, and fund benefits? The principal-agent problem.

c) How do you connect the full employee wage/benefit bill with taxpayers who enjoy the services? The fiscal illusion problem.

Right now, it’s a mess. Government accounting is a still a jumble. (But the real value is always knowable via market valuation.) No entity currently has the incentive to properly value and fund these systems. And in fact, we continue to see risk-taking and the shifting of assets into alternative investments, the issuance of Pension Obligation Bonds, and the deferral of reforms. Politicians have a short-term horizon.

And then there is the problem of “disjointed finance.”

Take the case of New Jersey. Local governments negotiate with their employees over wages. But pension policy is set by the state. New Jersey municipalities get an annual bill to fund their employee pensions based on the state actuary’s calculations. Local officials don’t have any sense of what those obligations look like going forward. The state’s annual funding calculations low-ball what is needed to fund the benefits. Could it be that such opacity leads local governments to offer wage enhancements, or hiring increases, that translate into total compensation packages that they can’t afford?

The Chicago Tribune’s idea only works if Illinois local governments accurately calculate what is needed on an annual basis to fund the pensions they negotiate with their workers and to have a full assessment of the value of compensation packages over time. How is market valuation incentivized? Perhaps Moody’s move to calculate pensions based on a corporate bond yield will have an effect. Or perhaps plans need to be managed by a third-party, as Roman Hardgrave and I suggest in our 2011 paper. 

Tying local costs to local taxpayers is a good idea. Another phenomenon the pension problem has revealed is gradual separation of taxing and spending in American public finance over the course of the past half century. That has produced a growing fiscal illusion in finance – where things seem less expensive than they actually are since the costs are spread over larger groups of taxpayers. Local costs are spread among state taxpayers, and now the worry is that state pension costs and debts will be spread across national taxpayers. At least, it’s been suggested.

In his 2012 budget, Governor Quinn alluded to a federal government guarantee  of Illinois’ pension debt. It’s not a popular idea with Congress at the moment. But it appears to have been part of the political calculations of those who are responsible designing and enforcing the rules that guide Illinois’ budget and determine pension policy.

 

 

 

 

Central Falls bankruptcy exit plan approved

In what is described as, “the quickest bankruptcy adjustment in U.S. history,” Central Falls, Rhode Island has reached an agreement to exit from bankruptcy with a plan that will fully repay bondholders (including any legal fees incurred), while slashing worker pensions by as much as 55 percent. None of Central Falls’ workers will get less than $10,000 and all will have to contribute 20 percent more for their health care until they are 65 and eligible for Medicare, according to Bloomberg News. The agreement was reached when the state promised to help supplement retiree pensions for five years.

Bondholders will be repaid via higher municipal taxes, or a four percent increase in property taxes each year for the next five years. No one escapes unscathed, except the bondholders, which is attributable to the fact that Rhode Island passed a law explicitly protecting them from municipal default last year. The bondholder protection law appears to have the intended effect with Moody’s promising to increase Central Falls’ credit rating.

Retirees are understandably upset but it’s important that the cause for plan underfunding be properly diagnosed. Accounting distortions rooted in risky discount rates are to blame. Central Falls’ Police and Fire Plan was deeply underfunded based on numbers that underestimated the liability. That is the lesson to be learned and the inescapable problem facing many other jurisdictions with defined benefit plans in the US. It is in the best interest of governments to accurately calculate their unfunded liabilities with reference to a risk-free discount rate and come up with a plan today. Waiting and gambling on a future market boom doesn’t do retirees any favors.

Fort Lauderdale issues a Pension Obligation Bond and adds to its debts

To fully fund its city pensions the City Council of Fort Lauderdale has voted to issue a $340 million pension bond. One problem with this plan is the city’s pension plans are underfunded to a far larger extent than the accounting recognizes. I calculate, using their 2011 CAFR, that while Fort Lauderdale’s two pension systems report an $388 million unfunded liability when using a risk-free discount rate, the total unfunded liability is closer to $1.7 billion.

In that year, both the General Employees’ plan and the Police and Fire Plan used a discount rate of 7.75 percent to calculate their liabilities. Today the 15-year Treasury bond is close to 2 percent. Thus, the source for great difference between the two unfunded liability calculations.

The rationale for issuing the POB is that the city’s pensions will earn better than the 4 percent assumed interest rate on the bond, and thus they will capture the arbitrage benefits. But that is a bet on both the bond market and the stock market, and not a certainty.  The pensions remain valued as though they are risky and now the city has effectively put more risk on the balance sheet, all in the service of lessening the pain of rising annual contributions. The POB does not address the structural reasons for rising costs even if it gives the Council a temporary sense of budgetary relief.

 

SEPTA and interest rate swaps

Interest rate swaps became a relatively popular means for municipal governments to save some money during the 1990s and into the 2000s. The basic idea is that an issuer (the government) enters into a contract with a bank to exchange interest rate payments on a cash flow. These can be structured to exchange a fixed payment for a variable payment in return, or vice versa.

These interest payments are calculated based on an underlying asset or instrument, such as a bond. That makes interest rate swaps a derivative, as their value is derived from an underlying financial instrument.

The issuer’s goal is to hedge against fluctuating interest rates and impart some stability to their budget.The bank’s incentive is to make a fee. It works for the issuer when they guess correctly and – by way of example -the issuer agrees to a payment based on a fixed rate of interest that is low relative to the adjustable rate of interest the bank pays to the municipality in return.

But that’s not what happened as rates began to fall after 2008. Many municipal issuers found themselves paying banks a fixed rate that was high relative to the variable rate the bank was paying in return. Jefferson County, Alabama is the most notorious example, as my recent article in US News explains. At work in this larger story is the role the LIBOR interest rate rigging scandal played in suppressing the variable rate leading some governments to sue banks for damages.

Pennsylvania governments were particularly keen on interest rates swaps, with 626 swaps having been entered into across the Commonwealth. Depending on how they were structured, some entities have come out ahead. The majority have lost on the contracts. That includes SEPTA, as Pennsylvania Watchdog explains.

Is the problem with the interest rate swap concept? I’d argue that the answer lies in how they are used. What might be a good hedging instrument for the financial sector exposes the public sector to a set of risks that aren’t fully appreciated. The risks -including the real hazard that the municipality incorrectly guessed the direction interest rates would travel- are passed on to taxpayers or service users.

 

 

Generational Unfairness in Pensions

California Governor Jerry Brown has led an effort to pass some changes to current state employee pension benefits that will affect new employees by raising their retirement age, capping their potential benefits, and requiring both new employees and some current workers to pay at least half of the cost of their pensions.

At Public Sector, Inc. Steve Greenhut explain that the savings from these changes won’t be felt for years to come:

It’s clear the reform would do little to touch current unfunded pension liabilities, estimated in California at as much as a half-trillion dollars, but will bring in reforms in decades after new hires start retiring.

The changes are projected to save state taxpayers between $40 billion and $60 billion. With these changes, California’s pension fund will still be underfunded by about $450 billion, calculated using the risk-free discount rate (pdf). If policymakers refuse to make further changes to the system, this remaining debt will require greater sacrifices from new workers and future taxpayers.

This unfunded liability represents generational unfairness. Today’s taxpayers are paying for current retirees who provided state services in the past. Likewise, the new reforms require sacrifices primarily from new workers. They will be receiving fewer benefits while paying into a system that benefits current workers and retirees.

States have unfunded pension liabilities due to management mistakes of the past. However, the costs of these mistakes are being felt today. Going forward policymakers should see the pain they impose on younger workers and make every effort not to repeat this pattern.

The longer that reforms are delayed, the greater inter-generational inequity grows. While California has the largest unfunded pension liability, it is not alone. Because Illinois has failed to take significant actions to address the state’s debt and pension liabilities, S&P downgraded its bond rating to A-plus with a negative outlook. This makes it S&P’s second-lowest-rated state above only California. Moody’s ranks Illinois’ bonds the lowest of all states. These ratings will be accompanied by higher bond yields on Illinois’ debt for future taxpayers. This will saddle them with more of their tax dollars going to debt service rather than current state services.

Policymakers have every incentive to engage in policies that benefit current voters at the expense of future voters because they want to receive credit for providing services that exceed their cost in the present. The only way to correct this tendency is for voters to demand that lawmakers do not force the cost of current programs onto those who do not have a voice in today’s elections.

Poway and the billion dollar capital appreciation school bond

Where does it cost $1 billion to borrow $105 million? In Poway Unified’s School District. With a pie chart showing the full cost of a $105 million capital appreciation bond being issued in a California school district to finance capital improvements, Will Carless’s local reporting turned into a national story. (Previous work on Poway’s bond financing was put together by a retired Michigan blogger, John Thurrell, who covers municipal finance).

The power of the story surely has much to do with the chart itself, which I reproduce from the original article here:

 The reason this bond is different from garden-variety school borrowing is that the district couldn’t issue a conventional bond without raising property taxes. So they “got creative.” With the help of a financial consultant they instead issued a Capital Appreciation Bond.

With a 40 year time horizon, the district doesn’t have to start making payments on it for 20 years – long after the students who enjoy the improvements have graduated. Future taxpayers will be paying bond investors about 10 times more than the initial loan.

The local taxpayer’s association calls the deal “loan-sharking,” but I also have to wonder what role property taxes and Prop 13’s limits on property tax rate hikes played in this story. Carless details how local officials figured out a way around the politically difficult choice of a tax rate hike: Proposition C. There wasn’t enough revenue coming in from the district’s $55/$1000 per assessed value levy. Proposition C asked voters if they would be willing to extend the levy for another 14 years. The idea was to collect the revenue now and start paying the bond back later. But the CAP maneuver shows that by limiting a direct and stable source of local revenues (via the property tax rate cap – which voters may modify), politicians have the incentive (and may even prefer) to pursue more exotic, and less transparent funding mechanisms.

The news story is also the power of a basic pie chart to convey information. This picture stirred up an online debate over what kinds of information citizens are given when they go to vote on bond issues. In response to the “chart-gone-viral”, the School district is defending its choice of financing while residents are “shocked” and “appalled.”

CAPs are getting a pretty bad rap in the press. One blogger calls them, “the poor community’s way to borrow their way out of insolvency,” with the “cancer spreading” to Los Angeles Unified. While California municipalities appears to have embraced CAPs, Michigan banned them in 1994. The NYT reports that U.S. school districts issued $4 billion in CAPs last year.

Strategy and politics in the of phrasing of bond referendum

How detailed should bond referendum be? The Arlington County Board heard comments from the public on the FY 2013 capital spending plan a few weeks ago. At issue was $153 million in local GO bond referendum that will be on the ballot on November 6th. The Arlington Sun Gazette reports there are four major “bundles.”

  • $31.946 million for Metro, neighborhood traffic calming, paving and other transportation projects
  • $50.533 million for parks, including the Long Bridge Park aquatics and fitness center and parkland acquisition
  • $28.306 million for Neighborhood Conservation and other “community infrastructure” projects
  • $42.62 million for design and construction of various school projects.

At issue was the language accompanying the bond packages. The Arlington County Civic Federation contends the $45 million dedicated to the acquatics center be listed as a separate item rather than bundled under the general category of park improvements.

Scott McCaffrey writes that the County Board has been bundling bonds under thematic groupings for many years as a strategy to lessen voter opposition, an interesting claim.

How explicit does language have to be in municipal General Obligation bond offerings? States typically require GO bond debt be subject to voter approval before issuance, but how does ballot language matter to the outcome?

While not addressing the matter specifically a few related questions have been pursued in the literature. Damore, Bowler and Nicholson in their paper, “Agenda Setting by Direct Democracy: Comparing the Initiative and the Referendum” (State Politics and Policy Quaterly, forthcoming) considers if agenda setters use the referendum process to extract greater spending than the median voter desires. Some of this research indicates that voters are less likely to support state referendum for tax increases but that between 1990 and 2008, 80 percent of bond referendum received voter approval.

As to the need for particular language, there are strategies. The Government Finance Officers Association (GFOA) lists six steps governments can take to improve their chances of getting a bond approved. This includes, “measure design” or “developing ballot language that appeals to voters and clearly explains how this measure addresses the particular issue targeted by the bonds meets the needs of the community.”

I did find anecdotal evidence that politicians struggle with language on ballot questions, in an effort to strike a balance between clarity and increased likelihood of passage. The Rockford Illinois School Board appears to be hemmed-in by how it phrases bond questions. The more detailed the questions the more legally-bound the board is to spend the money as specifically approved by voters.

Speaking of language, in writing this post I was unsure if I should be using”referenda” as the plural of “referendum”. “Referenda” sounds more natural to me but “referendum” appears to be used more often.

Given the difficulty of the original Latin grammar (referendum is a “gerund” and has no plural), it turns out there is an unsettled debate over this. Either is correct according to the Irish paper The Daily Edge. I felt better knowing that even The British Parliament debated over which plural form to use back in 1998. It turns out whether one uses the Latin “referenda” or the Anglicized “referendum” is purely a matter of taste.