Posted September 13, 2007

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Stop, Look and Listen!

The St. Louis Pension Bond Debate

As a child, my mother taught me that before crossing a dangerous intersection, I should 'Stop, Look and Listen.' City officials in St. Louis Missouri should have taken Mom's advice about their pending bond issue to fund their pension deficit. These so-called "pension obligation bonds" are a leveraged bet that the financial markets will produce a higher return than their borrowing costs between now and the end of the next recession. It's like borrowing on margin to juice up your IRA. The city is reportedly even putting up its fire stations as collateral on the deal.

That's not a bet that I'd make with my own money right now, so I'd like to wave a big yellow flag on this deal.

In fairness, let's give credit to the city financial team that's trying to solve a problem. As I understand it, a state supreme court decision requires that they properly fund their police and fire pension funds, and in the long run that's a positive step.

What troubles me is not the general strategy, but the timing and technique. It's not evident that pension bonds at this time are the best or only solution to the court order.

As I wrote several months ago in my column on OPEB bonding, there are good times to sell pension obligation bonds, and bad times. The worst time to sell such bonds is when the stock market is near its peak, and the odds of a recession have heightened. Stock markets typically decline about 25 percent in recessions, so a pension bond issue needs sufficient headroom before the peak of this market cycle just to break even from peak to valley, plus covering the interest on the bonds. (That would require the Dow Jones Industrials average to reach 20,000 before the next recession begins!) That's why the best time to sell pension obligation bonds and OPEB bonds is at the bottom of a recession, when interest rates and stock prices have hit rock bottom. Then the financing is cheaper and the probability of stronger investment returns is best. Just look at Wisconsin's record in 2003 — they did it right. I'd hate to see St. Louis look like a re-run of New Jersey's ill-timed pension obligation bonds of the late 1990s.

Bond underwriters and registered financial advisers should be required to disclose this math to their clients. The Municipal Securities Rulemaking Board should issue a rule about this. The Government Finance Officers Association has already published best practices to urge 'considerable caution.'

Already, St. Louis also has the SEC looking over its shoulder and questioning its techniques.

That wouldn't make me feel very comfortable as an issuer. And if markets fall out from underneath St. Louis, it will add fuel to SEC Chairman Christopher Cox's efforts to impose even broader regulation on the entire municipal bond market. Who wants to be the poster child of that campaign?

The fact that one rating agency assigns an anemic BBB rating to these bonds is another yellow flag. Issuers of pension obligation bonds should be AAA or AA credits, if you ask me. Otherwise, their borrowing costs in the taxable market will be as high as the yields on most bonds they would buy in their pension portfolio, which gives them too much incentive to leverage the portfolio towards equities.

It's time for the states to step in with an efficient facility that will work for both pension obligation bonds and OPEB bonds. Unless a local government has an AAA or AA rating, the only agency in a state authorized to sell pension obligation or OPEB bonds should be the state treasurer or a state pass-through financing authority for this specific purpose. The state will likely get a better interest rate, and provide appropriate expertise and oversight.

Pension and OPEB bonds are a calculated bet made with future taxpayers' money. They should not be issued unless the treasurer, the controller and the chief investment officer have certified as fiduciaries that:

• their issuance is timely in light of recent financial market developments, to preclude issuance of bonds at the peak of a business cycle

• if future plan assets exceed liabilities while bonds are outstanding, any excess will revert to a debt service reserve or tax relief and no other purpose, and only after the funding ratio exceeds 118 percent to 130 percent, as suggested in my previous Pension Overfunding column

• benefits funded with such bonds will not be increased until the bonds are retired; otherwise the taxpayers will pay twice

• for OPEB bonds, the benefits and associated expenses funded by these bonds have been sufficiently constrained so that the bonds can reasonably be expected to pay their full costs

St. Louis officials should insist on similar certifications before they plunge into a late-cycle stock market. State and local government officials should follow these basic rules, and 'Stop, Look and Listen.'

Last month:
· Pensions & Potholes
· Rx for Sick Leave
· CIOs Tell It Like It Is

Index of recent columns

Girard Miller, an analyst of benefits and investments with 30 years of experience in the public, private and nonprofit sectors, can be reached at Girardinmalibu@charter.net.
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