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March 2009
Vol. 23, No. 2
Panic
Promise Now, Pay Later
Among the states, the question isn't who's most likely to succeed. It's who is most likely to default.
Jim Walsh is an assistant editor of Liberty.
For a fleeting moment, between tabloid outrage over the crooked Illinois governor and Bernie Madoff's Ponzi scheme, we caught a glimpse of the coming reckoning. Bureaucrats at various levels of American government play a game of hot potato with financial responsibility for the benefits that politicians promise voters. The game involves trick plays — unfunded mandates, off-balance-sheet transactions, and imaginary "trust funds" that don't contain any money. But these tricks won't prevent the potato from dropping to the floor. It may not drop this time. But it will drop.
Already, in September of last year, California's state legislature was struggling to close a $15 billion budget deficit, one of the largest in state history. But its projections for the troubled 2009 fiscal year proved, almost immediately, to have been too optimistic. State tax revenues — from income taxes, sales taxes, and property taxes — were all down. Substantially. And within 90 days, the state predicted, it was facing an additional $11.2 billion deficit for 2009. Gov. Arnold Schwarzenegger had run out of jokey references from his old movies. He suggested an increase in the state sales tax; but legislators in his own (nominal) party, the Republicans, rejected the idea. He was left to admit that the Golden State might not be able to pay its bills.
California wasn't the only state having money troubles. Many states along the east and west coasts were pinned between the Scylla of collapsing real estate values and the Charybdis of constitutional mandates for balanced budgets. Some were reporting that their unemployment insurance reserves were running out, just as claims were starting to spike. They didn't have many options. To balance their books, they had to cut budgets or raise taxes.
So they appealed to the federal government for financial aid. Schwarzenegger spoke openly about his plan to appeal to the incoming president for direct federal support to California's operating budget. His assumption — which seemed to be shared by other state officials — was that the $720 billion Troubled Asset Recovery Program that Congress had created in the fall of 2008 could be used as a multipurpose slush fund. (And the Bush Administration's cagey use of TARP money only encouraged these conclusions.)
Some disgruntled Californians blamed the fiscal crisis on state benefits offered to illegal aliens and their "anchor babies" born in the U.S. And that is a major and growing expense. The real flashpoint, however, lies somewhere else. And it doesn't even show up in the red ink-stained 2009 budget.
During the 13 months ending in early December 2008, the investment portfolio of the California Public Employees' Retirement System (CALPERS) lost almost a third of its value — an $81.4 billion drop from just over $260 billion to just under $180 billion. CALPERS manages retirement money for a range of government employees, including firefighters, police officers, social workers, and some teachers. Fund managers said that capital reserves designed to protect against market downturns were helping offset the losses, but they reserved the right (accorded specially to CALPERS by California law) to require state and local governments to contribute additional cash to support the defined pensions promised to CALPERS beneficiaries.
This statist version of a capital call is unique in the American labor market. Only government entities can do it. But, as CALPERS executives reviewed their investment losses and mulled their options, local government officials insisted they didn't have any additional cash to contribute. CALPERS' response was that it would sue local governments that didn't pay up if the investment portfolio was still in the red by June 30, 2009. In terms of draining resources from the commonweal, illegal aliens are amateurs when compared to CALPERS pensioners.
California Treasurer Bill Lockyer, who sits on the CALPERS board, predicted that if local government agencies had to dig deeper to fund pension obligations, "state and local government employers would be spending more on retirement than on some immediate program needs." Legacy labor costs were overwhelming current operations. The beleaguered executives at General Motors could tell you about that.
It wouldn't take Friedman or Hayek to see that a rational solution to actuarily-unsound pensions for government workers would be to convert their pensions to a 401(k)-like defined contribution system. In 2005, Schwarzenegger had proposed converting California's public pensions to just such a system, but government-worker unions (chiefly the Service Employees International Union, but also some teachers' collectives) went on the warpath against the reforms. The Governator backed down.
Why is CALPERS in such financial trouble? If it funded reserves against market volatility, why does it have to go back to local governments, like a child at summer camp who's blown through his spending money and is now writing mom and dad, and asking for more?
In part, CALPERS is in a pickle because it didn't just invest in Treasury securities and index funds. Impaired by moral hazard, its fund managers mistook themselves for Donald Trump; they invested in high-flying real estate projects and other risky ventures. And why not? If they screwed up, they could always rely on the help of local governments.
As day follows night, they did screw up.
In June 2008, southern California-based LandSource Communities Development LLC filed for Chapter 11 bankruptcy protection — another victim of the subprime mortgage market collapse. LandSource's business plan had been to develop 23,000 houses on 15,000 acres of land it had purchased in the far outskirts of Los Angeles. The houses would be marketed to low- and middle-income buyers, precisely the people pushed out of the homebuying market when easy-credit mortgages disappeared.
But how did this longshot failure affect CALPERS? Badly. Just a year earlier, the pension fund had invested about $900 million in cash and property in LandSource, receiving in exchange a 62% interest in the development project. The original developers, which included real estate firms LNR Property and Lennar Homes, pocketed CALPERS' cash. At the time of this investment, LandSource's property was valued at $2.6 billion; a little more than a year later, in June 2008, it was valued around $1.8 billion. If you believe that losses don't matter, you're more likely to incur them.
LandSource wasn't CALPERS' only bad investment. It had purchased or guaranteed financing on more than $3 billion of real estate in several California markets. The guarantees had a disastrous impact on its portfolio. In many cases, it had bought undeveloped land using 75-80% debt, and then hired other firms to develop, build, and sell houses on the property. When the single-family home market collapsed, some projects dropped below the value of the underlying loans. Because CALPERS had guaranteed the financing, it risked taking losses on entire projects, not just on its cash investment.
Promiscuous use of the term "guarantee" is something common to CALPERS ventures. In early 2008, CALPERS investment executives started hiding behind money-management jargon that sounded more like sleazy Enron doublespeak than the populist righteousness they'd historically favored. According to one report, they "made [it] clear that those March [2008] valuations did not represent market value and that staff expects to provide net assets at fair market value in its next quarterly real estate report." And:
The board hired additional real estate consultants and advisers to help assess each project to determine whether to continue holding the property, build smaller homes on some parcels to pay down the debt or sell it off entirely.
Hiring consultants. The last act of desperate people.
For decades, government employee pension funds have been some of the easiest and most reliable sources of capital management fees for Wall Street firms. Despite (or maybe because of) this lucrative connection, many Wall Street sharpies say that the pension funds remain underfunded because the managers are stupid.
In the summer of 2008, CALPERS realized that it was going to have to do something to make up for losses it had suffered in its residential real estate adventures. It needed to maintain an overall investment return of about 7.75% to meet its financial targets. Its real estate projects were deep in the red, and its conventional stock portfolios were struggling. So, it cashed out billions of dollars from its stock portfolios and transferred that money to funds run by legitimate but aggressive investors like Leon Black and Wilbur Ross. In short, it got into the hedge fund market just as that market started to drop.
What's the upshot of these money mistakes? Forbes.com quoted one pension expert as predicting that CALPERS might have to cut benefits and payouts by 30% because of investment losses. CALPERS, of course, sees things differently. According to an October 2008 article that CALPERS supplied to a firefighter union website:
The U.S. economy is experiencing the biggest financial crisis since the Great Depression. . . . CALPERS remains financially sound, our members' defined retirement benefits are guaranteed by law, and our highly diversified portfolio and long-term market position will help us weather the storm. We will have a voice in much-needed market reforms.
That "guaranteed by law" part is an urgent theme for CALPERS. It appears three times in the firefighter article alone, and CALPERS repeats the phrase often, as if it has some talismanic quality. It doesn't. Laws have no magic that defies actuarial gravity.
In the article for firefighters, CALPERS went on to offer advice for "steps to fix the market":
- Continuing federal action is needed to restore stability — step by step, market by market — to remove leveraging and take losses.
- The federal rescue plan is a positive first effort of what should be a comprehensive, thoughtful review of the federal role in overseeing the financial markets. The focus should be on solving the problem and implementing the lessons learned.
- There's talk in Washington, D.C., of changing the regulatory environment to eliminate gaps in oversight and make it more comprehensive. These changes might entail stronger capitalization rules, realistic leveraging limits, and better reporting rules.
This was ironic: an insolvent pension fund presuming to recommend financial market reforms.
It's easy to talk about deleveraging and taking losses when your own mistakes are "guaranteed by law." In standard legal contexts, a contractual guarantee from an insolvent party is dismissed in bankruptcy court. But this resolution doesn't apply to the guarantees that local California governments give CALPERS. Those are required by statute. So the proper question is: What happens when one government entity makes a law that involves a "guarantee" by other government entities, which may not be solvent?
The short answer seems to be that all sides turn to President Obama for financial aid.
While CALPERS positioned itself to make a capital call that local governments couldn't afford, New Jersey's pension fund was creating similar discord in the Garden State. The New Jersey fund had lost more than half its value in the year ending in November 2008, dropping from a value of $118 billion to just under $58 billion. (This endowment funds pension payouts of about $5.2 billion each year.) Some of its bad investments included late purchases of stock in CitiGroup, Merrill Lynch, and several other ill-fated Wall Street firms, just as their troubles were becoming public knowledge.
While New Jersey Division of Investments chief Bill Clark ran through the wretched numbers with the State Investment Council, Gov. Jon Corzine promised a convention of local government officials that he would let them postpone half a billion dollars in payments that they were scheduled to make to the pension fund this spring. The local governments would gradually work their way back to full payments by 2012, the money to come, of course, from taxes. Corzine's proposal was moral hazard run amok. In trouble with bills coming due? Okay. Then stop making any payments, until you can find someone else to pay them.
The New Jersey approach seems, at first glance, more supportive of local governments hurt by the recession. Yet it is, ultimately, not very different from the California appeal to Obama. It just gets to the same point in another way. Corzine wasn't as direct as Schwarzenegger; in New Jersey, they'd count on the indirect effects of Obama's massive stimulus package to resuscitate state tax revenues. This was naive, to put it mildly.
The absurdity of New Jersey's situation wasn't lost on anyone. One government bond analyst replied:
The state of New Jersey is insolvent. Bankrupt might be a better word. New Jersey is $60 billion in the hole on pension funding and the Governor is planning on skipping payments in a "pension payment holiday" until 2012 so as to not increase property taxes. To top it off, the ongoing plan assumptions are 8.25%. Sorry NJ, that simply is not going to happen.
As in California, New Jersey's pension problems follow from bold promises and bad actuarial assumptions. On average, state workers contribute less 4% of their total expected pension return. In other words, some New Jersey employees invest $80,000 and get back defined benefits of $2 million over the course of their retirements.
As in California, some serious people suggested moving the New Jersey pension system to a defined contribution program. But others warned that, even if new government employees were given 401(k)-type retirement benefits, the existing employees would remain stuck in an unsound program. And, in many circles, the suggestion of moving existing state employees into 401(k)-type plans was deemed political suicide. Few elected officials in New Jersey will even discuss that scenario, at least on the record.
Another budget-buster was health insurance for retirees before they become eligible for Medicare. If New Jersey enacted legislation that required all state and local retirees to pay half their health care costs, the other commitments to pensioners would become manageable almost immediately. Few will talk about this. But denial isn't a solution. Pensions built on credit aren't viable in the long run. Supposed "guarantees" can't trump hard numbers.
Even before the investment losses of 2008, two actuarial factors were driving New Jersey's pension costs to unsustainable levels. First, the number of public employees on the pension rolls has increased dramatically in recent years; second, politicians had granted state and local government workers several unscheduled bonuses and cost-of-living raises. Taxpayer income and state revenue didn't keep up with the escalating public employee payroll costs, including guaranteed pension obligations.
State officials should have been honest about their pension obligations and made the necessary payments to fund them fully. Instead, they spent the early- and mid-2000s on a manic spending spree. In late 2008, the bill came due. Corzine recommended hiding it, unopened and unread, at the bottom of the stack, until he talked either New Jersey taxpayers or President Obama into taking care of it.
The thing to keep in mind, despite Corzine's rhetoric, is that the nearly $60 billion he was seeking was not money owed by New Jersey taxpayers. It was money already paid that government fund manager had lost. So, again, the relevant question: Is a guarantee from an insolvent government worth anything? During the summer of 2008, John Bury, a columnist for the Newark Star-Ledger, wrote:
Will participants in the New Jersey state retirement plan lose their pensions if the plan runs out of money? The answer I kept getting was that they won't because those benefits are safeguarded by the state constitution. After some research, I concluded otherwise.
In the precedent decision Spina v. Consolidated Police & Firemen's Pension Fund, the New Jersey state supreme court had declined to apply conventional contract rights to a retirement plan because a defined-benefit plan must, by its nature, assume solvency that a contract doesn't. "We think it more accurate to acknowledge the inadequacy of the contractual concept" as applied to retirement plans, the Spina court concluded. In other words, any contractual "guarantee" in a retirement plan is inherently suspect.
This is a key point: if you make a contract with a bankrupt entity, that contract is suspect. There's no guarantee of solvency. Claims of pension moneys being "guaranteed by law" are dubious. If the plan is bankrupt, its solvency is obviously not guaranteed. Public officials (and, for that matter, pensioners) who count on these supposed guarantees are being reckless.
Corzine wasn't alone in his recklessness. He was merely following a rogues' gallery of New Jersey governors in playing games with government employee pension accounting. In the 1990s, Gov. Jim Florio had the assets of the public pension funds reevaluated, since their book values were based on their purchase price, and they'd risen in value. He had fund investments revalued to show a rolling five-year historical average. Florio's adjustment gave the assets a higher value, which allowed any more contributions to be decreased or eliminated.
Five years later, Christie Todd Whitman was governor through the dot.com bubble. During her tenure, the New Jersey pension fund invested heavily in tech stocks. The return on those investments was good, but not good enough for her to keep taxpayer monies away from the pension funds. So she revalued the assets from Florio's five-year average to a market value average that boosted the paper value of the stocks even higher. And she told local governments they could take a holiday from contributing pension money.
Private-sector money managers avoid market-pricing asset models for retirement portfolios that are close to having to distribute funds to owners. The closer you get to needing to take money out of a retirement fund, the less the market value of holdings matters. What matters is the cash flow generated by those assets — which is why conventional money management strategies move retirees into fixed-income securities. Fixed-income investments (including corporate or government bonds) are more about paying dividends than about rising in value. But statist bureaucrats can't resist the go-go allure of booming asset values.
Rather than buying bonds, Christie Todd Whitman sold them. She approved issuance of $2.2 billion dollars in bonds with a 30-year term, paying 8% interest. Most government bond interest rates at that time were a couple of points lower, but Whitman argued that these bonds were special. They made no payments for the first 12 years and then, during the last 18 years, they paid both the deferred interest and the current interest. She appeared to assume that high interest rates would be no problem because dot.com-type investment returns would go on forever. She was wrong — sort of like the current CALPERS and New Jersey fund managers.
The interim governor who followed Whitman after she joined W. Bush's administration wanted to keep the job, so he kept using Whitman's grand assumptions and even raised government pension payments by about 9% in a shameless attempt to curry favor in and around Trenton. He failed. James McGreevey was elected governor. His treasurer came up with the idea of privatizing some of the investments to hedge funds, which were doing better at that time than conventional stock investments. This move wasn't immediately catastrophic, but it moved New Jersey several steps down the path to a high-risk pension portfolio. The pension funds dropped in value to $53 billion in 2003. By the end of fiscal 2007, they'd climbed back to $82 billion; but realistic actuaries argued that this was still at least $24 billion below being fully funded.
McGreevey had some personal-life issues and resigned. Corzine won the next election. To his credit, he did try to restore some local government contributions to the underfunded pension fund. But in actuarial terms his efforts were too little, too late . . . and he backed away even from these when the economy turned bad.
In both California and New Jersey, mistakes have been made by various administrations and both major political parties. From the perspective of government workers, Schwarzenegger, Corzine, and the others have all been stealing, because — whatever the mechanics of the various schemes — they haven't put in enough money to fund the supposedly guaranteed payouts. Even if the state of California or the New Jersey pension fund gets direct injection of cash from President Obama, there's little reason to expect that local politicians won't siphon it away again (perhaps indirectly, by putting in less than actuaries would require).
How can Schwarzenegger and Corzine get away with this stuff? What prevents Obama from telling them to solve their own problems?
The answer to both questions is government employee unions. The influence of public-sector unions (specifically, teachers' unions and the SEIU) in California and New Jersey leads to unsustainably generous benefit and pension packages. These have made California, Michigan, and New Jersey the General Motors, Chrysler, and Ford of state governments. Private-sector workers watch their retirements wiped out by Fed-induced market bubbles; financially responsible citizens watch their savings wiped out by Fed-induced inflation. All the while, government workers insist that their money is "guaranteed" by the spendthrift state.
The risks posed by the budget problems in California and New Jersey — which are, particularly, pension problems — are only beginning to surface. Similar issues will occur elsewhere. Limited-government advocates worry that, in the end, the only way Obama can save the pensions of the SEIU members who were his early supporters will be to copy Argentina and seize the savings of those who have saved for themselves.
Ambrose Evans-Pritchard, a tart financial columnist for the English newspaper the Telegraph, wrote a piece in November that looked at speculation among European traders that various nations and American states will declare bankruptcy, or default on their debts. These traders had developed markets for derivative securities that set present value on the risks that governments will default. According to British traders, the American states most likely to default, and their relative risk "scores," are:
| Michigan | 192 |
| California | 165 |
| Nevada | 164 |
| New Jersey | 150 |
| Ohio | 104 |
There were some limits to this exercise. The original models for calculating default risks were designed for sovereign nations. California doesn't print California dollars. (If it did, it would probably be debasing that currency even more aggressively than the U.S. is doing now.) Most of the British traders expected that, if an American state went bankrupt, the federal government would intervene.
Evans-Pritchard looked at the prospect of a state bankruptcy in the same way that a rational investor would look at a troubled company. If a company's risk was increasing, as reflected in a share price consistently below industry average and a cost of borrowing consistently above, what would investors want sound management to do? It would probably do five things, in the following order: replace some or all of the firm's directors, cut discretionary and operational expenditures not linked to wealth creation, dispose of assets that don't contribute to immediate wealth creation, pay down debt, innovate and improve performance to regain market share or develop new markets.
How does a financially troubled state government do any of these things? The judgment of governors and state pension managers is often clouded by moral hazard. This is the reason that government-employee pension funds (like some private-sector pension funds) are chronically underfunded. Employers, whether government or private-sector, make the rational decision that childlike demands for "guaranteed" pension benefits will result in some kind of subsidy or bailout at a later date.
The same phenomenon occurs when a young adult spends too much money because he assumes his parents will bail him out. Some young people never make this kind of mistake. Of those who do, most make it only once. A handful, from particularly indulgent families, make the mistake repeatedly. The United States has been particularly indulgent to its government pensioners.
The best solution is to privatize state pension funds and put them in the control of the beneficiaries. It's the only reliable way to keep politicians' hands out of the pension cookie jar and, ultimately, out of the taxpayers' pockets. It would force local governments to budget for and fund (in real time) new benefits granted or new employees hired. If the pensioner hands all of her money over to Bernie Madoff, that's her folly. The current crisis is a joint-and-several folly forced on all of us. It would be a little harder for politicians (the Madoffs of the "guaranteed by law" swindle) to lie to and steal from taxpayers if state employees controlled their own pensions.
Limited government advocates may have a hard time mustering excitement about the issue of government employee pensions. But the death of the leviathan state will start with a pension debate. Already, the post-World War II generations are finding Social Security benefits — which are even less actuarially sound than CALPERS' promises — smaller, and harder to earn for current recipients. If you're under 50, you know the feeling: you're not going to collect the way your parents have or did. You're going to pay more and longer into the system and you're going to withdraw less for a shorter time.
Inflation-indexed, defined-benefit pension plans and gold plated post-retirement health care benefits for government employers are the greatest off-balance-sheet financing trick of the post-World War II era. These actuarially unsound programs have a corrupting influence on all pension programs. They encourage citizens to think in childish terms about financial planning, crying about "guaranteed" benefits whenever times get hard. As the current and wretched state of these pensions suggests, they seem likely to drive all participating states to eventual bankruptcy or default.
Barack Obama probably has the political capital to prevent the current recession from becoming the crisis that kills big government. But a president's political capital is merely a function of America's overall financial capital. Sometime soon . . . maybe next time . . . the hot potato is going to drop and the game is going to end once and for all.
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