Replies

April 30, 2006

Sanders’ borrowing plan seen as risky -
San Diego Mayor wants to sell bonds to bolster pension
San Diego Union-Tribune |Matthew T. Hall

http://www.freerepublic.com/focus/f-news/1624313/posts
Posted on 04/30/2006 4:35:40 PM PDT by calcowgirl

It’s a gamble that governments big and small have taken with mixed results for two decades: borrow money at low interest rates and pump the cash into sagging
pension systems whose savvy managers count on high investment returns. Now it’s the centerpiece of Mayor Jerry Sanders’ fiscal fix for San Diego.

While Sanders insists his proposal is prudent, experts nationwide warn that the approach has high risks – even before factoring in a trend toward higher interest rates and a decline in presumed returns for pension system investments. Some experts say the borrow-to-invest strategy still makes sense, but others say a window of
opportunity has closed.

“Even in today’s market, it is worth a look,” said Donald Steuer, chief financial officer for San Diego County, which has sold $1.4 billion in pension obligation bonds since 1994. “It doesn’t cost you anything to look.” On the other hand, William Pollacek, the treasurer-tax collector for Contra Costa County, which has issued or refinanced pension obligation bonds three times since 1994, suggests that the practice would not be smart in today’s economy.

“My own professional opinion is I would not advise doing pension obligation bonds at this time,” Pollacek said. “The spreads have narrowed dramatically.”

The gambit works like this. Instead of paying interest on a pension deficit that matches the retirement system’s assumed rate of return – 8 percent in San Diego’s case – a government would borrow money at a lower rate, then inject it into the pension fund hoping for near double-digit investment returns or better. It’s called arbitrage. In theory, the cash infusion lowers the pension deficit and subsequently the amount the government must pay each year to cover retiree benefits. This in turn frees up money for other areas of the budget, mainly daily operations.

When the plan works, everyone wins. Fund managers get praise, pensioners get paid and elected officials get re-elected because they have spent more money on parks and public safety – and less on rising retiree costs. When the plan fails, it can fail miserably, leaving retirees less protected and politicians more vulnerable to the whims of angry voters who wind up, for example, driving on unrepaired roads to libraries that are closed.

Risk and reward
In 1999, Pasadena borrowed $100 million for its pension system, then lost $25 million to $30 million when the market went south soon after. Sanders’ chief financial officer, Jay Goldstone, orchestrated that pension obligation bond issuance when he worked in Pasadena as its finance director. Goldstone ended a September 2004 report to fellow financial officers with the words, “Yes, I would do it again, but let’s hope I don’t have to!”

San Diego’s pension system has a deficit of $1.43 billion, caused mostly by retiree benefit increases granted since 1996 by city councils that also intentionally underfunded the pension system for nearly a decade. In 2004, the city’s Pension Reform Committee received a staff report warning it of the potential risks and rewards of pension obligation bonds. Ultimately, the committee recommended selling $600 million in such bonds. In October 2004, the council approved then-Mayor Dick Murphy’s proposal to sell
$200 million in pension bonds in each of the next three years. Last year, the plan resurfaced under then-City Manager Lamont Ewell, and Sanders revived it this month.

The problem is the city cannot borrow at advantageous rates from the bond market until an outside inquiry into accounting irregularities and allegations of fraud and corruption is completed and three delayed annual audits are out. Sanders expects the inquiry to end in June and the audits to be released in the weeks that follow. He hopes to resume large-scale borrowing by year’s end. “We’re not playing any arbitrage games,” Sanders said in response to a reporter’s question three weeks ago when he laid out his plan. “We’re going to use sound financial principles, which I don’t think are games at all.”

That day, he dismissed questions about whether his plan might be a temporary solution, calling it “a long-term fix, putting in that amount of money along with the gains that the retirement system is making.”

However, City Attorney Michael Aguirre and the City Council’s top budget aide, Andrea Tevlin, have raised questions about it. On Friday, Tevlin said the plan has
“significant hurdles” and should be stripped from the mayor’s 2007 budget. Experts emphasize that pension bonds do not eliminate debt or create new debt.

Instead, they transfer a “soft” debt that conceivably could be renegotiated with employees to a “hard” debt owed to bond holders, a shift that potentially makes it harder to borrow money for pressing capital projects such as those the city has halted since its fiscal woes came to light in 2004.

Parry Young, director of the public finance department for Standard and Poor’s Ratings Services, wouldn’t comment on San Diego but said generally higher interest rates make pension bonds “a little more difficult to pull off.” The agency has suspended San Diego’s credit rating because of major fiscal problems that include unaudited books and low emergency reserves. Two other rating agencies have cut the city’s credit rating repeatedly over two years.

That rating would need to be restored before the city could access the bond market at appealing rates – one of the risks outside the city’s hands that was cited by Tevlin on Friday. Despite the uncertainty, Doug McCalla, chief investment officer at the San Diego City Employees’ Retirement System, says the pension board, its staff and 27 fund managers are standing by to invest any additional money from the city.

The system’s annual investment return has exceeded 11 percent on average over 25 years. That dips to about 10.7 percent over 20 years, 10.2 percent over 10 years and 6.3 percent over five years. The fund’s assets are invested mostly in domestic equities and domestic bonds, with international equities and bonds making up a smaller portion and the rest invested in real estate. McCalla said more cash wouldn’t change that.

Local history
Nearly $40 billion in pension obligation bonds were issued nationwide from 1993 to January, including a record $10 billion by the state of Illinois in 2003. Almost 100 issues totaling $14.3 billion originated in California over that time period. Locally, Chula Vista, Oceanside, San Diego County and the San Diego Metropolitan Transit Development Board have sold such bonds, in varying amounts and at interest rates generally at 5 percent or lower. Cliff Telfer, the chief financial officer for the Metropolitan Transit System, said: “The city has a very tough decision. I’m glad I’m not in their boots.”

Maria Kachadoorian, Chula Vista’s finance director, said her city recently explored the possibility of selling pension obligation bonds for the first time since 1994. But, she said, “it just didn’t make sense to us.” Chula Vista and San Diego County were part of a first wave of governments across the country that sold pension obligation bonds in the early 1990s. A second wave began in 2002 as cities, counties and states in growing numbers gambled on high returns in markets ready to respond. Giddy state and city leaders likened what they were doing to refinancing a home mortgage at a lower interest rate. In recent years, fiscal experts inside and outside of government have stepped up warnings for others who may be entertaining the idea.

Warnings
A year ago, the Government Finance Officers Association updated its position to reflect the inherent gamble by saying, “Governments issuing pension obligation bonds must be aware of the risks involved with these instruments and have the ability to manage these risks.” Patrick Born, the chief financial officer for Minneapolis and the chairman of a Government Finance Officers Association committee that recommends prudent debt policies, urges governments to understand that the sale of pension bonds is risky and “certainly not as compelling as it was a year or two ago.”

The cities of Pittsburgh, Philadelphia and New Orleans and the state of New Jersey learned the dangers firsthand when they gambled on pension bonds at exactly the wrong time,just before the stock market went south this decade. New Jersey’s $2.75 billion bond issuance in 1997 was the largest at the time. Within two years, the state stopped earning enough on the investment to cover its 7.6 percent interest cost.

Professors and government officials say San Diego would be on the back end of a bell curve for the latest wave of cities and other public borrowers tempted by record-low interest rates after the market’s rebound from a fall afew years ago. Yet, even those who support selling pension obligation bonds in today’s climate say they would caution those considering them that the bond proceeds can dry up – leaving the pension deficit intact or possibly worse – if investment expectations aren’t met in the earliest years after the infusion of bond proceeds.

Ronald Picur, a professor of accounting and finance for the University of Illinois at Chicago, says such plans work because the proceeds are invested up to 30 years, a time span within which investments are more inclined to mount.

Picur cautioned that this type of borrowing is like baseball in that “if you get behind in the early innings, then it’s really hard to catch up.”