When Detroit filed for bankruptcy protection last week, no one was shocked. It felt like it was inevitable. Now one has to ask whether analyst Meredith Whitney was correct but just early in her call in late 2010 on municipal defaults? For Detroit, the real culprits in the bankruptcy were skyrocketing pension and health care costs, even though mismanagement and reduced state and federal aid also played a role.
Those same issues are at the root of most of the fiscal challenges faced by state and local governments. As I write, there is controversy over the legality of Detroit’s bankruptcy filing because state law prohibits such a filing if it contemplates a reduction in pension benefits.
That said, there is no doubt that Detroit, with more than $18 billion of debt, cannot pay its creditors. Of that debt, the city owes $3.5 billion to its pension plans. The answers that Detroit will deliver to the marketplace regarding the distribution of its assets will be based on forthcoming judicial decisions that will determine which group of creditors skates and which ones get savaged. Detroit may well become the model for how the courts treat the creditors of future municipal bankruptcies. The credit markets are certain to take note, and there are certain to be reactions and price adjustments as a result.
Detroit may be just the beginning of the spate of municipal bankruptcies that Meredith Whitney forecast more than two and a half years ago. In the last month, studies have shown that municipal fiscal problems are much worse than previously believed. Actuarial estimates of unfunded liabilities have risen, not only because governments have failed to properly fund the plans under the old guidelines, but because the guidelines have changed.
A couple of years ago, Morningstar estimated the funding status of each state’s pension program. The 2011 results ranged from 43.4% (Illinois) to 99.8% (Wisconsin). That study showed that only 30% of state programs were at least 80% funded. But now, those estimates have all changed as, in late June, Moody’s introduced new measurement methodologies. Not surprisingly, Illinois was still at the bottom. What is significant is that Moody’s found that the median state must now devote 45% of its annual revenue just to fund and catch up with its existing pension obligations.
At the same time that Moody’s concluded that retirement costs have been vastly underreported, the Government Accounting Standards Board (GASB) was introducing new accounting rules for municipalities to increase transparency and reduce that underreporting. Significantly, last September, a report by the U.S. Senate’s Joint Economic Committee (JEC) estimated that underfunding to be as high as $3.5 trillion.
Artificially low interest rates have a lot to do with pension underfunding. If actual pension plan investment returns are lower than the actuarial return assumptions, there won’t be sufficient assets to pay the retirees. In July, Moody’s reduced the return assumptions for CALPERS from 7.5% to 5.5%, causing the funding status of CALPERS to fall from 82% to 64%. As you can imagine, the new studies and reporting rules are playing havoc with the interest rates that municipalities must pay. Much of the recent rise in rates in the muni markets have been blamed on Federal Reserve Chairman Ben Bernanke’s “tapering” pronouncements, which had a huge impact on the Treasury yield curve. But there can be little doubt that much of the recent increase in Muni-Treasury spreads was the result of the Moody’s study and the new GASB rules.
Although a financial meltdown was avoided in 2009, the crisis clearly isn’t over. State and local budget issues are going to have a significant impact on economic policy going forward. Their recognition may even delay the start of the Fed’s “tapering” program.
Muni investors, be forewarned: There is volatility ahead in the marketplace. As it turns out, the much maligned pronouncements on the health of state and local government finances by Meredith Whitney in late 2010 were actually prescient. Even the JEC agrees with her conclusions, as they reported that “some state pension funds will run out of assets in as little as five years.”
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee. Barone or the professionals at UVA (Joshua Barone, Andrea Knapp, Matt Marcewicz and Marvin Grulli) are available to discuss client investment needs.
Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.