Randomly Noted

To those fretting about the very real budget problems of U.S. cities and states, their difficulty in fulfilling  financial promises they made and the implications of all that for the market in tax-free bonds, here’s a number that might offer a measure of reassurance. 72. Or, if you like, 77.

These numbers represent the percentages, respectively, of the number of polled New Yorkers who support the tough budget proposal of the state’s new Democratic governor, Andrew Cuomo, and the percentage who have a favorable view of him. (The source is the Siena Research Institute.)

That’s New York, the fabled liberal state. Across the river in New Jersey, the controversial Republican governor, Chris Christie, is lighting into government worker benefit and retirement plans that threaten the state’s fiscal future.

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One of this bloggers favorite newsletters is one put together by John Mauldin. Not only does he have his own interesting economic insights, but he flags his readers to insights from others. His most recent newsletter focuses on a year-end review by Hoisington Investment Management. The area of the review that caught my eye were some of the remarks about the municipal fiscal mess we continue to face.

For starters, Hoisington notes that the rise in municipal bond yields significantly increased borrowing costs – which is not something good for already cash-strapped municipalities. That makes it more expense to fund capital projects that were planned, which could place some of those plans in peril. The firm notes that through history, state and local governments don’t undertake big projects when they have huge cyclical deficits. What’s not said here but is another consequence – the fewer capital projects underway, means fewer jobs for the employed and unemployed.

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If you are looking to make a contrarian macroeconomic bet in 2011, how about this one: real progress will be made in the U.S. at the federal and state level on reducing large, structural budget deficits.

I know it is a doozy. And I did say contrarian, which means if you believe it most people will say you are crazy. But contrarian sometimes does happen.

It’s pretty easy to build a case against deficit-cutting progress. Sky-high budget deficits at the federal level were just recently met by continued tax cuts, which makes the deficit worse. Messing with Social Security or Medicare still means flirting with the ‘third rail’ of American politics. State and city promises to retired workers are massive and underfunded. A divided government in Washington promises nothing but hostility and inaction.

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As we noted in an early post about Mauldin/Whitney and municipal budgets, a big reason for the budget gaps facing many state and local governments are because of massive costs to fund pension plans. On a recent “60 Minutes” segment, NJ Gov. Chris Christie made his position clear – states shouldn’t have pension plans and instead should have 401(k) plans like most companies have today. (Needless to say, his position is not popular with many of the unions, particularly the teachers).

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Two of the brightest people in the financial industry are John Mauldin (great economic insights) and Meredith Whitney (she called the banking industry crisis well before it happened in 2008). And they couldn’t disagree more on how severe the budget crisis is for state and local governments – and what that ultimately means for municipal bond holders.

Whitney appeared in a recent “60 Minutes” segment  called “The Day of Reckoning,” which took a look at the financial condition of states budgets. She thinks the state governments will be ok but not so for city and county governments. She predicts a spate of 50 to 100 sizable government defaults – and was predicting that coud amount to hundreds of billions of dollars. She believes the defaults will begin within a year. (Click here to see the “60 Minutes” segment.)

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Ever since it became apparent that tax legislation would not include an extension of the popular Build America Bond program, the traditional tax-exempt muni bond market has been in somewhat of a tailspin. Prices have fallen, yields have risen and investors have been pulling money out of long-term municipal bond funds.

That trend continues. The latest data from the Investment Company Institute showed more money flowed out of longer-term funds in the week ended Dec. 8.  Apparently, investors are concerned that municipal issuers, without the BAB program, will be flooding the traditional municipal market with new bond issues. Thus, there will be to much supply and not enough demand.

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California, meet Greece.

Illinois, meet Ireland.

Pennsylvania, meet Spain and Portugal.

It would be very helpful for the finance leaders of those states to study hard what’s going on with those European countries, especially if the White House’s deficit reduction commission is successful with a proposal to eliminate tax-free status of newly issued municipal bonds.

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It’s hard to imagine how the European credit crisis that hit hard many of the banks there could have an effect on bondholders of a housing agency in the U.S. whose reason for being is to provide affordable loans for first time home buyers. But that’s what could play out for investors – likely Mom and Pop types – who hold some $3 billion of mortgage revenue bonds issued by the Ohio Housing Finance Agency.

The housing agency, and apparently many other municipalities, have invested some of their funds in guaranteed investment contracts issued by a company called Pallas Capital Corp. The Ohio agency has some $106 million tied up with the Pallas GICs.  Some investors look to GICs as a means to extract a little extra yield. It’s not known what these particular securities were yielding.

Pallas sold GICs and then invested those proceeds in reverser repurchase agreements that were collateralized by a pool of structured finance and corporate assets, according to Moody’s Investors Service Inc. Moody’s recently downgraded the Pallas GICs because “the GICs are a direct pass-through rating of the reverser repo counterparty, DEPFA Bank. You know what’s coming next – DEPFA was recently downgraded on its ability to pay back short term loans.

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Underfunded pension commitments to public employees is a central, long-term issue for local governments and for the U.S. municipal bond market.

According to a new academic study, even substantial revisions to those pension plans likely will leave taxpayers with a big bill to fill the hole, a $1.5 trillion-sized hole.

Dramatic policy changes such as eliminating pensions’ cost-of-living adjustments and kicking retirement ages up to levels in line with the Social Security regime still leaves a $1.5 trillion hole, said Joshua D. Rauh, co-author of the study and associate professor at Northwestern University’s Kellogg School of Management.

And such changes can hardly be assumed. “While these ‘drastic’ actions may be less politically viable than more incremental policy measures, even these do not come anywhere close to solving the problems associated with states’ legacy pension liabilities,” says the  study by Rauh and Robert Novy-Marx of the University of Rochester.

Their findings were presented Thursday at a meeting of the National Bureau of Economic Research. 

Without changes, they estimate the unfunded liability stands at $3 trillion.

Throw another worrisome fact into the public pension mix. Most states figure they are going to earn a return on their existing assets of about 8% to help fund future payouts. At least in the current investment environment, that’s quite an assumption.

None of the gloom should stop states from enacting sane reforms for pension schemes. A nascent movement is under way. This column has previously noted a significant ‘agency’ problem exists with public employee retirement benefits. Temporary state political leadership has little incentive to tackle these nasty issues or to be tough in union negotiations, unless  they see tangible short-term political advantage.

As more voters understand the pension liability predicament many states are in, that political will may make itself known.

At a minimum, retirement age and other standards should better mirror private industry.

“The debate over the solution is over transfers,” the study’s authors write. “The current situation is one in which beneficiaries view their benefits as secure promises and taxpayers do not perceive that they will be held accountable for guaranteeing those promises.”

Ultimately, Rauh and Novy-Marx figure taxpayers will have to come up with the money to fill the bulk of the gap that remains regardless of the level of reform that takes place. “If unfunded liabilities continue to grow, the bailouts could be even larger.”

The statement is a strong one.

“The State of New Jersey didn’t give its municipal investors a fair shake, withholding and misrepresenting pertinent information about its financial situation.”

So said Robert Khuzami, director of the division of enforcement at The Securities and Exchange Commission. The occasion: the watchdog agency for the first time charged one of the 50 states with violations of federal securities laws.

New Jersey agreed to settle the case, without admitting or denying the SEC claims.

The penalty to New Jersey for selling more than $26 billion (with a b) tax-free bonds in 79 separate offerings in a six-year period ending in April 2007 while allegedly omitting or misrepresenting some material facts about New Jersey’s finances: agreeing to “cease and desist” from future violations of specific securities statutes.

The remedy for all the investors who bought municipal securities from New Jersey in 79 separate offerings during six years and were, according to the SEC, left in the dark about some crucial state pension underfunding: nothing that can be found in the SEC press release  or in the SEC’s order.

No individuals who were employed by the state of New Jersey from April 2001 to April 2007, when these misdeeds allegedly took place, are named in the SEC documents.

Specifically, New Jersey “misrepresented and failed to disclose material information regarding its under funding of New Jersey’s two largest pension plans …” the SEC said.

New Jersey “created the fiscal illusion” the pension pools were being adequately funded when, in fact, the state couldn’t make those needed contributions “without raising taxes or cutting other services, or otherwise impacting the budget,” the SEC said.

In other words, during all those 79 offerings New Jersey gave a more favororable impression of its fiscal fortunes than was warranted. It’s hard to imagine anything more relevant to an investor in a state’s municipal bonds than accurate information about the state’s fiscal situation.

 The dry legal language of the SEC doesn’t mask the allegedly shocking lack of proper procedures to bring a bond to market during this period in New Jersey.

“Prior to the release of an official statement, the State Treasurer, or his designee, signed a Rule 10b-5 certification, certifying that the official statement did not contain any material misrepresentations or omissions,” the SEC said. “During the relevant time period, the Treasurers did not read official statements and relied on their staff to ensure the accuracy of information contained in the documents.”

If that were not enough, the SEC continued, New Jersey’s Treasury “had no written policies or procedures relating to the review or update of bond offering documents. In addition, Treasury did not provide training to its employees concenrrning the State’s disclosure obligations…”

Since 2007, the SEC said New Jersey has improved, hiring expert lawyers and reviewing and enhancing its disclosure processes and training.

It’s hard to imagine that fact, or the state’s agreement to “cease and desist,” will provide much comfort to the individuals who bought New Jersey’s tax-free bonds in those six years.