Randomly Noted

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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In the 59 pages of sometimes radical notions proposed by the heads of a budget-cutting commission intended to restore discipline and sacrifice to the economic lives of slothful Americans, there’s at least one  idea that should be a no-brainer.

Gradually increase the age at which Americans retire and collect either early or full retirement benefits via the Social Security system. Make provisions for those 62 or older who can’t continue to work.

This one should be widley adopted by Americans if only to show they are ’mature’ about needed belt-tightening measures, given the size of current and future budget deficits. In France, major protests were launched about the plan to gradually increase the retirement age there to 62 from 60.

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So, the good news out of BNY Mellon Asset Management today is that corporate pension plans this past month were more fully funded then the month before. The bad news is that they remain significantly underfunded and what really helped the funding status in the most recent month was a rising stock market and a tool plans use to measure their liabilities.

In September, the funded status of pension plans stood at 75.9%. That means that if the plans had to liquidate today, retirees would receive basically 3/4 of what they were promised. What helped move this number up 4.6 percentage points was a buoyant stock market, that was up around 9.4% in the U.S. and about 9.8% internationally.

Pension funds determine their liabilities by using a discount rate – which is the aa corporate rate. They try to figure out their future obligations and use this discount rate to figure out the present value. The higher the discount rate, the less money a pension fund owes. So, discount rate assumptions by companies make a difference. And they generally happened to increase their assumptions by six basis points to 4.98%.

We’ll need a very significant increase in hte stock markets and much better corporate earnings to get these plans back to much higher funded levels.

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.

Investors in U.S. municipal bonds watch with concern the slow-motion deterioration in the finances of many of America’s cities and states.

There have been few defaults. As a historic rule, states and localities rarely default on their obligations to holders of their bonds. That’s the good news.

Also, many need to balance budgets every year, which gives them less flexibility than the federal government. That needed short-term balance also is good news for bondholders.

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There’s a new report out this morning that speaks to the funding status of corporate pension funds – and it doesn’t look pretty. What the report doesn’t address is the funded status of municipal pension funds. One can only assume that they are experiencing the same trends as the corporate side. And if so, that puts even more pressure on state and local governments to meet their budget needs.

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The largest U.S. public pension fund has launched a well-aimed campaign to get more public companies to adopt a “majority” rules policy for uncontested election of directors.

Indeed, the effort by the California Public Employees’ Retirement System is the proper use of this institutional investor’s heft to strike a better balance between shareholders and the boards of directors that are supposed to represent them.

Simply stated, too many companies have stuck with a “plurality” system when a director runs unopposed. Essentially, the plurality has to only be one vote, even if all other holders “withhold” their votes from the director.

“Majority” processes vary but they are pretty much what they sound like and should be familiar to anyone who has sat through a grade school civics class. Essentially, you have to get more “for” votes than those withheld or you have to at least offer to resign.

In this blogger’s previously expressed view, universal acceptance among U.S. publicly traded companies of the majority vote for directors makes unnecessary some of the other investor power pushes in which CalPERS and others have been active.

One of those is the so-called say on pay. It’s a misnomer on its face since most of those proposals for shareholders to have an after-the-fact vote on executive compensation are non-binding. Not much of a say. In majority voting, shareholder votes for directors have real power and can be used against directors at companies where shareholders think CEO compensation is too high.

Also unneeded is the ability of some large holders to nominate directors whose candidacy would be included and voting materials distributed by the company. It’s fascinating that this long-standing governance issue, referred to in short hand as “proxy access,” has now arisen in Senate deliberations about much broader financial regulatory reform, according to today’s Wall Street Journal.

Although I support regulatory or legislative oomph behind adoption of majority voting, it’s a trend that seems to be taking off without official edict. Maybe it’s the undeniable lack of fairness in the “plurality” system.

CalPERs said in a  press release that as of September 2009 about 71% of the S&P 500 companies and 50% of the Russell 1000 had come around to the majority rules concept.

CalPERS specifically said it would ask 58 of the top U.S. companies in its equities portfolio to adopt the majority rules standard. Said George Diehr, chair of the CalPERS investment committee, “The policy should include the required resignation of any director that receives a withhold vote greater than 50% of the votes cast. “

The political contributions of publicly traded companies seemed sure to become a governance issue for investors once the Supreme Court ruled in January to dismiss long-standing limits on corporate spending on political advertising.

Sure enough, movement. On Friday, New York City Comptroller John C. Liu trumpeted an agreement with Bank of America that has the bank agreeing to publish its political spending made with corporate funds and by bank-sponsored political action committees.

New York City Pension Funds hold about $600 million worth of common shares in Bank of America.

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The debate about shareholder rights and corporate democracy in the U.S. often omits a key fact: individual investors typically don’t get involved.

When that’s taken to account, the dynamics of issues such as whether to grant proxy access for the director nominees of certain large shareholders take on a different hue.

Rather than a scene where all-powerful corporations and their boards are set against powerless indiviudal investors, who desire a bigger voice, you have in reality a variety of powerful players: companies and their executives, boards, big pension funds, mutual funds and activist investors among them.

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