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This One Simple Trick Will Send a Lot of Municipalities Into Bankruptcy

Posted by on | February 14, 2018 | Comments Off

The “trick”:

Democrats in the state House have proposed issuing $107 billion in bonds to backfill the state’s pension funds, which are short $129 billion. Annual state pension payments are projected to increase to $20 billion in 2045 from $8.5 billion—not including interest on $17 billion in debt the state previously issued to pay for pensions.

At the request of state retirees, a University of Illinois math professor performed a crack analysis showing how the state could use interest-rate arbitrage to shave its pension costs. Under the professor’s math, the state could sell 27-year, fixed-rate taxable bonds and invest the proceeds into its pension funds. This would supposedly stabilize the state’s pension payments at $8.5 billion annually, save taxpayers $103 billion over three decades and increase the state retirement system’s funding level to 90% from 40%. Can the mathemagician make House Speaker Michael Madigan disappear too?

So what exactly does this mean? What is the trick?  Essentially, the trick is… investing using margin.  The professor’s math was based on borrowing at 5% and then investing at 7.5% returns (the returns the pension funds have gotten over the last several years’ bull market).    Ignore the fact that this rickety scheme probably will not be able to borrow at 5%, but likely at a higher rate.  Even at 5%, the problem is that if returns fall below the interest being paid on the bonds, the state and the pension funds are in worse shape than they were before.  If you saw a friend who was in the hole after a night of losing gambling who was trying to borrow more money from the house to try to make it all back, you would stop him, right?

Given the risk of falling short of covering the margin interest, one also has to worry about the portfolio asset allocation incentives here.  You certainly can’t borrow at 5% or more and expect to make any money investing long-term in almost any sort of reliable bonds.  This is going to push the pension managers into riskier all-equity portfolios and even beyond into trying even riskier investments that have almost never worked out well for government pension funds.

I write all this because apparently this insanity is coming to Phoenix. ugh.

 

 

 This One Simple Trick Will Send a Lot of Municipalities Into Bankruptcy  This One Simple Trick Will Send a Lot of Municipalities Into Bankruptcy  This One Simple Trick Will Send a Lot of Municipalities Into Bankruptcy

 This One Simple Trick Will Send a Lot of Municipalities Into Bankruptcy

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