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

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.

Update on the last point:  From today's WSJ:

A decade of low bond yields pushed some of the most stability-minded investors to dabble in risky investments that depended on markets being orderly. Now, those bets are looking problematic.

In the past, pension funds, endowments and family offices pursued relatively safe investments. After interest rates collapsed on the heels of the financial crisis, they ran into challenges paying pensioners and filling university budgets, and added riskier bets on hedge funds and venture capital in the hopes of winning better returns.

More recently, some of these investors also made big, unpublicized wagers seeking to benefit from what had been an unusually long period of low volatility, according to pension-fund consultants and others who deal with these institutions. The strategies, often involving the writing of complicated options contracts, were for years a source of easy money. Markets hadn’t been so calm since the 1950s.

Among those making such bets were Harvard University’s endowment, the Employees’ Retirement System of the State of Hawaii and the Illinois State Universities Retirement System.

Yet volatility has now returned to markets, with a vengeance. When the Dow Jones Industrial Average lost more than 2,400 points in a week, intraday market swings also surged. The Cboe Volatility Index, or VIX, a measure of expected swings in the S&P 500, closed at its highest level last week since August 2015, recording its biggest one-day jump ever on Feb. 5 as it surged to 37.32 from 17.31 the prior day.

The $16.9 billion Hawaii fund in 2016 began earning money selling “put” options—essentially a bet that markets would stay calm or rise. When markets fall, Hawaii is on the hook to pay out.



  1. August Hurtel:

    Between last summer and this coming one, municipalities have to change their reporting practices. Which means the already bad situation that they used to be able to sort of hide somewhere deep in the paperwork is now supposed to be much more visible. So I've already been looking for the cities to get into trouble. One wonders if they can deploy this ridiculous scheme before they get downgraded. Most will try. Politicians have such perverse incentives that we probably should ban them. If someone were to 'own' a city in some fashion, surely they would do better than these idiots.

  2. The_Big_W:

    There is a red, flashing "past performance is not indicative of future results" sign here.

  3. The_Big_W:

    Ban, politicians?! I'm in....

  4. Tenhofaca:

    Love that they brought in a math professor So that they could sell the scam. The math is easy; the investing is hard.

  5. marco73:

    Just another scam to throw the day of reckoning farther into the future, or at least until this batch of politicians leaves office.
    Some municipalities are becoming retirement plans for retired workers with city government services as a side business.

  6. Dan Wendlick:

    This is pretty much what caused the Savings and Loan crisis of the 1980s, with a sprinkling of "Let's borrow our way out of debt" on top. The key phrase is "Under the professor's math". The idea that the market would accept a yield of 5% on bonds form an entity already below investment-grade (junk) that was seeing to increase its leverage is astounding to me. The very investments that are yielding 7.5% rates are the paper written by, among others, municipalities looking to cover under-funded pension funds.

  7. sean2829:

    I can see why a municipality would do this. Cities in California like Stockton an San Bernardino ended up paying bond holders $0.10 on the dollar while pension benefits are left untouched. However I can’t see anyone in their right mind buying these bonds.

  8. Jaedo Drax:

    Don't worry, it's just government math covering for government accounting, covering for government budgeting.

  9. LB:

    Just as with film producers the issue is consent.

    The 'profs' idea is to force the public to effectively write a CDS on the government's debts

  10. RS:

    Actually, you're missing the best part. As someone with some experience with the municipal pension rules for the State of Illinois, good luck getting the 7.5% assumed rate of return. If your pension fund is less than $10,000,000, by state statue you are not allowed to invest more than 45% of your money in equities. If you're over $10,000,000 you can invest up to 65% equities.

    Also - the best part. A mutual fund, regardless of the underlying investments, is considered an equity. So if you're a small pension fund and you decide to save money and buy the Vanguard Short Term Federal Bond Fund (which is 100% cash or federal bonds - 0% in stocks) it counts against your stock allocation.

  11. glenn.griffin3:

    Is bond Ponzi! Why can't anyone say it?

  12. Not Sure:

    From the linked article...

    "Phoenix owes $4.4 billion to its retirees. But the new plan could knock off $10 million of that over the course of 20 years."

    At that rate, that $4.4 billion will be taken care of in what- 8,800 years?

  13. randian:

    As long as the slaves (sorry, *fellow citizens*) are on the hook in case of shortage why should public pension fund managers and their public employee beneficiaries care what risks they take? As a further incentive public pension fund managers get bonuses in good years yet suffer no clawbacks in bad years.

  14. BernieFlatters:

    Nothing will ever fix public pensions until the benefits are brought more line with Social Security or it becomes a defined contribution plan. Current benefits are simply too rich to be sustainable.

  15. Andy Turner:

    Such tricks are nonsense and destined to fail on the whole. Defined benefits pension obligations are essentially bonds. The employer has effectively borrowed current earnings from workers promising to repay the worker at a later date. if the pension promise is to be certain, then the appropriate discount rate for those liabilities is obviously the Treasury rate and only an investment in Treasury bonds matches the risk characteristics of the pension liabilities. Since there is no reason to believe that state and municipal governments have any expertise at investment management, these governments should have been buying Treasuries every step of the way to back the pensions. Of course, they did not. To the extent that non-Treasuries are being used to invest the pension assets held by the government, the government in running a (risky) hedge fund. Again there is no reason why taxpayers should want this or for us to expect the government would have skill at this activity. (And since the average of active managers always underperform, by definition, the alternative passive portfolio, we should expect such active management not to succeed.) And to the extent that the fund is underfunded, as every state and municipal plan in America is (on an economic basis, properly discounting liabilities at the Treasury rate), the government is running a leveraged hedge fund. Its insane. But we're stuck with it now. As Kubrick notes in Full Metal Jacket: "Its a huge s**t sandwich and we're all gonna to have to take a bite."

  16. markm:

    I wonder how many math professors are even capable of doing their own tax returns?