MuniLand

Chicago has nearly identical fiscal challenges to its home state of Illinois: pension underfunding, massive school deficits and recurring deficits. But unlike the state, many of the decisions that need to be made in Chicago are out of the control of leaders, especially related to pensions. These decisions are made in the state legislature. Chicago Mayor Rahm Emanuel seems to have had little success lobbying for the city’s interest. Chicago political writer Greg Hinz described it in Crain’s Chicago Business last year:

In a rare mayoral visit to Springfield, Rahm Emanuel today told lawmakers that they need to act now on pension reform for government workers, and he laid out some specifics as to what he wants.

Testifying before a House committee, Mr. Emanuel called for a 10-year holiday on paying cost-of-living increases in Chicago’s four pension funds and other government retirement systems around the state. That freeze would apply to both current workers and those who already have retired.

Workers also ought to contribute an additional 5 percent of salary to keep their defined-benefit pensions, he said. The increased contribution would be phased in over five years.

Despite Emanuel’s efforts, nothing has been accomplished in Springfield for pension reform. The House and Senate proposals for the state were not as far-reaching as Emanuel had proposed for Chicago. The big money challenge for the state is its pension liabilities.

The Federal Reserve Bank of New York has begun publishing data about the bond holdings of its primary dealers. Primary dealers are the largest and most active trading groups in bond markets. This new data will add a lot to our understanding of market flows.

The primary dealer banks own less half than 1 percent of outstanding municipal bonds, or $17 billion for the week ending June 19, 2013. The amount of municipal bonds outstanding is $3.7 trillion.

According to MSRB’s EMMA data system, the average daily trade volume by par amount for the last thirty days for municipal bonds is $12 billion. Dealers are holding about 1.4 days’ worth of trading volume. The big dealers traded $8.8 billion of securities for the week of June 19, controlling about 73 percent of daily muniland trading.

Muniland’s oversight organization, the Municipal Securities Rulemaking Board, has proposed some new rules to the SEC that may make it easier for retail investors to buy bonds that are newly brought to market.

The dealers who underwrite bond offerings tend to favor their institutional and high net worth clients, so typically retail investors have a difficult time getting an early part of the pie. In fact, the issuer would often prefer that their bonds be placed with retail investors, because they tend to be the most stable owners as buy-and-hold investors.

The MSRB’s new measures would strengthen the retail order period. The first would establish specific obligations on the senior syndicate manager to disseminate detailed information about the terms and conditions of any retail order period. Whatever terms the state or local government has set for retail investors to be able to buy bonds must be provided to all the dealers in the selling group (on a large deal this could be up to 15 or more dealers). It sounds simple, but it doesn’t always happen.

As the debate continues over public pension funding levels, we have this headline from the Financial Times this week: “US States need $980 billion to fill pension gap, says Moody’s.” This is not exactly news. A number of studies, including ones from the Pew Trust and the Public Fund Survey, have identified a massive shortfall for public pension funds. In fact, the Pew Trust said that the shortfall in 2010 was $1.38 trillion, so perhaps we should be applauding state legislatures for improving the gap since then.

The shortfall numbers in these studies, to put it simply, are all over the place. There are many variables that go into these models, but the main factor that causes variation is the expected rate of return on the assets in the plans. The official assumed return on the assets that are held in trust to pay pension liabilities is 8 percent, according to the Public Fund Survey. Fiddling with this projected rate of return can cause swings in the amount of unfunded liabilities. The Moody’s study uses an unconventional assumption. According to the Adjustments to state pension liabilities document:

Accrued actuarial liabilities will be adjusted based on a high-grade long-term taxable bond index discount rate as of the date of valuation (of the fund).

Reply to @cate_long at 9.35%, State of IL pays more than double-B Junk bond corporates which are at 6.75% in 20 year. That should a warning

— Patrick (@PDQ5661) June 26, 2013

Illinois, the state with the lowest credit in the United States, had to pay up this week to bring a $1.3 billion general obligation bond offering to market. Reuters reported that the general obligation bonds due in 25 years were priced at 5.65 percent on Wednesday. This was approximately 180 basis points (1.80 percent) over Thomson Reuters MMD AAA, compared to a spread of 138 basis points on Tuesday. In other words, Illinois got spanked hard.

Illinois has massively unfunded public pensions and a huge stack of unpaid bills that make the state less creditworthy and force it to pay higher interest rates when it borrows. But a new study by the Mercatus Center suggests that, since the risk of default for Illinois is very small, the state is overpaying for its bond offerings. The study’s author, Marc Joffe, formerly a Senior Director at Moody’s Analytics, developed a fiscal simulation model that takes into account pension, education and health care payments over time in addition to debt service:

It comes as no surprise to those who understand markets that the less liquid a product is, the more its price will decline in a fast market rout. This has happened over the last few days in the municipal bond market.

The buying and selling of individual municipal bonds can be especially illiquid for retail investors because they don’t have much real-time market data. More importantly, they face very steep transaction costs, or markups, that dealers put on bonds sold in small lots. I wrote about this last week:

Securities and Litigation Consulting Group of Fairfax, Virginia, recently published a report that analyzed almost $3.7 trillion worth of municipal bond trades that happened between 2005 and 2013 (page 8). SLCG found that the median markup for a trade up to $25,000 in size is 1.79 percent.

Mark Funkhouser, the director of the Governing Institute and a former mayor and auditor of Kansas City, took a few swings at the SEC for its securities fraud prosecution of Harrisburg, Pennsylvania. Funkhouser has three concerns with the SEC’s case.

First, he correctly points out, as the SEC case contends, that the city of Harrisburg did not issue any financial statements between January 2009 and March 2011. The SEC says that because of this, investors had to seek out other statements made by public officials that included material misstatements. Funkhouser blames it on investors for poor diligence. He says:

You’d think it would be obvious to potential investors that if there’s not much current information available about a city’s finances they might want to think twice about buying its securities. But investors don’t always exercise proper diligence, and it wouldn’t have hurt for the SEC to have driven home that point.

The twitter handle for Puerto Rico’s executive branch is @fortalezapr. Here are some of the tweets from Thursday:

We are in pretty grim times when an investment grade government is tweeting about bankruptcy to encourage people to approve big tax and fee hikes.

Who is in line to finance the $2 billion for the Highway Authority? Good luck with that.

Google Maps

Detroit Emergency Manager Kevyn Orr predicts that the chances of Detroit entering bankruptcy are about 50/50. But if we consider what the major participants, bondholders, public employees and retirees are likely to do, it’s almost 100 percent certain that Mr. Orr will be entering the federal bankruptcy court house on West Fort Street in Detroit.

The bankruptcy case of Stockton, California provides an indication of how willing bond insurers will be to make upfront concessions. In Stockton, they were totally unwilling to give up anything. From the written ruling of the bankruptcy judge in Stockton, Christopher Klein: (page 17)

Bond insurers are the legal grinding stone of the municipal bond market. They don’t give anything away if litigating would gain them some advantage. They have stables of high-powered attorneys to fight their battles.

It’s well known in muniland that retail investors, who buy smaller lots of bonds than institutional buyers, get hit with high markups. The rule is that dealers must deal “fairly” with investors. Translation: Markups to customers cannot exceed 5 percent. So if a dealer sells a bond worth $5,000, he may not charge the client more than a $250 markup. However, there is no regulatory requirement for the dealer to tell the client how much the bond has been marked up; just that it was marked up. Many believe these differences in bond prices are excessive, but no one has figured out a way to reduce or stop the practice.

Securities and Litigation Consulting Group of Fairfax, Virginia, recently published a report that analyzed almost $3.7 trillion worth of municipal bond trades that happened between 2005 and 2013 (page 8):

SLCG found that the median markup for a trade up to $25,000 in size is 1.79 percent. Here is an example of a trade with an excessive markup, from page 11 of the study: