Public Finance Crisis

04/23/2010 05:12 am ET | Updated May 25, 2011

The Wall Street Journal recently wrote that more and more municipalities are so strapped for cash, they are considering a Chapter 9 filing. Chapter 9 is a seldom-used part of U.S. bankruptcy law that gives municipalities protection from creditors (the largest Chapter 9 case was filed in 1994, when Orange County, Calif., lost $1.6 billion on interest rates derivatives).

As tax revenues decline due to harsh economic realities, many cities and counties find it increasingly difficult to meet their interest payments on municipal bonds. Unfortunately, people still believe that municipal bonds are a safe, low risk alternative to cash, because historically they experienced low default rates. But with the increasing strain on cities, the old standards no longer apply (and if interest rates rise, which they inevitably must, that would further erode prices of all fixed income instruments).

Moreover, a recent Pew Center study shows state pensions have a $1 trillion gap in funding their obligations to pension and health care promised to state employees.

In eight states, more than a third of the total liability was unfunded. Two states, Illinois and Kansas, had less than 60% of the assets they need to meet their pension obligations (Illinois alone has an unfunded liability of more than $54 billion).

As far as health care liabilities go, 41 states are less than 10% funded.

The real numbers are worse, because the Pension Plans' assumptions for future investment returns are between 7.25% to 8.5%. Those assumptions are simply outlandish. It makes no sense for everyone to expect to get 8% returns safely out of an economy that is growing about 3% per annum, unless employing the use of leverage or taking interest rate and foreign currency risk. We cannot all grow faster than the underlying economy.

With extremely low interest rates, what seemed like reasonable projections for a portfolio of stocks and bonds are now far too high. With the 10 year T Bills currently yielding less than 4%, expecting the states to earn such a huge margin over the risk-free rate seems like something the Mad Hatter would say to Alice when she comes to his tea party in Wonderland.

Why are pension assumptions worth quibbling over? Because current pension accounting allows pension plans to use an estimate of expected future returns instead of actual returns to compute periodic pension costs. Annual differences between actual and expected returns are accumulated and amortized over time.

As a rule of thumb, every 1% less in performance requires an extra 10% in annual funding to counteract. So the difference between 8% to 6% would be very significant.

And as Mike Shedlock of Global Economic Trade Analysis notes, many of the states in deepest trouble have the highest pension plan assumptions.

Once a state doles out a retirement benefit, it is difficult to rescind it. Pensions are considered contracts, and are thusly protected by law. Even if they weren't, the political ramifications of touching the "Third Rail" are daunting. No politician would be willing to effectively end their career by alienating government employees and unions in suddenly revoking their benefits.

After all, state employees have a point when they say that would be grossly unfair. They have been counting on their retirement benefits for years, and those were always considered part and parcel of their compensation.

Yet we can no longer afford these benefits. Reckless politicians in previous generations joined the Gadarene rush and granted generous pension plans, early retirement ages and liberal health benefits. They grew inexorably and as a result, municipalities and states are now at the brink of insolvency. The City of Los Angeles might run out of cash by this summer. California itself has long been in fiscal crisis mode. And at some point our political leaders and the public will have to choose between terminating the social contracts with state employees, ending basic services such as the police or fire departments, or defaulting on their obligations to municipal bond holders.

Alan Schram is the Managing Partner of Wellcap Partners, a Los Angeles based investment firm. Email at