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Reggie Middleton

Reggie Middleton

Posted: August 23, 2010 03:34 PM

In early 2008, I warned my readers that several states and municipalities in this country are going to run into some very rough times, with the spectre of default definitely on the table for a few. See Municipal bond market and the securitization crisis – part I and Municipal bond market and the securitization crisis – part 2 (should be read by whoever is not a muni expert – this newsbyte may be worth reading as well).

Of course, the highly contrarian nature of my views were (and are) bound to bring about its fair share of naysayers, pointing to the sparse record of actual municipal defaults. Of course, we all know the safety of driving forward while staring in the rear view mirror, California creating its own currency in the form of IOU’s and all… I also brought up the risks that the CDS market posed in Counterparty risk analyses – counter-party failure will open up another Pandora’s box (must read for anyone who is not a CDS specialist). This was done right about the time that I also called several companies out for their CDS (and direct) exposure to real estate, mortgage debt and municipalities – namely:

I considered three of the four to be insolvent in 2007 and early 2008. History has shown whether I had a point or not. I rehash history because a review of the lessons that hurt so bad, but were never learned brings us back to the muni markets, CDS and overleveraged exposure. Is this 2008, 2010, or some non-descript chrono-anomaly from a Twilight Zone episode?

Illinois Municipal Debt Defies Gravity

As municipal debt issuance continues to drop alongside yields, Chicago and Illinois continue to issue debt despite their deteriorating credit ratings and negative outlooks.  Even as rates for AAA tax exempt borrowers have fallen, statewide issues from budget shortfalls, unemployment a full percent above the national average, and most importantly for the municipal bond market, declining state revenues have started to drive Illinois credit spreads wider than the poster child for state profligacy, California.  Recent headlines have made it clear that state services in this fifth largest of the US states are under pressure.

Illinois Budget Crisis Draining State Services: Bloomberg

  • State retirement liabilities are near $130 billion, Illinois holds the country’s largest pension and health care funding gaps
  • Pension debt is $90 billion, and programs are unfunded to the tune of $54 billion
  • The state’s unpaid bills have risen by $1 billion in the past year

Chicago Downgrade Raises Borrowing Costs Amid $164 Million Sale: Bloomberg

  • Chicago is planning a multibillion dollar education capital plan, which it will debt finance
  • Chicago has continued to thin out its cash reserves, and when faced with firing 1,200 public school employees, it instead chose to let the good times roll (party like it's 2005)
  • Recent credit ratings downgrades may have raised the debt financing cost by 40%

Illinois Pension Continues to Borrow From Future: Sun Times

  • In January of this year, Illinois raised $3.5 billion in five year pension obligation notes at a tax free rate of 3.84%, most of the funds going to the Teachers Retirement System (TRS)
  • The pension fund usually reinvests the some of the proceeds from the bond sale into financial markets to try and beat the 3.84% interest rate, however, in 2009, the TRS fund lost 22%, even as the S&P 500 strengthened by 26%
  • The pension system has reached an endpoint where simply cutting future benefits will not be enough to get out of a fatal debt spiral

And Yet, Illinois Bond Spreads Tighten: WSJ

Perhaps the only thing more frightening than the TRS asset shortfall is the TRS asset holdings.  Illinois has exposed itself to material credit risk and CRE exposure through their CMBS holdings. I assume an astute sales team sold this to the pension fund. For more on the profitability (for the banks) on selling CRE products to institutions, see When It Comes to Wall Street Real Estate Funds, the House Always Wins – Even When Investors Get Slaughtered (it’s long, but it drives the point home). TRS has also assumed (and probably generated) material global credit risk in the OTC credit derivatives market by underwriting sovereign CDS on government bonds.  An audit of fund holdings indicates that these positions have lost $515 million, with the audit occurring at the end of March 2010, so it is ok to assume that these positions have become even worse as spreads have blown out in Europe.  For those who are not aware of my stance on credit risk as well as the financial and economic contagion hotbed boiling in Europe amid the rampant mis(and dis)information , see my series on the Pan-European Sovereign Debt Crisis.

Hey, Mr. and Mrs. Illinois Teacher, Reggie Middleton thinks your pension fund is picking up pennies in front of a freight train!

So, we have teacher’s pensions writing insurance on the biggest European debacle of this century. We have same said pension buying the debt of assets, 40% of which are probably underwater. What was not mentioned thus far is that this very same pension has more than 80% of its holdings considered “risky” according to a study by “Pensions and Investments”, and industry rag – and that was in 2008, without the benefit pending defaults in Europe and the ever higher climb of LTVs in CRE.

Then there’s the fact that TRS is also:

  • selling swaptions,
  • shorting international interest rate swaps
  • knee deep in GNMA, FNMA instruments,,,,

and this is just from a cursory view of their holdings. They paid over $160 million in management fees, and if I had to take a guess, they are reaching for yield and quick returns over the prudence of looking to preserve capital which in my opinion should be the mantra of a pension fund shepherding the retirement funds of real people. Then again, there I go being old fashioned again.

In addition to the market performance of the actual positions themselves, one must ponder… If a credit event is triggered, does the Illinois TRS have the liquid capital to make good on its CDS obligations? When BoomBustBlog created the Sovereign Contagion Model, who knew it left out Illinois.  If the TRS is unable to make good on its CDS positions in the event of a tail event, it is definitely not unfathomable that Illinois could be the domino that falls into the blow up the CDS market.

Illinois is facing what Hayman Capital Advisors manager Kyle Bass referred to as “The Keynesian Endpoint”.  To paraphrase, when debt service exceeds revenue, deficit spending becomes permanent and structural until default inevitably occurs.  Since the bursting of the housing and credit consumption bubble back in 2008, tax revenues have fallen, and pension liabilities continue to receive funding through debt markets.  Using basic accounting, the gimmicks used to placate state employees are about to come to an end.

Economic data points toward a prolonged recessionary environment for citizens of Illinois.  While fiscal measures need to be taken to correct imbalances in revenues and expenses, it certainly appears from the outside looking in that policymakers have instead elected to ransack the future with an unbearable debt burden.  Even the people these policies are designed to benefit, public workers, will have to take significant steps once reality hits that their pension benefits may not be as great as once thought.  Watching the future of Illinois finances will be interesting considering the similarity Illinois shares with the likes of Portugal, Italy, Ireland, Greece, and Spain in that there is no printing press to provide a quick fix for long term fiscal imbalances.  One thing is clear, Illinois will be very dependent on debt markets, as secular revenue growth is not coming back anytime soon.

For those who like pour over numbers and asset holdings, here is the FOIA Answer, requested by reporter Alexandra Harris illustrating TRS holdings and giving us a peak into what lies in their funds, and here are the TRS asset holdings as per the state audit.

 

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