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:
- Bear Stearns: Is this the Breaking of the Bear? (months before the collapse, while the company was trading in the $180s, the sell side still had buy ratings and the rating agencies had high investment grade stamps on it)
- Ambac (Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility) – which also had investment grade ratings, trading in the $80 range,
- MBIA (A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton), ditto above;
- and Assured Guaranty (Reggie Middleton on Assured Guaranty).
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?
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
- Even with Illinois public debt being issued on a negative outlook, foreign markets ate up the Build America Bond offering at only 325 basis points over 30 year treasury yields
- Analysts claim foreigners are opting for Illinois municipal bond over Greek government bonds (why own either?) See our take on the Greek situation:
- Greek Crisis Is Over, Region Safe”, Prodi Says – I say Liar, Liar, Pants on Fire!
- Lies, Damn Lies, and Sovereign Truths: Why the Euro is Destined to Collapse!
- As I Explicitly Forwarned, Greece Is Well On Its Way To Default, and Previously Published Numbers Were Waaaayyy Too Optimistic!
- The state is in its worst cash position in its 200 year history
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.
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.