Special Series: Bond Holders Seek Governmental Transparency
MARCH 20, 2012
By DAVE ROBERTS
Once upon a time buying a municipal bond was considered a safe bet. A decent rate of return with little risk – just the thing for junior’s college fund and grandma’s retirement account. But that was before Standard & Poor’s downgraded the U.S. government’s credit-worthiness, sending shock waves through the bond markets. And before governmental agencies increasingly defaulted on loans and threatened or declared bankruptcy, converting safe securities into junk.
That’s potentially a lot of junk. Investors hold nearly $3 trillion of municipal debt in the United States.
Municipal bond holders have become concerned that they can’t get access to adequate financial information from governmental agencies about their credit-worthiness. Many are senior citizens who may know members of their city council or water board. In the past, the citizens blindly trusted in the fiscal soundness of government, considering it a safe place to park their money without having to worry about pouring through bond offering reports, prospectuses and audits.
One of those investors receiving a wake-up call is Irv Siminoff, a World War II veteran who served in the Pacific Theater and began investing in municipal bonds in the early 1980s to provide a stable income for his son’s tuition at Stanford.
“I started out investing in Wall Street right out of college, and in those days things were pretty calm,” he told the Securities and Exchange Commission at a hearing last year in San Francisco. “One could get 5 to 6 percent in dividends and could reasonably expect maybe a 5 to 10 percent annual return from the underlying corporation. In addition to income from my equity portfolio and my growing business, muni bonds seemed like an ideal, good security, a given income and investment return at some time in the future at a scheduled date. Boy, was I naive.”
‘Looked Really Safe’
His first municipal bond investment was in the Washington Public Power Supply System. It was not insured, but, he said, it “looked really safe. What could be better than revenue from power?” He wound up losing half of his money after delays, cost overruns, mismanagement and political opposition to nuclear power resulted in WPPSS defaulting on $2.25 billion in construction bonds. Investors and the public were largely kept in the dark about the problems. Siminoff was luckier than some investors who only received 10 cents on the dollar.
He then shifted his account to Drexel Burnham Lambert and bought bonds that turned out to be secured by nothing more than raw land and an Oklahoma hospital center that was on the fast track to bankruptcy. Bankruptcy is also where Drexel wound up after its illegal activities in the junk bond market were discovered. “Looking back, these deals were sold on projections, not on established facts,” said Siminoff. He got similarly burned on Mello-Roos bonds that were based on pie-in-the-sky projections.
While Siminoff was naive at the outset, even sophisticated investors can suffer from insufficient knowledge about the risks in these supposedly safe investments. Peter Kuhn, a former accountant for Price Waterhouse whose wife calls him a “municipal bond geek,” bought from a professional trader a general obligation bond issued by the Hayward School District, getting a very good yield. “However, Hayward is having some financial challenges, and their certificates of participation were just downgraded to nearly junk, if not junk status,” he said.
Lack of Information
A lack of up-to-date governmental financial information was a common complaint at the SEC hearing by both individual and institutional investors.
“The municipal securities market lacks many of the basic investor protections that exist in most other sectors of our capital markets,” said Andy Gill, senior vice president at Charles Schwab. “It is time for this circumstance to change, beginning with an improved disclosure regime that will boost investor confidence and improve access to information about the municipal securities market. Financial reporting by municipal issuers can take up to 270 days to reach an investor.
“This information lag is particularly worrisome because, for many investors, bond assets provide stability and income generation, the most critical portion of an individual investor’s assets.”
Institutional investors have an advantage because they are exclusively treated to investor road shows in which bond issuers may provide financial information that never appears in financial statements, according to Mary Colby, representing the National Federation of Municipal Analysts. But they share the complaint about being kept in the dark.
“Given that most issuers only undergo audits annually with a substantial lag after the end of the fiscal year, this often results in fairly stale financial information being included in offering documents,” said Colby. “While this situation has improved in the last few years, perhaps in response to the financial crisis, it is still fairly common to see an official statement that only includes audited financials that are six to nine months old.”
The situation is even worse in the secondary market in which bonds are resold; for example, Chicago takes 13 months to file its financial information. A lot can go wrong financially for a government agency in the meantime.
“During the current recession, many state and local governments experienced double-digit declines in revenues, including sales taxes, personal income taxes, property taxes and mortgage recording taxes, among others, all of which separately or jointly secure tax exempt debt,” Colby said. “Investors during the period were often left relying on financial information gleaned from newspaper articles, because secondary market disclosure lagged so substantially and was so infrequent. The municipal market contrasts very poorly with the corporate sector where quarterly disclosure is the norm.”
In addition to late filings, many small-to-medium sized government agencies provide incomplete information when they do file.
“Often after a few years, the filings may shrink to only the audited financials – and the additional items of information disappear,” said Colby. “These items may range from annual updates for assessed valuation, property tax delinquencies and tax appeals — all of which are critical for assessing a general obligation bond — to operating information for a water and sewer system or sales tax collections, all of which are vital to a thorough analysis of associated bonds. There are numerous issuers currently under financial stress about whom newspaper articles frequently appear, but who have not released any updated financial information.
“While some might argue that the filings are an unnecessary burden, given their low rate of default among municipal general government issuers, we feel strongly that the issuers have availed themselves of the benefits provided by issuing debt in the public market and must be prepared to follow through with the promises they have made to investors to provide complete and timely information.”
A lack of transparency and deceptive practices were unveiled in the Los Angeles Community College District’s $140 million bond construction program. An audit by state Controller John Chiang released in August 2011 concluded that the district “could not produce complete and timely records, spent funds outside voter-approved guidelines, ignored its own procurement rules, failed to plan effectively, and provided poor oversight of bond funding. Shoddy fiscal management and sub-par oversight of a project of this magnitude will undermine the public’s trust and threaten billions of public dollars.”
Problem? What Problem?
But to listen to the government representatives at the SEC hearing, you would not think there was any problem. They argued that, as public entities, they are even more transparent than private corporations.
Said California Treasurer Bill Lockyer, who manages a $67 billion investment pool of state and local funds and annually issues more than $30 billion worth of debt, “As both investor and issuer, we’re responsible for protecting the public trust and adhere to the highest standards of transparency.”
Lockyer had a complaint of his own about the ratings provided by S&P, Moody’s and Fitch, which have pegged California’s general obligation bonds in the A-minus to A1 range. The A-minus score ranks California tied for last with Illinois, or second worst behind it, among the states in credit worthiness — and that rankles Lockyer.
“There’s been historic discrimination in public issues compared to corporate issues,” he said. “Municipal bonds rarely default. A study by S&P revealed that 0.33 percent of municipal bond issues rated A-minus defaulted during the last 15 years, while corporate issuers rated A-minus had an average default of 3.16 percent. So, 100 times more likelihood of default, but same rating.
“That discrimination costs taxpayers a lot of money because our cost of issuance goes up, and it’s unfair to investors to not be able to accurately compare the choices that they would be making.”
Fair or not, the credit agencies’ ratings can negatively affect the municipal bond market, particularly the sector tied to federal debt. Moody’s recently warned 177 municipal issuers with high exposure to federal funding about possible downgrades, including 162 local governments in 31 states, 14 housing finance programs and one university, according to Wells Fargo Wealth Management. The company advises investors to be wary of these issuers, particularly bonds issued by Virginia, Tennessee, South Carolina, Maryland and New Mexico.
But as bad as that seems, the problem actually may be much worse, given the under-reporting of unfunded pension and retirement health care liabilities for state employees. Taxpayers may be on the hook nationwide for more than $2.5 trillion in pensions, according to David Crane, a registered Democrat who has been an economic advisor to former Republican Gov. Arnold Schwarzenegger, with perhaps $500 billion of that in alifornia alone.
“State and local governments utilize a misleading method for reporting the size of public pension obligations,” said Crane, calling it “the Alice in Wonderland world of government pension accounting that allows governments to hide liabilities.”
The California Public Employees Retirement System, the largest pension fund in the nation, voted in March 2011 to keep its discount rate at 7.75 percent, despite a recommendation from its actuary to lower it to 7.5 percent. The rate reflects what the fund expects to earn on its investments over 20 years, allowing it to reduce what it owes by what it expects to bring in. In the past 20 years, CalPERS has earned an average 7.9 percent rate of return, despite the Great Recession.
“According to our actuaries, maintaining our discount rate at its current level is prudent and reasonable,” said CalPERS Board President Rob Feckner. “Given the current economic environment, we believe keeping our discount rate unchanged is in the best interest of our members, employers and taxpayers.” Despite his recommendation to lower it, Chief Actuary Alan Milligan went along with the status quo, saying, “The discount rate adopted is reasonable and achievable, and appropriate for funding the promised benefits.”
CalPERS was especially hurt by the market crash of the summer of 2011. CalPERS, which has 49 percent of its investments in the market, lost $17.5 billion in just five weeks, representing 7.4 percent of the $237.5 billion balance it reported on June 30, as reported by Calwatchdog Managing Editor John Seiler on August 9, 2011. Some of that has been restored. But as of December 12, 2011, the fund’s value stood at $238.3 billion, up not even a billion dollars from the June 30 amount.
Crane considers a 7.75 percent discount rate a misrepresentation of reality, and provides the following example:
“Suppose an individual wears two hats. One is a just-retired government employee entitled to pension payments from the state government, and the other is an investor in a general obligation bond issued by that very same government. Assume the pension payments and the bond payments are unconditionally owed by and fully recoursed to the government.
“Suppose further that the pension payments and the bond payments have identical profiles. For example, suppose that both require a payment of $30,000 per year for 25 years. Also with respect to the bond, assume that, at the interest rate at which it was issued to the retiree, the government would record a present value obligation of $425,000. With respect to the pension payments, that very same government would record an obligation of only $320,000. Now how can that be? Two identical, fully recoursed and unconditional obligations owed by the same government are valued at different amounts.”
In March 2012, CalPERS bowed slightly to reality and dropped its discount rate to 7.5 percent from 7.75 percent.
Overstating the pension fund’s ability to cover its liabilities can lead to expensive mistakes. Such as what occurred in 1999 when CalPERS reported that its fund assets equaled 128 percent of liabilities, when a more realistic discount rate would have put assets at only 88 percent of liabilities, according to Crane. That imaginary surplus led the legislature to increase employee pension promises, which could result in an additional $150 billion hit to the state budget, he said.
“California wasn’t alone in this regard,” Crane told the SEC. “Unrealistic reporting of pension promises is a systemic problem. That’s why the SEC must require realistic accounting of public pension promises. For that to happen it must insist upon a realistic discount rate when reporting pension liabilities.”
A month later Crane took his case to the Governmental Accounting Standards Board, which is considering revising the accounting rules for pension funds. A decision could be made sometime in 2012. It remains to be seen whether the SEC will revise pension reporting rules, but there’s a chance it will seek more openness in governmental financial reporting.
“There seems to be a disparity between the level of information that institutional investors in this market are able to obtain compared to what a typical retail investor can access, and that’s a serious concern for all of us, particularly for me,” said SEC Commissioner Elisse Walter, who chaired the hearing. “And while I would not want to see a door shut on institutional investors obtaining the information they need to make sound decisions, we can’t close our eyes to the fact that retail investors are really in need of the same types of information. As in so many areas, improving investor education and financial literacy about issues of risk, whether it’s credit risk, default risk, interest rate risk, always has to be a high priority.”
Walter also acknowledged Crane’s concerns, saying, “Disclosure of accounting for pension and other post-employment liabilities is quite complex and implicates serious public policy issues.”
In late July 2011 the SEC wrapped up its field hearings around the country on the municipal securities market. It is preparing a report with recommendations for further action, which may include changes in rules and industry best practices as well as legislation by Congress.
Roberts is a contributing editor to Calwatchdog and a long-time Bay Area newspaper reporter.
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