State Treasurer John Chiang issued a report recently that praises California’s fiscal strides in dealing with debt but also raises warnings that the state is still in the deep end of the debt pool. The issue of debt will be on voters minds as they confront a number of likely ballot issues next year that deal with bonds.

First, the good news from Chiang’s report. The treasurer notes that over the last five years the state has finished paying off economic recovery bonds issued during the fiscal crisis of the last decade, strengthened the state budget rainy day fund, and potentially saved millions with pension reform. All this has lead to increased credit ratings from the credit rating agencies Moody’s, Standard & Poor’s and Fitch.  With the improved ratings the treasurer was able to refinance some of the state’s debt and save taxpayers up to $2 billion.

However, Chiang observed that despite the rise in credit ratings, California still has the third worst credit rating of all the states ahead of only Illinois and New Jersey. He raised concerns about health care and pension costs for public employees that add to the state’s debt.

Chiang, in his report, argued that adding to debt could be a good thing or bad thing depending on how the money is spent. He points to the value of Pat Brown’s State Water Project as a positive use of bonds. But he also warns too much debt can lead to catastrophic circumstances as it did in the cities of Stockton and San Bernardino.

Bonds on the Ballot

State voters will consider adding to the state’s debt in next year’s general election.

Already qualified for the November 2016 election is a school construction bond that came via the initiative process. It is backed by a combination of business and labor. If passed it would allow the state to sell $9 billion in general obligation bonds.

In addition, there is a discussion about another water bond. The argument is that the Proposition 1 water bond of 2014 was not enough to deal with issues related to the drought. The size of this bond proposal is not known. Proposition 1 approved a bond worth $7.1 billion.

There could be more bond ideas coming out of the special session considering ways to improve the roads and other infrastructure. In fact, Chiang touched on infrastructure in his report: “I strongly believe we need to conduct a full accounting of all the state’s capital assets – including its crumbling roads, bridges and levees. We then need to assess the remaining useful life of this deteriorating infrastructure and determine the cost of repairs and ultimate replacement.”

Finally, there likely will be a measure on the November 2016 ballot that will give voters a say on revenue bonds over $2 billion. Voters already have a say in general obligation bonds that are covered with tax dollars. Revenue bonds are repaid with funds generated from the services provided by the projects the bonds are used to build. This measure is controversial and will get much attention.

The issue of debt is once again front and center for California’s voters.

The State of California has found a way to save $270 million — without budget cuts or raising taxes.

State Treasurer John Chiang recently announced that his office had completed the sale of $1.93 billion in general obligation bonds, which will deliver hundreds of millions of dollars of savings to taxpayers. Like homeowners refinancing their mortgage, the overwhelming majority of funds were used to refinance approximately $1.54 billion of existing debt.

“I am very pleased at the result of this sale, which will save taxpayers such a substantial sum over the remaining life of the refinanced debt,” Chiang said in a press release announcing the bond financing deal. “Recent credit upgrades have increased the market’s confidence in the state’s credit worthiness and individual and institutional investors alike continued to demonstrate faith in California.”

Market volatility affects savings

Recent volatility in the stock market, according to Chiang’s office, made the substantial bond savings harder to achieve.

“This is a particularly favorable result, given the tremendous volatility in global equity and debt markets over the past several weeks,” he said. “In the face of this volatility, which saw unusual swings in bond yields, the issue met with good success.”

Earlier this summer, the state treasurer’s office announced that the state had made its final interest payments on the economic recovery bonds approved by voters in 2004.

According to KQED, the state had been paying more than “$1 million a day, every day, for 11 straight years.” Proposition 57, which was drafted at the behest of then-Gov. Arnold Schwarzenegger, adopted $14 billion in borrowing – with roughly $5 billion paid in interest payments and fees.

California’s improved credit rating

Ratings by the independent agencies affect the interest rates paid by the state, and in turn, how much it costs taxpayers to service billions of dollars worth of bond debt. The state’s credit rating for general obligation bonds varies with each of the three major credit ratings agencies.

In July, Standard & Poor’s Ratings Services raised California’s grade for general obligation bonds from “A+” to the higher “AA-.” The upgrade was credited to the state’s swift action on the state budget. In late June, Brown signed a $115.4 billion spending plan less than a week after lawmakers approved an on-time budget.

S&P’s summer upgrade followed a February uptick from Fitch Ratings, which raised the State of California’s general obligation rating to “A+” from “A.” According to the State Treasurer’s office, Fitch welcomed the state’s “continued improvement in its fundamental fiscal position, institutionalized changes to its fiscal operations, and ongoing economic and revenue recovery” as motivation for its credit ratings upgrade.

Moody’s Investors Service, the final of the three major bond ratings agencies, classifies California with an “Aa3” rating. That rating has not changed since June 2014.

California’s Long-Term Debt Picture

As of August 2015, the state has roughly $155 billion in authorized bond debt. Of that amount, $77.4 billion in long term outstanding bond debt has already been issued.

However, the state’s total debt burden is much larger than its outstanding bond obligations. State officials peg the total state government debt at $263 billion, or 12 percent of the state’s $2.2 trillion gross domestic product. The much-maligned, debt-burdened nation of Greece, by comparison, had a debt to gross domestic product ratio of 177 percent – prior to this summer’s implementation of capital controls, according to the Wall Street Journal.

Although the state’s debt burden is nowhere close to Greece, some financial experts caution that deferred maintenance on infrastructure as well as unfunded health care and pension liabilities add to the state’s total debt – raising the debt ratio to 50 percent.

“Of course, the official numbers sit at the low end of the estimates,” argued the LA Times’ Jon Healey. “They leave out $66 billion in deferred maintenance on infrastructure, $31 billion worth of bonds that have been authorized but not yet issued and roughly $10 billion owed to the federal government for unemployment insurance benefits.”

“Even using these worst-case-scenario numbers, though, the state’s debt-to-GDP ratio is less than 50 percent, compared with 175 percent in Greece,” he wrote earlier this year.

The next state general obligation bond sale is expected to occur in October.

Assemblyman Scott Wilk, R-Santa Clarita, introduced Assembly Bill 6, which would cancel outstanding bond funds approved by Proposition 1A, a 2008 voter-approved initiative to fund the state’s high-speed rail project with $9 billion in bonds. In its place, voters would be asked to spend the remaining funds on constructing and modernizing dilapidated school facilities throughout the state.

“Don’t get me wrong, I love trains and would be happy to be able to take one from Los Angeles to San Francisco for ‘dinner and a show’ and back,” Wilk wrote in a recent piece at the Los Angeles Daily News, “but not at the expense of the people of California.”

Before allocating up to  $8 billion for school construction, AB6 first would first pay off the outstanding debts incurred for the state’s high-speed rail project. The bill requires two-thirds approval of the state Legislature and a majority approval of voters.

“Our students deserve to have well-maintained facilities and it is irresponsible to continue prioritizing the crazy train over our schools,” Wilk said, echoing a favorite phrase coined by GOP gubernatorial candidate Neel Kashkari, who on Nov. 4 lost to Gov. Jerry Brown. “The high-speed rail boondoggle has been a proven failure and it’s time we spend taxpayer dollars in a responsible way.”

State Allocation Board: California needs as much as $12 billion for schools

Wilk points to a Jan. 2014 report by the State Allocation Board that contends California needs to devote as much as $12 billion toward new school construction and another $5 billion to modernization of existing facilities. The obscure board, which includes representatives from the governor’s office and the Legislature, couldn’t definitively peg the total cost of school modernization.  Other State Allocation Board estimates put the figure between $5.9 billion and $6.6 billion.

“There is demand for new construction and modernization funding,” the State Allocation Board School Facility Program Review Subcommittee concluded earlier this year. “The Subcommittee did not come to a consensus on a total dollar amount needed for future school facilities or the exact structure of a future bond.”

The committee struggled to identify the state’s total school modernization costs, in part, because “California does not track the number of schools and classrooms available for use. …

“Currently, data on the number of school sites and classrooms and/or the age of the facilities in the State is unknown.”

Wilk: Put schools before bullet train

How likely is Wilk’s idea to gain traction in Sacramento? Brown remained a steadfast supporter of the project during his reelection campaign. However, support is wavering among other Democratic leaders and state lawmakers. Wilk’s proposal to transfer rail funds to schools could provide liberal Democrats a reason to join a burgeoning right-left alliance against the state’s rail project.

CalWatchdog.com contributor Chris Reed, who has reported extensively on the problems with California’s high-speed rail project, noted that one of the  biggest critics has been Kevin Drum, a reporter for the liberal Mother Jones magazine.

Drum has questioned the ridership assumptions produced by New York-based Parsons Brinkerhoff, which claimed “the high-speed rail system could carry 116 million passengers a year, based on running trains with 1,000 seats both north and south every five minutes, 19 hours a day and 365 days a year.” Drum also pointed out the potential conflict of interest: Parsons Brinkerhoff  helped fund the initiative and has a stake in the outcome.

Flaws in California’s use of school facilities

Wilk’s idea is likely to gain support among conservatives and taxpayer groups, who view the state’s high-speed rail project as an irresponsible boondoggle that enriches private companies at public expense. Since 1998, state voters have approved $35 billion in school construction and modernization bonds. The most recent state bond package, $5 billion approved in 2006, has nearly been exhausted, with just $187.3 million remaining for school construction and $142.4 million left for seismic repair.

California’s school facility repair program, much like the state’s high-speed rail project, has faced similar questions about flawed oversight and accountability. School bond funds have been spent to modernize portable school buildings, despite their shorter life spans.

“Some concerns about the current program included whether a portable can be truly modernized, as well as the concern that was also expressed in the new construction section that 30 year funds were being spent on buildings that would not have a 30 year life span,” the State Allocation Board found in its Jan. 2014 report.

Any attempt to shift the high-speed rail bonds to schools would different state political functions to the head of the class. Brown has made the rail project his baby, but also is working on reforming school finances.

The teachers’ unions are strong Brown allies. But in addition to the need for school construction and repairs, the California State Teachers Retirement System needs $4.5 billion a year from the general fund to remain solvent.

With such financial problems ahead on the train tracks, high-speed rail may be a ready candidate for the junk yard.

It seems common sense that bond money approved by a state’s voters would be spent directly on the projects it was intended for.

Unfortunately, lawmakers, trying to find resources to bandage constant budget imbalances, often raid bond funds by borrowing against them to finance other areas of state and local government.

In California, this shuffling is shameless. The state Legislature went so far as to reject a measure by the Republican Senate minority leader that would have prevented it. As a 2013 investigative report by Katy Grimes detailed on CalWatchDog.com, California politicians “are well known for their budget fund shifts, ‘borrowing’ from agencies and funds, and creative accounting gimmicks.”

Voters approve bonds for specific purposes, such as spending on roads, freeways, affordable housing and levees. When politicians transfer the funds among agencies and commissions, they are essentially borrowing against borrowed money, and violating the taxpayers’ intent.

Bond Mismanagement

In 2011, for example, a California state audit found that voter-approved funds for the Santa Monica Mountains Conservancy, which was created by the Legislature in 1980, were going to ineligible programs that had vague missions and opaque budgets. Progress reports and reimbursement claims were “incomplete and inconsistent with grant scopes and budgets.”

The misuse of voter-approved bond money included a range of other expenditures for park and clean-water projects, adding up to a total of $6.4 billion in bond funds. The audit cited notable weaknesses, including “improper management, monitoring, and authorization of fiscal activities,” and “awarding grants or incurring expenditures not in accordance with the Bond Acts.”

That’s a lot of diverted money. It wasn’t the first time the Santa Monica Mountains Conservancy was chastised. A 2004 Department of Finance report found the group had mismanaged bond funds. The conservancy’s chairman at the time, Jerome C. Daniel, was unapologetic: “It bothers me to be questioned about the way we’re doing business, when what really matters is the end result,” he told the Los Angeles Times.

Audits of other local projects in California have shown similar mismanagement. Bond funds from Proposition 40, which totaled more than $120 million allocated for the California State Library Cultural and Historical Endowment, were used to reimburse “unallowable or unsupported expenditures” and pay for facility costs that “were not equitable or properly supported.” Planning grants were also used as a means to fund capital projects, and the CCHE “did not assess the grantee’s financial capacity to complete the project beyond the planning phase.”

Borrowing against bonds is not simply a violation of the public trust. It is also a dangerous balancing game that could end in a fiscal meltdown of state and local government. And it’s technically illegal.

Article 13A of the California Constitution holds that the money must be used for the specific purposes outlined by in the bond measure “and not for any other purpose, including teacher and administrator salaries and other school operating expenses.”

Lack of Accountability

But no one party in the state government has the authority to sanction those who misspend the money. Audits are periodically conducted by the state Department of Finance office that can assign a “corrective action plan.” But the department doesn’t have the authority to halt the misuse of funds or penalize agencies that don’t comply.

And those officials doing the borrowing can point to other government codes to justify their practices. For example, when the Sweetwater Union High School District in San Diego County caught flak in January 2011 for a plan to borrow $58 million against local bond measure funds, district officials pointed to a California Education Code Section 42603, which allows that money in any fund “may be temporarily transferred to another fund or account of the district for payment of obligations.” The district opted not to borrow funds in 2011 because of public pressure, but previously had borrowed $40 million in 2009-2010 and $28 million in 2008-2009, according the U-T San Diego.

Politicians seem to pay little attention to angry local voters. Last year the state Senate passed SB 633, by state Senate Republican Leader Bob Huff, R-Diamond Bar. It would have given the Department of Finance additional authority to issue cease-and-desist orders to state agencies and conservancies found to be using bond funds inappropriately. But it died in the Assembly.

Among the powerful interests that opposed the legislation was the Los Angeles Unified School District. A spokesman for LAUSD said the district hadn’t used bond money for unapproved purposes. But with the billions the district has raised in bond issues in the last several years, it wants to keep its hands untied.

Why aren’t the investors in the bonds up in arms? Under the current law, even if a government body goes bankrupt, bond investors are among the first creditors to be paid, no matter how their investment money is used.

The taxpayers will be the ones on the hook. Yet California voters have taken on billions in debt in recent elections for the high-speed rail system and for improvements in children’s hospitals, among other obligations. “Californians have authorized the sale of $54 billion in general obligation bonds” since 2006, said Huff.

Come 2014, Californians will vote on another bond initiative, one that promises a “safe, clean, and reliable drinking water supply,” according to its namesake. The last time California passed a water bond, in 2006 through Prop. 84, part of that money went to Santa Monica Mountains Conservancy — which, as noted above, misused the funds.

By John Seiler

The state supposedly “balanced” its budget only with the Prop. 30 tax increase. Three California cities declared bankruptcy last year. Businesses keep streaming out to greener pastures. So what does the California Legislature do? Road trip!

Steven Greenhut writes in Bloomberg:

“the state Senate advanced an ill-defined new ‘bond’ plan to provide schools with a fresh source of cash.

“The Dropout Reduction and Workforce Development Bond Act of 2013 is based on social-impact bonds, a creative financing mechanism popularized first in the U.K. as part of the Conservative Party’s ‘Big Society’ effort to use market discipline to improve public services.

“Typically, financing for social-intervention projects is obtained from investors, not taxpayers, and government contracts with nonprofit institutions to do the work. Government gets to borrow money for social programs and shift the risks to investors, who get paid back only if the programs reach certain performance and cost-saving goals.

“But leave it to California’s dominant Democrats to turn a concept designed to apply some measurable standards to hard-to- measure social programs into a shameless effort to grab more money for existing government agencies.

“The legislation promises to ‘revolutionize public education’ by offering three tools. First, businesses can buy bonds ‘and earn a rate of return tied to performance measures.’ Second, those businesses receive tax credits for their investment. Third, the bill creates trust funds in every school district to collect those business investments and other funds to finance expanded career programs.”

Any business “investing” in such an idea should face a shareholder rebellion.

However, the obvious intent is to tie businesses into school financing, providing an incentive for them to support tax increases for schools.

But as with anything in any government budget nowadays, state or local, any new funds only would go to pay for the spiked pensions. This plan truly is “revolutionary” — as in the Bolshevik Revolution, Mao’s revolution, or Pol Pot’s revolution in Cambodia.

Read the rest of Greenhut’s article here.

By Chris Reed

My five-month-old crusade to get the California mainstream media to acknowledge the insanity of “construction bonds” which take 30 years to pay off being used routinely by school districts for short-lived electronics and basic maintenance hasn’t gotten far yet. The most significant article from a respected mainstream education reporter about this outrage came in December from John Fensterwald in EdSource. State newspapers’ education reporters? They can’t be bothered.

Yes, the California media do care about nutty capital appreciation bonds, which can’t be prepaid and delay initial repayments for 20 years out, leading to such ridiculousness as the Poway Unified school district borrowing $105 million that will take $981 million to repay — beginning two decades from now. But the problem of using 30-year borrowing for short-term needs is much worse than CABs. It’s far more common; it’s everywhere.

Maybe what the Los Angeles Unified school board did Wednesday finally will give this issue the attention it deserves:

“During the … meeting, the board also approved {Superintendent John] Deasy’s proposal to spend millions to supply every student and teacher with a tablet computer by 2014. …

“Deasy’s plan to supply all 650,000 students in the district with a tablet computer by 2014 will ultimately cost $500 million. The tablets are supposed to support the transition to Common Core Standards. They are being paid for by revenues raised for school construction bonds R, Y, and Q, which voters approved to address ‘unmet facilities needs.’

“Several school principals spoke during the meeting about a spike in math and English test scores after incorporating tablet apps into their lesson plans.

“Gina Russell-Williams, principal at Curtiss Middle School, said the tablets would help her teachers provide additional intervention and tutorial services to students. Other teachers said teaching students on tablets would allow them to compete with wealthier, smaller, private schools.

“Board member Bennett Kayser abstained from the vote, saying in a statement after the meeting that the process should be slowed down and studied further. No one voted against the measure.”

Is giving kids quality high-tech devices to assist in their education a good idea? Of course.

Is giving kids quality high-tech devices to assist in their education a good idea if bonds to pay for the devices are still being paid off in 2043 — decades after the devices stopped being usable? Of course not. That’s grotesquely irresponsible.

If CEOs did what superintendents did, they’d be in jail

But what would be criminal or subject to shareholder lawsuits in the private sector is just fine in the corrupt world of public education.

The L.A. school board’s actions confirm what I heretofore will refer to as Reed’s Law: Whether in the Legislature or in local school districts, the top priority is always freeing up or increasing revenue to allow tenured teachers to receive the automatic “step” raises that typically are provided for 15 of their first 20 years on the job — just for showing up.

That’s why we see lies about attendance and property tax receipts. That’s why we see grotesque bond abuses. It’s all about preserving the pay status quo for veteran teachers. Understand this, and California politics becomes demystified and uncomplicated.

It’s not “all about the kids.” It’s all about the veteran teachers.

Maybe L.A. Unified spending a half-billion dollars over the next 30 years on iPads that will be broken or stolen by 2016 will finally hammer this home.

By Chris Reed

The push is on to gut Proposition 13, with the nominal rationale being the urgent need to help public education by making it easier to pass parcel taxes. But will the Democratic lawmakers behind this first do anything about two huge education finance scandals? I explore this topic here.

The first is one that got international attention earlier this year after revelations that the Poway Unified School District had borrowed $105 million using capital appreciation bonds (CABs) at a long-term cost of $981 million. Why are CABs so insanely expensive? Because the interest on them builds for 20 years before the district contractually can begin to pay them off. …. 200 California school districts … have used these bonds. ….

[The less-known] second school-finance scandal [is] the increasing practice of districts all over the state of using 30-year “construction bond” borrowing to pay for routine maintenance, short-lived electronics and other needs that are supposed to be paid for by the operating budget [such as] San Diego Unified buying nearly 100,000 laptops and iPads with bonds that won’t be fully repaid until 2039.

“There are restrictions in current statutes,” [state Sen. Mark] Leno said. If 30-year bonds are being spent this way, “they’re not being used as they should. … That’s not a formula that’s sustainable.”

However, state Superintendent of Public Instruction Tom Torlakson said in an interview last month that he considered this use of bond funds understandable because of school budget woes.

On the first scam, I believe that state Treasurer Bill Lockyer’s outrage will lead to constructive change. But Torlakson’s response will be the norm, I predict, in how Democratic elected officials respond to bond insanity no. 2.

Never forget that the overriding goal of the most powerful people in Sacramento — the teachers unions — is preserving the automatic raises that teachers get for 15 of their first 20 years on the job. Few if any California Democrats will stand up to the teachers unions. The few who do are demonized and marginalized.

The result: School districts using 30-year borrowing to pay for graffiti removal will be adjudged to be just fine. Gotta keep those automatic raises coming for teachers.

Editor’s Note: This is the eighth in a CalWatchDog.com Special Series of in-depth articles on municipal bankruptcy.

Nov. 9, 2012

By Wayne Lusvardi

Are the staggering forecasted public pension obligations facing state and local governments in California the result of overspending or under-taxation?

The technical answer to this politically contentious question is: neither.  This is because most cities and counties have deferred both spending and any tax increases for pensions to the future. But starting around 2015 or sooner, bubble pension obligations are going to start showing up with dire consequences to city and county budgets.

What About Vallejo and Stockton?

Sure, cities such as Vallejo and Stockton went on wild spending sprees to build residential subdivisions during the real estate bubble of the mid-2000s.  Such cities hired too many permanent employees. They gave out overly generous salaries and pension benefits.  They expanded the division of labor and created superfluous job positions with lavish compensation packages.  Overreliance on development fees, property taxes and sales taxes from new commercial developments fueled this spending binge. It appeared it would continue forever. But as the saying goes, “If it looks too good to be true, it probably is.”

In 2008, Vallejo’s City Council voted to file for Chapter 9 bankruptcy.  It became the largest California city to ever do so.  Reportedly, the salaries and pension benefits exceeded 80 percent of the city’s operating budget.

The city of Stockton additionally built a new marina, baseball park and sports arena.  None of these projects broke even. Stockton declared bankruptcy last summer.

What mostly threatens future city budgets are the labor contracts that obligate each city to pay out future pension benefits.  Typically such lucrative pensions have been based on unrealistic pension fund investment returns during the real estate bubble. Nonetheless, the California Constitution guarantees such “bubble” pension benefits.  Without legal relief from these constitutional mandates, many cities may be facing:

* Court approval for any pension reductions;

* Employee layoffs;

* Having to roll existing, approved pensions benefits into risky taxable pension obligation bonds that end up costing double due to paying interest on the bonds plus taxes;

* Ultimately bankruptcy.

Why Spending Was Invisible During the Bubble

About 80 percent of a city’s general fund budget goes to salaries, based on data from the California League of Cities.  Pensions only encumber roughly 5 percent to 10 percent of most city or county operating budgets today, according to Howard Cure, director of Municipal Bond Credit for Evercore Financial Management in New York.  Payment of long-term debt for capital projects — bonds — typically takes up another 5 percent to 10 percent of a city’s budget.  Cities usually set aside 10 percent of gross revenues for reserves. Future pension liabilities don’t usually show up in a city’s operating budget until the benefits need to be paid out.

But if pensions grow to 20 percent or higher, then there is a fiscal — or budget — insolvency crisis at hand, as shown in the simplified table below.

How Pension Bubble Causes City Budget to go Upside Down

As you can plainly see in the above table, the cost of the pension bubble does not show up on a city budget until after the real estate bubble. This is because pension spending is in the future. So it gives an illusion that increased hiring levels and lavish pension benefits are sustainable. Current pension benefit obligations in California are “eventually unsustainable,” according to Cure.

Alternatives to Bankruptcy Aren’t Much Easier 

The city of Costa Mesa is an example of what happens in a post-bubble economy.  In 2011 it had to lay off 50 percent of its employees because pensions were going to rise to 20 percent of the city budget by 2014.

The city of San Jose has chosen a different route than layoffs. On Dec. 6, 2011, the city council voted to put a pension-reduction measure on the June 2012 ballot. Part of the proposed San Jose deal would reduce pension levels in return for job security.

The constitutionality of such measures is likely to end up in court and would eventually set a precedent for what is going to happen all over the state.  If the courts uphold existing, guaranteed pension levels, then there is a much greater prospect that cities would end up seeking Chapter 9 bankruptcy as their only way out of unsustainable pension obligations.

The city of Pasadena has decided to refinance its existing police and firefighter pension plan and roll it into a $65 million pension obligation bond.  Because it is an existing pension plan, the refinancing doesn’t require voter approval. The city must also make a balloon payment of $81 million in 2015 to keep the pension plan afloat.

Pasadena is a wealthy city. It had nearly two-thirds of a billion dollars — $666,000,000 — in budget reserves, investments and cash in early 2008.  But now it is running a $20 million deficit in its special revenue fund to renovate the Rose Bowl.  This could end up tapping the city’s general fund. Pasadena now wants to at least temporarily bring a National Football League team into the Rose Bowl to bail itself out. As real estate developers often say when the economy turns down, “The only way out of a hole is to build out of it.”  But should government be in the “spec” real estate business?

Some cities have had to turn to speculative recreational development to hopefully generate a tax base to bail themselves out of their self-created pension crisis.  For example, Stockton is stuck with a bunch of revenue-generating recreational projects with a negative cash flow. The proverbial rule, “If you have dug yourself into a hole, stopping digging,” seems to apply here.

Playing the Rate Spread With Pension Obligation Bonds

Much as sports betting plays the point spread between football teams, cities have gambled the interest rate spread to pay off unfunded pension liabilities.

According to the State Legislative Analyst, since 1963 more than two-dozen cities and counties in California have issued taxable pension obligation bonds to pay off their unfunded liabilities in a lump sum. Payments to the bondholders substitute for payments into the pension fund.

The difference in interest charges between the pension system’s higher assumed rate of return — say, 8 percent — and the interest rate on the bonds — say, 5 percent — supposedly generates savings for the city.  Thus, a city with a pension obligation bond does not have to generate around an 8 percent average rate of return.  It only has to pay off a bond at, say, 2 to 5 percent interest, plus taxes.

This is also called arbitrage and typically is forbidden with the use of tax-exempt bonds.  But pension obligation bonds are taxable, which adds to their cost to the taxpayers.

Courts have upheld that pension obligation bonds do not require voter approval.  This is because they reflect the replacement of an existing debt with another debt.  This is also called refinancing. The State Legislative Analyst’s Office states, “Incurring debt for operating costs is ill advised.”

California Pension Obligation Bonds –POB’s

(Source: Hewitt Associates, the Segal Company, Deloitte Consulting, 2009.)

One of the problems with municipalities playing the interest rate spread is that the expected rate of return on pension fund investments — historically around 8 percent — is risky. The 8 percent is a rate before monetary inflation. The goal is to generate a net rate of return after inflation of around 5 percent. But today the U.S. Federal Reserve Board has lowered effective interest rates on Treasury Bills to near zero. T-Bills set the benchmark for interest rates on municipal bonds and other investments.

In a near-zero interest rate environment, the 8 percent target interest rate of pension investments is unrealistic. During the real estate bubble, 8 percent was considered a typical average return rate partly because most investments were puffed up by debt and high leverage (little or no down payment). But leveraging is also a thing of the past.

A recent bond issue of a taxable state bond provides an example. On Dec. 16, 2011, the state issued a $4.4 million “California State Taxable Bond — Variable Purpose.” It yielded 5.68 percent and matured in 2036 — a 25-year bond.  The 5.68 percent indicates a 2.32 percent spread from the 8 percent benchmark rate.

But inflation is running 3.5 percent.  So is there really an advantageous spread between a taxable pension bond and an estimated 8 percent return from a pension investment fund?  Has the interest rate spread gone poof? A report issued Dec. 9, 2009 by Hewitt Associates, the Segal Company, and Deloitte Consulting, “Perspectives on Pension and Retiree Health Obligation Bonds,” questioned the advantageousness of the spreads on this type of bond.

Perhaps this is why the quoted return rate on CalPERS and other pension fund investments is asserted to be 7.5 percent.  If it were lower, it would indicate little or no advantage to issuing taxable pension obligation bonds. Thus, the only apparent advantage to a pension bond is that it is exempt from voter approval.

All of this may explain why Moody’s bond rating service is starting to treat pension liabilities like bonds. Previously, pension liabilities only influenced the yield rate on bonds.

So we may see many cities turn to high-risk pension obligation bonds to bail themselves out of their pension obligations. However, it should be understood that pension obligation bonds are for municipal “high rollers.”

How Did California Get Into This Mess?

So, how did California local governments over-commit future revenues?  The suspects as to what is causing the emerging municipal budget crisis are:

* SB 400. Senate Bill 400 passed the Legislature in 1999 and was sponsored by then-Assemblywoman Deborah Ortiz, D-Sacramento. It retroactively increased the formula for government workers’ benefits based on the “superior return on system assets” of the California Public Employees’ Retirement System — CalPERS. SB 400 was initially passed in the California Legislature by an overwhelming majority of both parties.

* According to the Reason Foundation, the extra benefits provided by SB 400 will add $3.5 billion in pension costs in 2011, or about one-sixth of the $20 billion structural state budget deficit.

* Boom in Public Employment. Costs of government have soared in many ways. Since 1998, California’s government work force has grown by 31 percent, to 356,000 workers.  The state population grew by about 12 percent over that same time.

* Boom in Public Employee Compensation. The cost to the state general fund for California’s government pension and retiree health and dental care costs have increased five-fold, from about $1 billion in the 1998-99 fiscal year to $5 billion in 2010. According to the Reason Foundation, state retirement spending is expected to triple, to $15 billion, within the next decade. That tripling will crowd out funding for other public services in the state budget, some of which flow to local government programs.  The future $10 billion increase in pension costs would increase the structural state budget deficit to $30 billion.

One third of San Francisco city workers have salaries at $100,000 or higher. At the Metropolitan Water District of Southern California, 69 percent of the workers make $100,000 per year or higher; 89 percent make $75,000 a year or higher.

The salary abuses at the city of Bell are now legendary, where the city manager earned a compensation package in excess of $1 million.  Public compensation has grown out of control in most municipalities.

* Puffed Pension Benefit Packages. In 1960, 5 percent of government employees received “public safety” pensions funded at 90 percent of their ending salary rather than the typical 60 percent funding. Today, 33 percent of employees receive the premium public-safety benefits originally intended only for firefighters and police officers.

California is the sole state that uses a pension benefit formula based on the last year of service, while most states use three-year or five-year averaging formulas that limit pension spiking. The one-year final salary rule was implemented in 1990 in California under Senate Bill 2465, by state Sen. Cecil Green, D-Norwalk.

* Move To Providing Luxury Public Services. While the real-estate bubble was inflating, cities went wild with spending on all kinds of inflationary luxury goods: open space acquisitions that inflated the market price of housing; luxury affordable housing projects in upscale locations near light-rail stations; malls that replaced mom-and-pop businesses with upscale chain stories and with markets with unionized employees; public subsidized urgent care centers to relieve congested hospital emergency rooms;  subsidized restaurant business incubators, etc. You name it; cities funded it.

But these luxury public goods are often empty jobs programs. As William Voegeli writes in an article in City Journal, “The Big Spending, High Taxing, Lousy Services Paradigm,” “Whatever theoretical claims are made for imposing high taxes to provide generous government benefits, the practical reality is that these public goods are, increasingly, neither public nor good: their beneficiaries are mostly the service providers themselves, and their quality is poor….

“It’s true that many people are less sensitive to taxes and more concerned about public goods, and these consumer-voters will congregate in places with extensive services. But it’s also true, all things being equal, that everyone would rather pay lower than higher taxes. The high-benefit, high-tax model can work, but only if the high taxes actually purchase high benefits – that is, public goods that far surpass the quality of those available to people who pay low taxes.”

State and local government got into the business of providing luxury public goods to replace the loss of industrial jobs due to de-industrialization. Without the real estate bubble, which brought in record tax revenues, the wild spending spree by local government would have been more apparent. Instead, at the time, it was seen as just another California gold rush that would go on forever.

Not to be outdone by the cities and counties, the state of California also rushed into providing luxury affordable housing; duplicative stem cell research bond financing; five water bonds totaling $18.7 billion that mostly went for open-space acquisitions; and landscaping and aesthetic water habitats around upscale residential communities. California got few new water resources added to its water supply for that $18.7 billion. The voters bought into the social marketing of these programs by voting for bonds at the ballot box to fund them, without concern about the ability to pay them off in the coming economic downturn.

The Bottom Line

California cities, technically, didn’t tax and spend themselves into the pension ditch they find themselves in.  They kicked the can down the road to the future. The future is now.

Lusvardi writes for CalWatchDog.com

By Chriss Street

Last week, we first reported first that “Permanent Link to Calif. sales tax revenue nosedives 33.5%,” then that “Moody’s warns of mass Calif. municipal bankruptcies.”

During the Great Recession of the last four years, the California private sector was forced to slash employment and infrastructure spending, but the public sector made only modest cutbacks. Much of this state and local spending was funded by selling municipal bonds to elderly investors who were told the “muni market” was safe because the default rate is very low.

Now a new Federal Reserve Board study, “The Untold Story of Municipal Bond Defaults,” debunks the belief that municipal bonds are safe investments and blames the Moody’s and S&P credit rating agencies for deceiving the public. This is sure to fan the flames of the growing panic among holders of California municipal debt. According to the August 15 report:

“The $3.7 trillion U.S. municipal bond market is perhaps best known for its federal tax exemption on individuals and its low default rate relative to other fixed-income securities. These two features have resulted in household investors dominating the ranks of municipal bond holders.”

Individuals own three quarters of all municipal bonds; with $1.879 billion held directly and another $930 billion through investments in mutual funds.  The Fed report emphasized that the perception of a low historical default history of municipal bonds has played a key role in “luring investors” to buy huge amount of municipal debt.

The Fed specifically points out that the perception of low default rates is due to widely advertised reports of low default rates by credit-rating agencies.  But the Fed determined the credit-rating agencies have not told the whole story about the level of municipal bond defaults.

Default records

Moody’s Investors Service and Standard and Poor’s (S&P), the two largest bond rating agencies, provide annual default statistics for the municipal bonds.  S&P reported that its “rated” municipal bonds defaulted only 47 times from 1986 to 2011.  Similarly, Moody’s indicated that its “rated” municipal bonds defaulted only 71 times from 1970 to 2011.  This compares much more favorably to the record of thousands corporate bond defaults during the same period:

But when the Fed tracked default listings from 1970 to 2011 through the Mergent and S&P Capital IQ data bases available to institutional investors, the municipal default rates during the same periods skyrocketed from 71 to 2,521 for Moody’s and 47 to 2,366 for S&P.  The Fed calculated that there were a total of 2,527 municipal bonds that defaulted from the late 1950s through 2011 — confirming that the real rate of municipal bond defaults was 36 times higher than Moody’s and S&P reported to the public.

The Fed warned that information regarding municipal bonds tends to be “self-selected.”  Issuers stop seeking an annual rating from Moody’s and/or S&P, if their bonds are likely to not receive an “investment grade” rating.

The Fed also determined that “the municipal market is bifurcated into general obligation (GO) bonds and revenue bonds.”  GO bonds carry a full faith and credit pledge of a state or local government, but revenue bonds are backed by a pledge of revenues raised from a specific enterprise, such as an airport, hospital, or school.  According to the Fed, over the past 16 years, 60 percent to 70 percent of newly issued municipal bonds were revenue bonds.  Many of these projects appear to be politically justified to bankroll crony capitalist “sustainable” investments as industrial development bonds.  IDB financings often involved new technologies or projects with no historical track record. The Fed wrote:

“the services offered by an alternative energy plant, pollution control facility, or other corporate-like entity may not be considered essential, because of the availability of other energy sources. Thus, these enterprises may have less potential to generate revenue.”

Culpable

The bottom line of the Fed report is Moody’s and S&P are culpable for understating the risks to investing in the municipal bond market.  Within 48 hours of the release of the Fed report, Moody’s acknowledged 10 percent of California cities have declared fiscal crises and disclosed that “across-the-board rating revisions are possible following a review of our ratings on California cities over the next month or two.” Based on the Fed report and Moody’s reaction, California and other municipal bondholders should be panicked.

Chriss Street and Paul Preston Co-Host
“The American Exceptionalism Radio Talk Show”
Streaming Live Monday Through Friday at 7-10 PM
Click Here to Listen:  http://www.mysytv.net/kmyclive.html

By John Seiler

If you’ve ever lived in Washington, D.C., as I did in 1977 and from 1982 to 1987, you know the place lives under a bubble. They have no idea what’s going on in the rest of the country. But they tell us what to do.

That’s sure the case with E.J. Dionne, the Washington Post’s top political writer. From a San Francisco dateline, he asks:

“If the United States were still governed under the Articles of Confederation, might California be in the position of Greece, Spain or Italy?

“After all, California has a major budget crisis and all sorts of difficulties governing itself. Its initiative system allows voters to mandate specific forms of spending and to limit tax increases and also make them harder to enact. Absent a strong federal government with the power to offset the impact of the recession and the banking crisis, how would California fare in a global financial system?”

He doesn’t seem to know that, unlike in those countries, California law mandates that bond payments are the first priority of payment in any budget. So the state’s current $73 billion in general obligation bonds (meaning they must be paid for from the general fund) are quite secure.

It’s true that California vies with Illinois for the state with the worst credit rating. But that’s because, should the national economy begin to implode, it is these state economies that would be hit the hardest, demolishing their state budgets. But so long as the national economy doesn’t implode, that won’t happen.

Bond rating

So the real problem then shifts to Dionne’s beloved federal government, which has taken out $16 trillion in debt in the name of all Americans. If the Articles of Confederation still were in effect, the federal government never could have run up that debt.

Under the Articles, Congress had no power of taxation. The federal government ran only on money given it by the several states. So the federal government never could have grown into the monstrosity it has become, wasting $3.8 trillion a year while running up trillion-dollar annual deficits.

On its own, California’s far-left politics would not be tempered by the more moderate politics of the rest of the United States. So it might resemble Cuba.

Then again, Canada is run by left-wingers — but lefties who figured out about 15 years ago that they could only manipulate society if reasonable tax and regulatory policies keep the economy growing. Same thing for Australia.

California’s large Latino population also pushes its politics to the left. But as an independent country, California might resemble Mexico; which, as I noted in an earlier article, has less than half America’s national debt (as a percentage of its economy) and has pursued progressively more free-market policies since 1995.

So, by itself, California might develop a hybrid Canadian-Mexican system with lower taxes and less regulation, but maybe a government-run medical system that’s inefficient (as in Canada, where there are long lines and people go to the United States for many operations), but costs half as much.

Dionne’s ‘solution’

Dionne’s “solution” the the ongoing economic problems of California and the United States is … the suspense is unbearable … massive new federal government spending! So the deficits and debt now weighing us down would be increased. Dionne:

“First, we are lucky to have a robust federal government, which the European Union lacks. Early in the recession, the feds were able to offset problems in the country’s most troubled regions with a stimulus program (and also with that auto bailout that so many, including Mitt Romney, opposed). The stimulus should have been bigger, and it should have extended over a longer period. But it helped.”

First, the opposite is true. There never was any recovery. Certainly not in California, where unemployment remains at 10.8 percent.

The bailouts didn’t work. GM would have been better off if its assets had been auctioned off. By now it would be a strong, independent company. Instead, taxpayers lost about $14 billion in the bailouts of GM and Chrysler.

Worse, the GM bondholders were ripped off so that the UAW could get a piece of the action. This set a dangerous precedent and undermined every business bond in the country, disrupting capital formation — and so business and jobs formation. Now, no one’s bonds are secure.

How D.C. looks at California

On California, Dionne naturally likes Gov. Jerry Brown’s proposed $8.5 billion tax hike:

“Moreover, Gov. Jerry Brown deserves credit for trying to get a handle on the California budget crisis. He’s going to the voters this fall with a referendum to raise about $8 billion in taxes to stave off further cuts. Without the money, Brown says, education spending would have to be slashed beyond the cutbacks that have already taken effect.”

Actually, Brown deserves no credit. The tax increase would chase even more businesses and jobs from the state. He also offered only a paltry reform of the state’s underfunded pension systems. And the problem with California’s education system is not a lack of spending, which is generous, but severe structural and pedagogical defects, with the powerful California Teachers Association and the California Federation of Teachers impeding reforms.

Dionne’s view is important because it gives us Californians a glimpse into what our masters in D.C. are thinking about us — and are preparing to do to us.

Maybe the good old Articles of Confederation weren’t such a bad idea after all.